The 7 Challenges That Hold Back Great Stock Picking
Imagine picking up your car after it’s been supposedly repaired and discovering it’s still not fixed. Then, after a second trip to the shop the problem is still not resolved. What if this issue was an industry-wide phenomena? How would you feel about auto mechanics?
According to the most recent SPIVA report , 60% of large-cap managers and 73% of small-cap managers in the U.S. under-performed their respective benchmarks for the prior 12 months. Furthermore, over 70% of domestic equity managers, across all capitalizations, failed to beat their benchmarks over a five-year period.
To an outsider, observing that over two-thirds of the industry fails to achieve its stated client goals (generating alpha) would probably be astonishing. In what other industry is such a high failure rate allowed? (This question isn’t rhetorical…please email me at Info@AnalystSolutions.com if you know of one.)
The equity research profession has many problems, some that are outside of our control, and others we choose to ignore
From my perspective, here are the seven biggest challenges that help explain why stock picking is so difficult. I’ve ranked them in order of “ability to resolve” with the most challenging at the top and the easiest at the bottom.
- Some factors that move stocks can’t be forecast: Since 2008, the financial media has been more fixated on the next Fed move than any time I’ve seen going back to the late 1980s. Let’s face the fact that the Fed, inflation, the economy and even political events in the Middle East, can all shift the “risk-on” trade to “risk-off” which can kill a great stock call. Few professions are dependent on getting such unpredictable elements correct in order to service the client’s needs.
- There’s an urgency to act on proprietary insights: If you continue to conduct research to get 100% of the information you need to make the call, as you’re conducting more work there’s a greater likelihood the rest of the market will obtain this information, thus making your call obsolete. A CFO of a company I covered once told me “you’re too quick to put out research” but he didn’t realize we don’t have the luxury of most other professions, namely extra time to research every last detail, like we might see from a CFO presenting a capital expenditure budget to a board of directors.
- There isn’t always a great stock-picking opportunity in an analyst’s space: Most analysts are assigned a universe of stocks and assume they should be recommending some of those stocks. If you’re measured on performance relative to your universe, then it’s not as difficult, but for those who are evaluated relative to the market, there may be times when the entire sector looks expensive, such as the industrial sector when we’re 5-6 years into an economic expansion period. How does a long-only analyst come up with a good stock call in this instance?
- All of the information needed to make a perfect stock call is rarely available: There’s some information in the market that’s 100% certain, but since it’s in the consensus thinking, it can’t help in generating alpha. Information that’s not in consensus is usually the type that’s difficult to forecast (e.g. growth of Apple’s next product) and often difficult to obtain. Some of this can be resolved with more thorough research, but not all.
- Emotions cloud clear thinking, often causing an analyst to make the wrong decision: We’ve identified the 14 most common “mind traps” that cause professional investors to make mistakes that could be easily avoided. We discuss them in detail in a prior Best Practices Bulletin. The good news is that many of them can be mitigated with training.
- Many analysts are so overworked they don’t have time to find unique insights: This is arguably the most feeble excuse for poor performance, as well as the most prevalent and one of the easiest to fix. I routinely coach analysts who cover 100-250 stocks, asking me “how can I generate a unique insight?” This is akin to finding a way for a farmer to plant a thousand acres of corn in a week without any equipment. We consider the farmer’s task preposterous, but not the scenario of the analyst covering too many stocks. It’s this simple: to consistently generate alpha, you need to have out-of-consensus ideas, which are derived only when you have time to dig deeper than consensus.
- Analysts are not provided training: This might come off as self-serving, but the reality is we (as an industry) don’t train our people…partly because our people don’t think they need help. Many within our industry have a belief that if someone is smart and has a phone and computer, they automatically become “Super Analyst”, but the statistics I mentioned above would suggest otherwise. Most other professions, especially where the stakes are high and historical track records are low, will advocate intense training, and yet we have no industry-wide continuing education requirements.
Over the past 7 years our industry has seen over half a trillion dollars of assets shift from actively managed funds to index and ETF options, which I attribute to poor performance. If you disagree, ask yourself this…would you take your car back to the mechanic who took three tries to fix it?
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.
©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