For most investors, the process of making a stock pick is one of two basic scenarios. The first one is simply starting with a theme, then drilling-down within that theme until you arrive at an individual stock. The second scenario completely bypasses the process altogether, as the equity pick is based on news or a company announcement. On the surface, both scenarios have a certain degree of obvious logic behind them. However, actual investing results may prompt an investor to look for a third methodology in finding stock ideas, as the first two processes don’t yield the expected results often enough to keep using them blindly.
The Flaw In The Theme-Driven Process
One of the classic examples of a theme-based selection process is the search for a beaten-up stock that is deeply undervalued. Superficially, the theme makes sense – buy a stock that’s temporarily underpriced before it recovers, or reverts back to its appropriate price. The flaw here is that it’s a one-dimensional view, assuming that obvious logic prevails at all points in time. However, it does not. Let’s look at an example.
One of the most common starting points for investors searching for good value ideas is the P/E ratio. The lower the P/E, the ‘cheaper’ the stock is. And if a company has a significant drop in its P/E, then most investors would say it makes for a good buying opportunity. However, the theme is much more complicated than that. Take Dell Computer (DELL) for instance. As of December 31st, 2004, its P/E was 34.83, while shares were trading at 42.14. By November 11th, 2005, the P/E ratio was at 22.79. That 34.6% drop in the P/E ratio had many investors thinking that there wouldn’t be a much better time to get into Dell shares at the then-current price of 29.40. By May 12th, 2006, the P/E was 17.26, and shares were at 25.20. Any investor who bought in late 2005 based on a low P/E ended up losing 14.3% on their investment within a few months. In this case, that ‘low P/E’ made perfect sense. However, there was obviously more to the equation that just a cheap stock.
In this case, the fact that the P/E kept dropping highlights one of the key problems with a theme-based approach. Dell shares were indeed cheaper in late 2005 than they were in late 2004, but the stock was still sinking like a rock. The strategy of buying cheap stocks wasn’t flawed – it was the theme itself. It was based on an assumption that cheap stocks rise. The theme, however, doesn’t take into account that stocks can and do develop negative momentum, nor does the theme recognize any absolute P/E levels to use as entry points. Clearly a P/E of 22.79 wasn’t cheap enough to suit the market, but the theme didn’t account for that idea.
The question any investor should be asking themselves about turning generalizations into stock picks is whether or not the generalization is flawed. Obviously no method is perfect, but is it at least complete, with downsides minimized?
The Flaw In The Event-Driven Process
The event-driven process is notably different than a theme-driven process. Rather than taking a broad idea and finding a stock that fits within that mold, an event-driven selection process starts and finishes with a specific stock or company in mind. Classic examples of even-driven picks are buying stocks after strong earnings are announced, buying after a key FDA approval, or buying after a positive news story in a high-profile investing publication. There are flaws with this strategy too, however. Namely, positive news is too often released after a stock has experienced most of its gain potential. Let’s take a look at a couple of examples.
Going back to the Dell Computer scenario, many investors were excited that Dell hit record earnings levels (1.02 billion) in September of 2005. The results topped off what was almost a perfect five-year streak of earnings improvements, and the stock had nowhere to go but up, right? In September of 2005, Dell shares reached as high as 41.02. By the end of April 2006, Dell shares were at 26.20. Good news for the company wasn’t good news for shareholders. It was quite the opposite, in fact. One could argue that the following quarter’s earnings dip was the culprit, and that the pessimistic view was the reason shares sank. Perhaps that’s the case, but it doesn’t explain the fact that Dell’s earnings popped back up to 1.012 billion the quarter after that, yet Dell shares are still well under the 40 level they were at when earnings were just a fraction higher, at 1.02 billion. The point is, earnings announcements clearly yield inconsistent results for stock owners, even when the news is consistent.
Favorable write-ups in periodicals lead to equally problematic results. In the February 20th, 2006 issue of Barron’s, these blurbs appeared on the cover:
1) “Texas Roadhouse (TXRH) is looking tasty.”
2) “Toll Brothers (TOL) is a buy again.”
Between February 21st (the first trading day that the news was actionable) and May 12th, 2006, following the advice would have been more than disappointing. Texas Roadhouse shares fell by 13.3 percent. Toll Brothers fell by 6.2 percent.
Could the two bullish recommendations just have been through a very unexpected run of bad luck and marketwide selling? Maybe, but not likely. The S&P 500 was up just fractionally (+0.3 percent) during the same timeframe. So, the two stocks in question had no major barriers to overcome; it was just poorly-timed (or completely errant) advice.
And what if three months wasn’t the timeframe the journalists intended? Good point. The problem is, in both cases, the only stated timeframe was a vague reference to one calendar year. There were no specific target prices or stop-loss prices. Since the stories ran, there has been no follow-up from Barron’s on either stock.
An Alternative Method
Rather than scouring the newspapers and absorbing the constant flow of information from television, an investor may be well advised to pick stocks from a completely bottoms-up approach. In simplest terms, that means reverse the process with which you choose stocks. A specific course of action could be……
1) Scan and sort for stocks that are starting to trend higher (chart action)
2) Check the underlying fundamentals to see if they justify any further growth
3) Scan for those stocks that are relatively the ‘cheapest’ (P/E comparison)
4) Compare any individual stock to its broad sector – Is it fighting the current?
5) Verify that the market is indeed going higher, since a bear market can drive even the best stocks lower.
You’ll notice that the steps involved may not be all that different than the top-down approach most investors already use. What’s different is the sequence, which ultimately means that the order in which you weed out stocks will lead you to a completely different list of potential buy candidates. What you’re likely to find are names that you’ve never even heard of. That’s ok – those are usually the best purchases. Stocks that are bounced around the media are always subject to big let-downs and a lot of investor emotion, since they’re hyped by the media. Plus, odds are that any theme-based strategy an investor is using is being used by most other investors as well. That doesn’t give you an edge, since everyone else is doing the same thing. Look for good names and quality stock ideas in ways and places that nobody else is. The best way to start doing that is by using scan and sort tools to find the obscure, undiscovered ideas that the news sources and other investors haven’t even thought of yet.
There are many free websites that can provide basic scan and sort features.