7 Philosophies to Ensure the Ideal Entry Point for Stock Picking
If you’ve had the opportunity to visit a casino, what’s your reaction when walking through the impressive, color-filled lobby while hearing the clanging of the slots? Does your mind immediately go more to “this is going to be fun” or “how am I going to beat this system?” If it’s the latter, you might have steps you follow, like counting the face cards being dealt in blackjack, while also adhering to philosophies like “I’m not going to have more than one drink an hour.”
Do you approach stock picking in the same manner, namely with specific steps and philosophies to ensure success? My TIER™ framework for stock picking was designed to help analysts organize and follow the dozens of steps and philosophies required for great stock picking based on best practices gathered while interviewing analysts for my book and from the 30-40 well-known books and academic papers on investing (and from some of my personal experience). I’ve provided the philosophies that fall under the “E” of TIER™, (Ensure Ideal Entry Point) below. Think of these as general philosophies to follow as you’re preparing your investment thesis or wondering if a stock is worthy of an upgrade. It’s worth mentioning, the list below does not include the 13 steps for the “E” of TIER™ which I explore in a post about validating your view and another about assessing and influencing the market’s view).
These important philosophies for successful stock picking may seem simple, but are too often forgotten or ignored
7 Philosophies to Ensure the Ideal Entry Point
- Keep it simple: the more complex the investment thesis, the more things can go wrong or be misunderstood by the market.
- Avoid the blow-ups. Many well-respected money managers say it’s not about achieving one big win after the other but rather racking up a number of small-to-medium wins while also avoiding the blow-ups. If you’re conducting research on a stock and realize there isn’t much upside, consider how you can help your PM or client with this same research to avoid a potential blow-up (it’s not all about having estimates well above consensus).
- Don’t be a contrarian just to be a contrarian – the market tends to be right more than it’s wrong. If you begin to develop an out-of-consensus view, assume you’re wrong and try to disprove your new thesis. If you can’t you probably have a sound thesis.
- Know why you differ: If the upside to your price target is materially different than the expected upside in the broader market, determine which of your areas disagrees with consensus:
- Financial forecast?
- Valuation multiple?
- Question greed vs. fear: When individual stocks or sectors appear to be moving too far too fast for irrational reasons (not based on fundamentals), deeply reflect on the contrarian view. For example, when four sell-side analysts downgrade a stock for missing the quarter and the stock is down 10%-15%, it may be the perfect buying opportunity (the reverse may hold when four upgrade in a day).
- Appreciate the market’s risk appetite before making a stock call: Risk appetite can change in a day, but too often I see analysts focused on their individual stocks, with little regard for how the sector performs relative to the overall market or macro factors (i.e. resist recommending weaker companies when the market’s risk appetite is waning, such as near the end of an economic cycle). The market’s relative appetite for risk can be gauged by monitoring:
- Treasury yields
- The size of the deal calendar
- Recent stock performance of:
- Weak companies versus stable companies
- Emerging markets versus developed markets
- Small cap versus large cap
- Be adaptable to different investment styles: No single investing style will be successful over every time, period. Analysts should have a toolbox containing different approaches and know when to use them. If you’re not familiar with these styles, go to lunch with your colleagues, one at a time and pick their brain on this topic because I’m sure they will have different approaches (I’ve never met two analysts that have the same approach).
I hope by following these philosophies it will help improve your stock picking. Referencing my casino example above, I encourage you to approach the job with the philosophy “this is going to be fun” while also putting as much emphasis (or maybe more) on “how am I going to beat this system?”
Let me know if this Best Practice Bulletin™ helps and how I can improve upon this best practice. If you’re interested in exploring this topic further, AnalystSolutions provides equity research training with a specialized workshop to help Master the Stock Call Techniques of Highly Experienced Analysts.
Improve you or your team’s stock picking and communication skills with our equity research analyst training tools, which includes workshops such as the one above, as well as our GAMMA PI™ assessment and one-on-one coaching. Also, consider ordering the book that inspired the founding of AnalystSolutions and the Best Practices Bulletin: Best Practices for Equity Research Analysts.
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©AnalystSolutions LLP All rights reserved. James J. Valentine, CFA is author of Best Practices for Equity Research Analysts, founder of AnalystSolutions and was a top-ranked equity research analyst for ten consecutive years