How to Pick Stocks the Smart Way
Our Proven 9-Step Method for Selecting Stocks
When it comes to how to pick stocks, investors face a unique challenge. While most bonds have a clear valuation technique through Discounted Cash Flow (DCF), stocks are more complex. Stocks are more like people – with unlimited potential, but that potential is difficult to value as it may or may not be fulfilled. That’s why investors rely on multiple methods to evaluate stocks, like Discounted Cash Flow, Price-to-Earnings ratio, Price-to-Sales ratio, Price-to-Book ratio, and more.
As a rule of thumb, if multiple, widely accepted valuation methods exist, none of them work well. That is why investors use numerous valuation methods in the first place. Using multiple valuation methods for stocks presents a dilemma: when one method suggests a stock is cheap, another may indicate it’s expensive. This isn’t just a hypothetical scenario; it’s a common challenge in real-life situations.
Drawing on our extensive experience and expertise, we unveil our proven 9-step method for selecting stocks.
1) Steer clear of potential value traps when making stock selections
Like AT&T Inc. (T), stocks with exceptionally low valuations are value traps. They are like terminally ill patients – their future will most likely be worse than the present. Generally, if a stock is significantly below the Price to Earnings Ratio of the S&P 500, we will exclude it from consideration. Warren Buffett calls those companies “cigarette butts,” but even he rarely buys any of them nowadays.
2) Avoid stocks that have lost more than 70% in value since their all-time highs
This is controversial and not obvious, but the allegory here is retail sales. What signs do we see if a retail store goes out of business? Usually, “GOING OUT OF BUSINESS! UP TO 70% OFF!” Isn’t that the case? What do you expect to find if you buy a pair of socks with cash at 95% off? Holes, invariably, holes.
Same pattern on how to pick stocks; a stock can realistically lose more than 70% of its valuation from its peak only if its business model is threatened. If a company’s business model is threatened, it is UNREALISTIC to expect that any valuation will hold. There could be exceptions if one is familiar with the company, but the risks may be too high. Examples here include former darlings like Nio Inc. (NIO), Zoom Video Communications Inc. (ZOOM), and Peloton Interactive Inc. (PTON).
3) Don’t forget that profits matter – companies that are not profitable may never become profitable
Investing is a serious business; investing in stocks that have never shown to be profitable or rarely turn profits is too dangerous. Most stocks will not fulfill their potential; we look to invest only in companies that have proven consistently generate yield with their business models. By following this principle, we uncover the secrets of how to pick stocks with a higher probability of success.
We understand that we may miss some big winners like Tesla Inc. (TSLA) and Amazon Inc. (AMZN) but the majority of unprofitable companies rarely become like Tesla. Investing is based on the history of successful execution of a profitable business strategy, NOT a potentially profitable business strategy. We refer to the latter as speculation.
4) Stay away from complex stock, focus on simplicity
Our strategy is to steer clear of complex stocks. We do not make any attempt to value over 80% of the stocks listed on S&P 500. It’s important to note that these stocks can be valued, but we find it a challenging process and not worth the effort. There are multiple examples here, but one of the most recent ones is Icahn Enterprises L.P. (IEP). We find holding companies, in general, too complicated to value accurately.
“Investing is like amateur tennis – just return the ball.” – Howard Marks
5) Invest only in U.S stocks – executive compensations matter
Consider this: Do you know how much the CEO of Samsung Electronics received in annual pay in 2021? Approximately 10 million USD. Now, compare that to the CEO of Apple, who received around 100 million USD in annual pay for the same year.
Given this information, one should not be surprised to learn that since the end of 2019, Apple stock is up 130% while Samsung stock is up 30%. This is an extreme example, but executive compensation is generally the worst in Asia, decent in Europe, and excellent in the U.S. We are virtually at a loss for words when we hear that investors are looking to buy Asian stocks because Asia is expected to be the engine of growth for the global economy. Most likely, Asia will be the growth engine, but the majority of those Asian stocks will probably disappoint.
Why? Because company executives in Asia are rarely strongly incentivized to deliver significant price appreciation to shareholders.
6) Pay attention to valuations when picking stocks
While we will not necessarily shy away from stocks with high Price to Earnings Ratios, there is a limit to our tolerance. Typically, we are comfortable paying a premium of up to 20% relative to the market averages. Although it’s not an inflexible rule, we find ourselves adhering to it in most instances. Rest assured – we make prudent decisions while staying open to opportunities.
7) Select stocks with revenues above GDP growth rate
We prefer companies with ten or even 20-year operational history to newly minted businesses. Moreover, we are looking primarily at companies in industries where revenues are growing above the GDP Growth Rate. Preferably much higher than that! Many of the companies in the NASDAQ-100 will qualify here – Apple Inc. (AAPL), Microsoft Corporation (MSFT), and Alphabet Inc. (GOOG). They have been our top picks in “Why You Must Like Technology Stocks (QQQ)”.
8) Buy only the leaders
The best example here is Adidas AG (ADS DE), Nike, Inc. (NKE), and Puma AG (PUM DE). The world of athletic apparel is dominated by Nike and Adidas. While Puma has the lowest valuation, it is the underdog. Most amateur investors, and people, love rooting for the underdog (another form of value trap). The underdog is the underdog for a reason – it will most likely UNDERPERFORM. Large companies tend to be better-ran and more resilient players. Once you drop below the #1 or #2 company in any industry, the odds of eventually winning drop significantly.
Low valuations could be of more help when it comes to investing in underdogs. We would only consider investing in Nike and NOT Adidas AG or Puma AG. The reason is that Nike, Inc. is the clear leader in the sector, and its stock and earnings performance is higher quality than Adidas (less volatile). Moreover, the current Price to Earnings Ratio also favors Nike.
And Puma AG? Well, it is “up and coming,” but it will take years to challenge Nike or Adidas in any significant way potentially, and we are not sure even if that is ever going to happen.
Typically, voters tend to favor incumbent presidents for a second mandate, although Mr. Trump proved to be an exception. Similarly, market leaders often earn recognition for their ability to sustain their lead over competitors, particularly smaller ones.
9) Stay away from companies that are serial underperformers
In general, we shy away from investing in companies that have underperformed significant indexes over the last ten years. Ideally, we would like to see a slowdown in earnings and price appreciation, not serial underperformers. The best example here is Intel Inc. (INTC) – it was a leader in the industry, and the stock has not lost too much value from its highs. However, it has largely underperformed its peer in the sector recently and over the last ten years. In the words of Gordon Gekko, a character from the movie “Wall Street,” it is most likely, “a dog with fleas.”
In conclusion, let us unravel the enigma of how to pick stocks. It’s like finding a needle in a haystack – a challenging task. But with our proven 9-step method for selecting stocks, the haystack just got a bit smaller. Remember, avoid value traps, not-so-profitable companies, and serial underperformers. Instead, invest in leaders and companies with high revenues, and avoid complex stocks. And finally, always be cautious about investing in underdogs.
We hope you found our guide informative, helpful, and amusing. Happy investing, and may the odds ever be in your favor!