When Picking Stocks, Keep It Simple

Foreword from ShareInvestor

This article “When Picking Stocks, Keep It Simple” by Gabriel Chen was first published in The Business Times on 11 Jul 2010 and is reproduced in this blog in its entirety.

Investing is part science and part art, and going for a business you would like to own works best

A few months ago, I was giving a talk on investing at a secondary school and I was posed a question from the floor.

“How do you pick shares?” the student asked.

I will tell you what I said later. But his question got me thinking about whether there is an optimal way to pick a stock.

I asked a couple of friends who are not in the financial industry on how they pick theirs.

One said he follows price movements. “If the stock is cheaper than what it was months ago, I’ll buy it,” he said.

This would literally mean sifting through hundreds of shares when there is a market correction, I thought.

Another gets tips from his broker and said it works for him.

What if his broker is wrong?

I believe that stock market investing is part science and part art, and it is precisely for this reason that a variety of strategies have been developed.

It is worthwhile looking at what the professionals do. There are two common strategies that money managers use to select stocks for investment, namely the top-down approach and the bottom-up approach. They describe a systematic way of identifying stocks for investment.

Top-down investing goes from the big picture to the individual stock or, stated another way, from the macro to the micro.

The top-down investor looks at the world economy and asks himself which economies are expanding the fastest.

For example, he might come to the conclusion that it is China, India and Brazil.

Next, which industries are growing the fastest in these economies? He ponders again. Consumer products in China; services in India; and commodities in Brazil.

He continues with his research until he identifies companies in industries that will likely prosper under current economic conditions.

In other words, if you are using a top-down approach, you are getting the big picture first and then drilling down to individual stocks.

In this process, you may be considering demographics and population trends. You may also be looking for clues about the strength and direction of the economy, taking into account indicators such as interest rates, employment and inflation.

The bottom-up approach, as the name suggests, works in quite the opposite way.

Using this methodology, the investor zeroes in on the best companies regardless of how the economy is doing.

He concentrates on the fundamentals of the company – its sales growth, profitability, cash flow, debt ratio, price-earnings valuations and dividend payouts, among other variables.

He then compares the company’s financials with those of its peers to decide which stock offers more bang for the buck.

Both approaches are not foolproof.

Take the top-down approach. If your analysis is wrong, your portfolio may be underexposed to certain sectors and you could miss out on an opportunity.

The bottom-up approach also has its flaws.

Ignoring major economic trends can backfire if a company is more vulnerable to upheavals than the investor believes.

So should you study the macro picture or look at individual shares first?

The answer is not clear-cut and is also dependent on factors, including one’s investment objectives and time horizon.

That is why many professionals combine other “investing principles” with their chosen approach and meld them into a system that makes sense to them.

For example, when insiders – the likes of chief executives, executive directors and so forth – are selling their shares in a company en masse, it is usually not a good sign.

Companies that buy themselves glamorous skyscraper office towers with gold-plated taps and award executives with fat salaries not linked to performance are also those you may not want to invest in.

One of the greatest investors, the now-retired fund manager of Fidelity Investments, Mr Peter Lynch, had this principle: If you like the store, chances are you will love the stock.

Mr Lynch would take his wife and children shopping at large malls and would see for himself which chains were doing well.

This led him to names like The Body Shop, retailer of cosmetics and related products, and clothing store Gap because his daughters would spend some of their pocket money there.

I like to think that a great investment approach is like a road map that is elegantly simple. It does not help you avoid every pothole on the road or navigate every small turn, but guides you broadly through the way.

And it should feel easy and natural to you.

You may be wondering by now what reply I gave the student.

I said: “When you buy a stock, think whether you would like owning this business. If the business does well, the stock will follow.”

Sometimes, keeping it simple works best.