Sunday, June 13, 2010

General Stock Picking Strategies: Don't Use Them!

Here at The Catholic Investor, I try to make you a more informed investor.  There are many theories, strategies, and products out there that cater to "dumb" investors, shall I say?  Mutual funds are definitely one of them.  They mostly use a "buy and forget" strategy.  Sadly, after 2008, most people who owned mutual funds did indeed want to forget about their investment!  It's quite a funny phenomenon, but many of us do more research when buying a TV or computer or fridge than when we decide where to place our money to invest.  The ramifications of not doing proper research is HUGE!  You can look back to my retirement post and see what kind of difference a few percent makes in the long term.

So recently, I've becoming somewhat intrigued by dividends (I'll save this topic for another day) and read a relatively old book called The Dividend Rich Investor.  It's an introductory book on dividends.  The reason I mention it is not because I wanted to do a book review or talk about dividends.  In one of its chapters, it talked briefly about the various strategies in buying dividend stocks and mentioned James O'Shaughnessy's What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time.  I haven't actually read O'Shaughnessy's book, but it's very popular and many people have read it.   I do know what it is about.  In a few sentences, here's a summary of what he wrote in the book.  O'Shaughnessy examined many general stock picking strategies and put them head-to-head against each other to see which one wins out.  When I say "general stock picking strategies", what I mean is you set a criterion and look at the performance of all of the stocks that fall into this one criterion (e.g. low P/E ratio, high P/E ratio, etc.)  In the end, he showed that buying stocks with low price-to-sales (P/S) ratios was one of the most successful strategies.

General Stock Picking Strategies
I know you know I'm going to totally trash this strategy, but I do want to highlight its advantages and tell you who should use these strategies (hint: I'm not one of them).  First, O'Shaughnessy's strategy is data backed.  He selected stocks based on his strategies and ran years of data to find out which is the best.  Second, it's based on key ratios used by fundamental analysts.  It's the closest thing to fundamental analysis that a lazy person can use.  If you are this lazy person, build your portfolio around a low P/S strategy, and you may have a chance of outperforming the market.

Now, here is the reason why you shouldn't use the strategy: this strategy requires you to diversify. When people hear the word "diversification", one immediately associates this word with the idea of being responsible and prudent.  To these two words, I would also add the word "underperforming".  Since the P/S strategy just tells you to buy stocks with low P/S ratios, it does not discriminate between good and bad companies.  A company with a low P/S ratio may be on the verge of bankruptcy and that is why its price is so low.  So, to mitigate this risk, you must diversify and buy a large number of stocks.  Most of us don't have millions of dollars, and so, we can either i) buy a limited number of stocks, ii) buy a large number of stocks but with small amounts in each, or iii) buy a mutual fund that uses O'Shaughnessy's strategies.  Obviously, the problem with i) is that you do not diversify.  The problem with ii) is that commissions will erode the gains that your stocks make very quickly, since you can only purchase a small amount of the many stocks that you hold.  With iii), you get hit with fees and have little control of what stocks are held in the fund.  The latter could make an ethical investor nervous because morally questionable companies may sneak into your portfolio.  Moreover, a large majority of mutual funds underperform the overall market (think > 95% of them).

Diversification - Good or Bad?
Diversification, in its most commonly held way, is a concept that is rammed down our throats by mutual fund companies.  They want us to believe that ordinary investors have no way of picking good stocks, and so, the only way to make money is to diversify, i.e., buy mutual funds.  It is true that if you blindly pick a few stocks to buy, their prices could tank and you would lose a lot of money.  However, if you have done research and know that the several companies you have bought are rock solid companies at bargain prices, you do not have to be afraid of market gyrations.  Your main enemy in diversification (and also its main purpose) is the averaging effect.  Yes, you will average out the losers in your portfolio, but don't forget that you also average out your winners.

This is not to say that you should buy one stock only.  After all, we are human and even after countless hours of research, we may still err and pick the wrong stock.  Or worse yet, your company could be doing well, but an unexpected disaster may occur that could easily wipe out half the worth of your company's stock (BP is a very good example).  You still need to diversify, but in its strictest sense (i.e. buying more than one stock), and not just buying many stocks for the sake of it.  I would augment diversification with good fundamental analysis.  Check out Rule #1 Investing for a methodical way of evaluating a company's intrinsic value.  You need to pick 5-10 high quality stocks in different industries to provide you with diversification in your portfolio.  That way, you are averaging out the performance of several high gainers, and not just arbitrarily throwing different stocks into your portfolio.

One way of thinking about the stock picking strategies is by using the bell curve.  The whole market is one big bell curve.  By using the general stock picking strategies, you are simply splitting up the market into various smaller bell curves.  Some strategies will perform better, some worse.  By employing any one of these strategies, you will need to buy all of the stocks in that bell curve, even the bad ones.  On the other hand, if you use, say Rule #1 Investing, you look at the big bell curve of the market, and you only pick the ones on the good end of the curve, and leave the bad ones behind.  If I haven't lost you yet, you will know that the latter is the superior method.

In Conclusion
In summary, general stock picking strategies are merely for the lazy.  In essence, what they tell you to do is just buy a whole bunch of stocks based on one single factor, regardless of the underlying business of the stock.  The stocks may be good or bad, but as long as you diversify, you will hopefully do well.  This is not the way we do it at The Catholic Investor.  We like to get to know the business a little more before throwing our life savings at it.  By buying several high quality stocks, we can outperform the market by a significant margin.  And this is exactly what we will continue to do in this blog!