Top TIER™ Analysts Follow These Four Steps To Ensure Great Stock Picking

This post covers this element(s) of GAMMA PI: #3. Make Accurate Stock Recommendations
best practices for stock picking

If I asked, “What are the steps to making a delicious lasagna?” or “What’s required to hit a golf ball straight down the fairway?” you might know the answers already, but if you didn’t, you’d definitely know where to find someone who does. What would you say if I asked, “What are the steps to making a great stock call?” Could you find the answer as easily?

I was forced to come up with an “answer” when I had the responsibility of building a global training program for Morgan Stanley’s 500 analysts and associates. Through that experience as well as the research I conducted for the book and ultimately AnalystSolutions’ workshops and coaching material, I realized it can’t be distilled down to 5-10 concise steps. One of the challenges in creating a concise list of steps is that certain stock picking elements are more philosophical than procedural. In my lasagna example, a procedure would be laying down the base noodle whereas a philosophy could be selecting the level of seasoning for the sauce.

Every analyst has at least one good stock call, but the best stock pickers increase their odds of success by having strategies in all areas of our TIER™ framework

To make it easier to learn and follow the 100+ best practices for stock picking (procedures and philosophies), I split them into four buckets, which I’ve named our TIER™ stock-picking framework.  If you think about it, every “tip” you hear from a great stock picker (well-known or not) falls into one of these four categories.

Target a realistic price. A stock call must have a price target and if we boil it down to its simplest form, a price target is simply a valuation multiple applied to a financial forecast. Getting these two elements correct can be a challenge, so much so, that they are the subject of thousands of text books and investment best sellers. Given my limited space here, I’ll highlight only two key thoughts as they relate to setting price targets:

  1. Don’t rely primarily on Excel, company guidance or the financial media in building your forecast. Tens of thousands of analysts have access to these and so you’ll never come up with differentiated stock calls if this is all you use. Instead have exchanges with industry and company experts that don’t work for the company being researched.
  2. Keep valuation objective, but don’t overcomplicate it. The two most common valuation mistakes I see are when analysts; A) don’t look back (ideally 5-20 years) to see where a stock has traded and what caused it to fluctuate from one period to another; and B) don’t focus enough on the market’s current psychology (e.g. why is the stock at a 15% premium to the market or its peers when it’s been at a 5% discount over the past 5-years?)

Identify and forecast the catalyst(s). Assuming you have a financial forecast that’s more accurate than consensus, and you apply an objective valuation multiple, you should be left with a sound price target.  When a price target is materially different than the current stock price, great analysts then answer this question before making a stock call: “What’s going to get the market to come around to my thought process?”  Sometimes, it’s as simple as the company beating consensus estimates two or three quarters from now, but I find great analysts are more specific such as “the market will be surprised by how quickly the company takes market share in emerging markets.” Too often analysts don’t identify and forecast this type of catalyst, which leaves them with fireworks that don’t have a fuse.

Ensure ideal Entry point. Timing is everything…getting in too late can be just as bad is getting in way too early. A good part of this element is ensuring your emotions are in check so you don’t fall into one of the more common professional investing mind traps.  For example, the best analysts avoid overly-simplistic shortcuts, hopeful thinking and following the herd, which cause so many other analysts’ calls to blow up.  Furthermore, taking steps like fully understanding “what’s in consensus”, imminent danger (such as a company likely to guide down in the near-term, even if it has great long term prospects) and current investor psychology are all helpful. When it comes to ensuring the ideal entry point, the answer doesn’t lie within your Excel model or simply having greater faith than consensus in management’s guidance. The best analysts are routinely speaking with market participants, such as other buy-side and sell-side analysts, PMs, institutional salespeople and traders to have their ear to the ground. It’s impossible to determine if the market is about to come around to your thinking if you don’t know how the market is currently thinking.

Review performance and thesis. This element is the easiest to conduct, and probably the most overlooked.  Great stock pickers are routinely reviewing their comp table to ensure their strongest-conviction recommendations are those that offer the best risk-adjusted returns. To do this, these analysts have comp tables that include more than just their financial forecasts and valuation multiples. They include the all-important probability the forecast will occur. A stock with 15% relative upside is likely a better investment than one with 25% upside if the first stock has a 90% chance of executing the analyst’s forecast versus only 40% for the second. In reviewing their performance, great analysts aren’t afraid to cut bait if the thesis isn’t working and for stocks that are working for them, they know to leave the party before it ends.

Not every great stock picker goes through all four elements of our TIER™ framework in the exact same manner, but they all have processes to ensure these key areas are covered. As I mentioned above, stock picking can’t be distilled down to 5-10 easy steps and so my thoughts above are highlighting the broad strokes.  I’ll return in later posts where I can provide more of the “procedure vs. philosophy” for each element.  But hopefully there’s enough here to reflect for a minute on your own highest-conviction stock call and ask yourself if you have a strategy in each of the four areas.

AnalystSolutions has developed two workshops to cover this all-important area.  Our workshop Apply Practical Valuation Techniques for More Accurate Price Targets covers the “T” of TIER™ while Master the Stock Call Techniques of Highly Experienced Analysts covers the remainder.

This Best Practices Bulletin™ targets activity #3, “Make Accurate Stock Recommendations” within our GAMMA PI™ framework.

©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

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