Before passive and quantitative investing gained prominence, stock picking was the holy grail of fund management. The reality however was that actively managed funds seldom beat the index. However, for several reasons, individual investors may still want to consider a stock picking strategy alongside other investment products in their portfolio.
Trading commissions are much lower than they used to be, and retail investors have access to more information and tools than ever before. Buying individual stocks can offer another way to diversify risk and generate alpha. In this post we discuss the pros and cons of stock picking and how to pick stocks with good odds of beating the market.
- What is stock picking?
- How to define your investing goals
- Stock picking best practices
- Risk management when picking stocks
- Is stock picking better than passive investing?
- Picking stocks based on sentiment data
- Advantages & disadvantages of stock picking
What is stock picking?
Stock picking is the process of actively selecting stocks you expect to outperform the market. If you are happy to earn the market’s return, or beta, you can simply buy an index fund. However, to make excess returns, known as alpha, you will need an active strategy. This will entail investing in an actively managed mutual fund, a hedge fund, or selecting individual stocks.
Stock pickers typically make decisions based on fundamental analysis. However, quantitative and technical analysis is increasingly being used to rank and filter stock picks. Stock picking is most commonly associated with long-only funds, but hedge funds use similar methods for short selling stocks.
How to define your investing goals
Individual investors often pick stocks without clear objectives. That is fine if you are investing money you can afford to lose. However, if you are investing long term savings in your stock picks, you need investment goals. You also need a way to measure your performance and manage risk.
It’s a good idea to start by allocating a small portion of your total portfolio to stock picking. The objective is to beat the market, so you should prove to yourself that you can do so before allocating the bulk of your capital to stock picking. There are two approaches you can take to allocating capital and measuring your performance.
If you plan to manage a broad portfolio of large-cap stocks, then your stock picking portfolio could start out at 10% of the total portfolio. This would be part of your general equity holdings, the rest of which could be in an index fund. The MSCI world index or the S&P 500 index are both excellent proxies for the overall stock market. You could invest the rest of your general equity portfolio in an exchange-traded fund that tracks one of these indices. You can then use the same index as your benchmark.
Alternatively, you can specialize in specific sectors, small caps, emerging markets or region stocks. In this case, you should start out with an even smaller portfolio. You should use two benchmarks – one relevant to the types of stocks you are buying, and one general benchmark. You should be aiming to beat both to justify your stock picking program. If your stock picking proves successful, you should increase the allocation slowly. If your active portfolio outperforms, its share of the total portfolio will increase automatically, so you shouldn’t need to switch much capital to it.
Stock picking best practices
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price” – Warren Buffett
If you are looking for short term gains, market dynamics like momentum, volume, news flow, and sentiment can all be critical. Almost any stock can move 10 to 30% higher in the short term given the right environment. These can be oversold stocks, turnaround plays, cyclical stocks, or stocks that have experienced corrections.
A stock can rally over a period of months based purely on speculation and sentiment, without the company’s performance playing out as expected. Stock picking for the long term is different. Over a period of more than a year or two, a company must generate revenue and at least show the potential for profitability. Evidence of growth and profitability must also justify the stock price and valuation.
For the most part, growth companies make the most sense for a stock-picking portfolio. There is more potential to beat the market with companies that are compounding growth rates of 20% and more. The other area to consider is dividend growth stocks. These are companies that are growing their dividends rapidly. This can increase the yield on the initial investment very quickly. The following are some of the essential traits to look for in a potential stock pick:
- Growing market: It is easier for a company to increase its profits if it operates in a growing market, rather than having to fight for market share in a static market.
- Industry leader: Over time, most of the value in an industry accrues to the company with the leading product or brand. Tracking the relative strength of each company in an industry is an excellent way to find the industry leader.
- Profits: Some companies never manage to earn enough profit to justify the risk of investing in them. Look for companies with a ROE of 15% or higher, or a realistic path to get to that level.
- Good management: Most great investments are companies run by visionary and charismatic leaders. Look at the CEO’s track record when researching a company. Avoid companies with questionable corporate governance.
- Simple business model: If you cannot understand the business model and how the company makes money, there may be a reason. Companies with complex business models are often hiding the fact that they cannot make money.
- Debt: Companies in different industries use different levels of debt. It’s best to avoid companies that use substantially more debt than their peers.
How to determine a reasonable price to pay for a stock
When it comes to the price you pay for a stock, there is a trade-off to be considered. The return you earn from a stock pick will depend on the price you pay for it, and how the company’s fundamentals play out after that. Very often, you will have to pay a higher price to buy a stock that goes on to grow its earnings. The better the company’s prospects, the more you should be prepared to pay. However, there should also be a limit to what you will pay.
High-quality growth companies usually trade on far higher PE multiples than the broad market. The PEG, or PE to Growth, ratio can give you some perspective. Market-leading growth companies typically trade on PEG ratios of 2 to 5. Within that range, the higher the ratio, the more conviction you should have about the company’s ability to grow for at least three more years. A PEG ratio above five should be treated with caution.
The other ratio to consider is the price to sales ratio. Most growth companies trade at 3 to 7 times revenue, and you should be cautious about paying more than that. Finally, you can look for companies with consistent earnings growth. This usually means recurring revenue and growth that is steadily compounding.
Risk management when picking stocks
When it comes to managing risk when stock picking, perhaps the first thing to remember is to be realistic. You won’t get it right all the time. Peter Lynch, regarded as one of the best stock pickers ever, said that “if you’re great in this business you’re right six times out of ten.” Lynch also said you should “let your winners run and cut your losers.”
You should plan for quite a few investments to go against you. Also, you should make sure that your winning trades are big enough to cover the losers and still give you a return. One of the best ways to protect your portfolio in case your stock picks don’t work out is diversification. Your stock-picking portfolio should be just one part of a broader portfolio. Diverse asset allocation to index funds, other asset classes, and alternative investments like hedge funds will reduce portfolio risk.
Within a stock picking portfolio, you should limit initial investments to no more than 5% of the portfolio, and they should never be allowed to grow to more than 10% of the portfolio. If this portfolio is 10-20% of your overall portfolio, you will be limiting the overall risk on each stock to no more 2% in each stock. In the case of smaller companies and companies with volatile price action, position size should be even lower.
Is stock picking better than passive investing?
Wall Street doesn’t have a very good record when it comes to picking stocks. This is one of the reasons for the growing popularity of ETF investing. Passive investing offers market returns with very low fees. That’s fine for a core equity portfolio. However, you may be limiting your chance to improve returns by only investing in index funds. Stock picking offers the opportunity to invest directly in companies that have better fundamentals than the overall market.
Stock picking can also be used to reduce the risk of investing in market cap indices when the largest components are overvalued. A stock picking portfolio can be considered a different type of investment product, just like bonds, commodities and hedge funds. Picking stocks is therefore neither better nor worse than passive investing, but another means of diversification.
Picking stocks based on sentiment data
Market sentiment is one of the more reliable means of identifying potential price moves in the stock market. Fundamentals drive stock prices in the long term. However, it is sentiment that drives prices over the short to medium term. The challenge is that market sentiment is a somewhat subjective metric and requires numerous inputs and sources of data to be reliable. Fintech companies are entering the asset management arena, using cutting edge technology to find new sources of real-time data.
Catana Capital’s Data Intelligence Fund uses market sentiment derived from real-time data as part of its stock-picking process. Big data sources like social media platforms are used to gather user-generated data that reflects sentiment for each stock. Natural language processing algorithms process over 2 million news items each day to generate sentiment scores.
Artificial intelligence is then used to find patterns encompassing sentiment, price action, and other market data. This is an automated process which runs continuously. Decisions can, therefore, be made in real-time, as sentiment and stock prices change. The fund’s automated real-time process takes advantage of this to pick stocks for long positions. Short positions can also be held in equity indices (DAX future) to manage exposure and reduce systemic risk.
Advantages & disadvantages of stock picking
Like most things related to investing, there are advantages and drawbacks to stock picking. The following are the significant advantages of stock picking:
- Holding individual stocks alongside passive funds allows you to increase exposure to smaller, high-quality growth stocks. Doing so also lowers your overall exposure to large companies with weak fundamentals that indices include.
- While stock picking doesn’t guarantee success, individual investors do have several advantages that institutions don’t. With a smaller account, you have no market impact, and you can enter and exit positions in seconds. Large funds cannot take advantage of fleeting opportunities.
- The popularity of index funds may result in some form of a bubble. This may result in indices earning poor returns. In that case, stock-picking may allow you to not only beat the market but deliver more respectable returns.
- Most actively managed funds are mutual funds which have high management fees. If you can pick good stocks yourself, you can earn alpha without paying extra fees.
The following are some of the drawbacks of stock picking. Many of these disadvantages can be mitigated by holding a diversified portfolio of assets alongside your active portfolio:
- A stock-picking strategy typically holds larger positions in each stock than an index fund does. That means you have more stock-specific risk.
- Stock picking requires a lot of research, which is very time-consuming. To pick stocks successfully, you must have enough time to do adequate research. You will also need time to monitor your portfolio regularly.
- Managing a portfolio can be very stressful. Active investing comes with ongoing uncertainty. It is not suited to every personality type.
Conclusion: Stock picking can diversify risk and earn alpha
For those with the time and commitment, stock picking can offer another means to diversify risk and earn alpha. Private investors have more information and tools available to them, and trading costs are the lowest they have ever been. Carefully selecting stocks with good odds of beating the market can generate additional returns for a portfolio. However, picking stocks does come with risks, and should not be a considered a replacement for a well-diversified portfolio.