There is no shortage of jargon and theories on how to select the best stocks. This column will attempt to describe the main processes people use, and what my 40 years of experience has taught me about them.
Hearsay or hot tips
During the speculative buildup to The Great Depression, shoeshine boys provided hot tips to their clients. And in the buildup to the recent speculative era, Uber drivers replaced shoeshine boys.
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Many market participants make decisions simply around what they hear, read, or see on TV. I have succumbed to this lazy approach in the past but given the number of times burnt, I now always do more digging before buying. I garner a lot of ideas from what I read, which is just the first step in the selection process.
Technical analysis
Some market participants believe future stock price movement is foretold by previous stock price movement. Technical analysis is the study of charts to determine future expectations. There is a complete separate lingo for technical analysis of which I understand little. What’s a candlestick pattern? I understand but rarely use the basic principles, like double tops, double bottoms, a trading channel, upwards trending (higher highs and higher lows) and downward trending (lower highs and lower lows) patterns and moving averages.
My most significant experience with technical analysis was a couple of decades ago subscribing to a website that performed such analysis and provided green arrows when it was time to buy and red arrows when it was time to sell.
During the promotional presentation, numerous examples illustrated how well it worked. However, when I tried to implement, I found there were more times the arrows didn’t work than when they did. Those examples must have been accidentally omitted during the presentation. Technical analysis motivates short-term trading, which is difficult to implement when already busy.
I came to a similar conclusion as Warren Buffett, who said, “I realized that technical analysis didn’t work when I turned the chart upside down and didn’t get a different answer.”
I think there are valid aspects but with the vast array of potential decision points it doesn’t rank high. Many use technical analysis in commodity price predictions, and while I don’t have experience, my gut feel is it could be more useful here.
Momentum
Some believe it best to buy stocks that are moving upwards and sell those that are moving downwards. Logically, this makes sense but how short is the reference time frame. Sometimes prices go up five per cent in the morning and end the day down five per cent. How do you know when the momentum has changed?
If the reference time frame is short, the process would lead to significant trading activity. From a long-term perspective, I like companies that have trended upwards for a long time but have declined recently because of a market sell-off rather than specific company issues. Like technical analysis, momentum is a process used more by traders than investors.
Fundamental, top-down approach
As the name suggests, this refers to the study of fundamental factors affecting share prices. A top-down approach refers to the process of looking at macro factors first like GDP, inflation and interest rates; then, moving to a study of the sectors that would benefit from the macro factors. And, finally, a study of companies in the sector identified as having the most potential is conducted.
Again, this all sounds good, but my issue is that GDP and interest rates are effectively unpredictable. A great example of this unpredictability is how far off the mark the U.S. Federal Reserve and the Canadian Central Bank were on their 2022 interest rate expectations. The guys making the decisions drove their tractors into the wrong section.
Fundamental, bottom-up approach
This approach focuses on the study of company metrics such as growth rates, profitability, cash flow, debt levels and valuations. While I may use elements of the previous factors mentioned, my focus is on these fundamental metrics. I study the past decade of performance with an educated guestimate around whether past trends are likely to continue.
A great exercise would be to calculate your portfolio performance for at least the past five years. If your compound annual growth rate is more than 10 per cent, what you’re doing is working. If below 10 per cent, then switching to a fundamental, bottom-up approach might be in order.
