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Gather some investors together, mix liberally with beer, garnish with some grub, lose track of time, and there’s a question which inevitably bubbles to the surface:

So, stock picking…is it bloody art, or is it science?!

If you’re a regular reader, you might recall my Why I Read (I, II & III) series & this more recent piece (Investing Haiku), and assume I’d argue stock picking is ultimately art. That’s understandable – and if you buy me enough drinks, I’m sure I’d be more than happy to expound on that very argument! [And yeah, maybe I can talk even more than I can write. 😉 But only v occasionally… 🙂 ] But in the hard light of day, I’d be far more reluctant – not because of the argument itself, but because of how it tends to be abused…

First, we have the experts who never really share/explain their actual investment process. Who knows if they’re afraid to share their secret sauce, if they’re looking to add some mystery & glamour (and a following), or if they’ve simply succumbed to false modesty? Intentional or not, they persuade investors their stock picking is ultimately art – so you can invest with them, slavishly copy their stock picks, or you can simply give up…because you can never hope to emulate them!

[I mean, look at Warren Buffett – here we are, 60 years into his career, still slavering over any attempt to reverse-engineer the keys to his investment process & success. Whilst lauding a schizophrenic media that likes to preach why you should invest like Buffett, and why you can’t invest like Buffett! Before he dies, Alice Schroeder needs to perform the ultimate public service – lock herself in a room with Buffett, and only come out when she’s fully documented the real nuts & bolts, facts & figures, and dollars & cents of his major stock picking successes!]

[Apologies, I’m really not blaming Warren here: How’s he supposed to explain all he really does is sit around & read, just waiting for a bell to go ding in that giant investment brain machine of his. Yes, it’s that simple…call it art, or call it what you will!? Actually, he has explained it – many times before & in so many words – but we’re never satisfied…]

Then you have the charlatans prophets who seek to dazzle us with their prowess: Stock picking is an art, which only they have truly mastered. And maybe they’ll let you peek behind the curtain – funnily enough, just for a little while & probably for a price. But falling for them is all too easy…they speak with great authority, and they’re always ready with a nod & a wink as they hint about their next spectacular investment insight.

And worst of all, we may not even need the persuasion of others. Because we always have ourselves… And too many of us are willing to believe stock picking is truly an art – because that somehow grants a licence to break all the rules, throw caution to the winds, and to bet large on that special gut feeling you have about some surefire all-or-nothing winner. Less work, more reward, who wouldn’t love that?! Yeah, if only it were true…

The core problem here really is a failing to recognise stock picking is actually two very distinct & independent activities:

i) Stock Valuation, and

ii) Stock Selection.

All too often, investors confuse & conflate the two… So, by default, they end up deciding good shares deserve far higher valuations, while bad shares get marked down accordingly. Sure, at first this sounds like it makes perfect sense, but in reality it’s absurd..! If a share’s genuinely ‘bad’ – say, in terms of excessive debt, poor margins, low return on equity, erratic P&L record, etc. – then logically, those sub-par financial metrics will automatically get incorporated into your stock valuation anyway (in suitably quantitative fashion). Perhaps you should consider the alternative – you’re simply applying an additional & unjustified valuation haircut to a share…purely because you don’t like it!?

Of course, the inverse is far more dangerous… It’s like nearly every corporate capital expenditure project request I’ve ever reviewed: Hey, we like this project, we’re going to do this project…so what bloody figures do we need to dream up here to hit our hurdle rate & get this project approved PDQ?! Investors fall into the same cart-before-horse trap – allowing stock selection to dictate their entire investment process…they like the stock, they want to buy the stock, so now how do they arrive at a stock valuation that justifies it?!

Don’t believe me? Well, look around – every single day, you’ll see the same absurd situation: Investors (& the financial media) constantly apply drastically different valuations to companies/stocks which share essentially the same underlying financial metrics. Challenge them to reconcile their valuations back to cold hard facts & figures, and they can’t… Or they patiently explain how the company’s future prospects are so much brighter than its past, which more than justifies their valuation. A good rejoinder, except for the inconvenient fact the same glowing future was usually promised five years ago, and never actually happened..!

But stock valuation really has nothing to do with such qualitative judgements as ‘good’ or ‘bad’. I’d argue:

‘Stock valuation is purely quantitative, stock selection is far more qualitative.’

And:

‘Stock valuation is (mostly) about the past & the present, stock selection is more concerned with the future.’

Also:

‘Stock valuation must be absolute, but stock selection is usually relative.’

As I’ve said before, ultimately:

‘Stock selection may be art, but stock valuation is most definitely a science.’

Now, the blog already provides numerous & detailed examples of stock valuation, so we don’t need to cover that old ground here. And I hope you’ll agree I practice what I preach – i.e. valuing stocks really is a science, I approach each & every stock in a similarly consistent and quantitative fashion. But this does pose certain issues:

– It appears to place a huge emphasis on stock valuation for ranking & selecting individual stocks, vs. their peers & all the other potential stock buys you may have lined up, according to their upside potential (i.e. current share price vs. current intrinsic value). [And yes, I regularly do that in many of my individual blog posts & series – TGISVP, for example]. Now, this isn’t necessarily a bad thing, it obviously provides a useful quantitative framework to work with – but as I’ve stressed before, high upside potential is in no way a guarantee I’d ever dream of buying certain stocks! Stock selection is an independent, but equally important, process for determining which stocks I may actually want to buy…

[I regularly reply to readers’ emails where I have to stress stock selection vs. valuation, or vice versa, depending on their biases. I notice Ed Croft at Stockopedia felt compelled to write this article recently about their StockRank methodology, for much the same reason(s)].

– Unfortunately, it has sometimes proved difficult to stress the (equal) importance of stock selection on the blog. I mean, it’s like trying to prove a negative…how do I adequately document all the stocks I’ve rejected, vs. the one stock I ultimately selected?! Sure, I focus regularly on peer stock comparison & review, but that’s really just one component of my ongoing stock selection process.

A new & more detailed post is what’s required here, digging into all of the factors you might want to ponder when you’re considering stock selection. [I may upset some value purists along the way…] And though I’ve acknowledged stock selection may (ultimately) be art – yes, there’s always a certain indefinable magic in the stocks you choose, vs. the ones you don’t – I’d definitely make the argument it’s mostly grounded in science. Because in the end, great investing is like great art – it’s inevitably & necessarily built on a hard-earned foundation of knowledge, experience & discipline…

To Be Continued…

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