Validating Your View Raises the Odds of a Great Stock Call

This post covers this element(s) of GAMMA PI: #3. Make Accurate Stock Recommendations
Validating Your View Raises the Odds of a Great Stock Call

If you’re an equity research analyst, you probably do a fair amount of flying. How would you feel if you were at the airport and overheard the pilot telling the gate agent, “We’re running late and so I’m not going to go through my standard safety checklist.”? I would probably take another flight, not so much because of the missed checklist (the analytical side of me would conclude there’s a relatively low chance of a fatal mechanical problem for any given flight), but because the pilot lacks good judgement.

During my years as an analyst and participating in stock selecting committees, I noticed many analysts didn’t use a checklist (on paper or in their minds) before making a stock call, which is why I developed the TIER™ framework. The “E” is for “ensure ideal entry point” which is divided into two key steps: 1) Validate your view; and 2) Assess and influence the market’s view. In this post, I walk through the best practices for the first step and will follow-up with a later post on the second step.

The majority of failed stock calls can be avoided with better preparation and reflection before the call is made

I find the best equity research analysts go through most, if not all, of these steps below, well before making a new stock recommendation.

Ensure Ideal Entry Point: Validate Your View

Avoid costly psychological shortcutsAs you’re conducting your initial research, avoid the mind traps we've identified as "costly psychological shortcuts" that tend to appear early in the process, including familiarity, availability, and recency biases as well as over-reliance on heuristics.
Ensure the call is differentiated (FaVeS™)Ensure the stock recommendation is differentiated from the consensus thinking in at least one of the areas below (the FaVeS ™ framework):
  • Forecast of financial results, such as EPS or cash flow; or
  • Valuation multiple or methodology; or
  • Sentiment of the market toward the stock (void of an impending change to the forecast or valuation multiple/method)
Avoid Pollyannaish or hopeful thinkingAs you’re developing your thesis, avoid the mind traps we've identified as "Pollyannaish or hopeful thinking" which include confirmation, over-confidence, self-attribution and optimism biases
Weigh risk as well a returnAmong your universe of available stocks to recommend, ensure factors beyond just absolute return are given priority as part of the pending recommendation (i.e. risks). These often include:
  • Predictability of earnings or cash flow forecasts that drive thesis
  • Conviction in the catalyst occurring and moving the stock to the price target
  • Reliability that management will deliver on its goals
  • Timing for when the catalyst will occur (e.g. next month or 2 years from now?)
Ensure no imminent dangerEnsure there are no clear near-term risks that will offer a better execution point, such as the company falling short of current quarter expectations. This may seem like common sense, but too often an analyst will recommend a stock based on a long-term thesis and fail to appreciate that the stock will remain weighed down in the near-term. Examples include:
  • Current quarter’s consensus expectations are opposite your long-term view
  • A large class of investors are still exiting (growth investors selling after a stock appears to be moving into the maturity phase)
  • The current economic cycle appears to be reaching its peak
  • A large management lock-up is about to expire
Document thesisAvoid a number of mind traps above by documenting your thesis and price target specifics before making the recommendation, because this will help prevent the mind from revising history, which it so badly wants to do when a call isn’t going in the right direction. Also establish a stop-loss price to reduce the downside risk and as a place to re-evaluate if the unique insight isn't playing out as expected.
Sleep on itBefore changing a rating, reduce anxiety and the “overreaction” mind trap by contemplating it overnight (assuming time allows). "Sleeping on it" usually provides more objectivity than making a quick decision during a workday.

Incorporating all of these steps above into your process before making a ratings change will increase the odds of a making a great stock call and avoiding a blow-up. This Best Practice Bulletin™ targets #3. Make Accurate Stock Recommendations, of GAMMA PI™, within our Pathway to Success Framework

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 Generate Differentiated Insights Through Better Discovery, Questioning, and Influencing.

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.

Visit our new Resource Center to find more helpful articles, reference cards, and advice towards your growth as an Equity Research Analyst.

©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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