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Continued from here.

OK, time for a more in-depth look at stock selection. [NB: We’re presuming you’re already comfortable with the rigour & consistency of your stock valuation process]. While I’m happy to acknowledge stock selection may (ultimately) be art, here I’m going to illustrate & argue why it should be mostly grounded in science. So yes, I’m sorry – I don’t have any magic tricks up my sleeve to avoid, for example, a situation we all abhor…you know the one I mean:

You dutifully winnow a list of stocks down to two finalists, do a fine job of valuing them side-by-side, and make your final/fateful selection…only to see one stock double in three months, while you ponder the 35% loss on the stock you actually bought!?

But this can & does happen to the best of us! Unfortunately, it comes with the territory… You have to remember buyer’s regret & remorse are really just symptoms of Fear & Greed. Which can be tackled in two ways:

Ignore the ProblemAs tempting as self-flagellation is, why indulge in such a pointless exercise? Don’t forget, we’ve already assumed you’re doing a bang-up job with your stock valuation process – so you obviously shouldn’t be buying dud stocks, or forsaking a decent margin of safety! What you’re dealing with here is really just Lady Luck…and her rough edges tend to get smoothed out over time.

Systemise Your Process:  Stock selection is an independent, but equally important, part of your investment process – and as I’ve argued before, formalising & systemising every single component of that process is the best way to subdue and kill your fear & greed. Like I said, stock selection is mostly a science..!

And as I wrote in my last post:

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

The problem with rigorous stock valuation is quant tunnel vision – you tend to end up weighing & ranking all stocks purely in terms of their upside potential. [Well, at least I do…clearly, many don’t! I’m always amazed by investors who haven’t even got a price target for a stock they own, let alone any kind of intrinsic value estimate!?] Yes, obviously it’s an essential discipline to start with, but it won’t ensure you get to your final destination – in the end, stock selection’s just as much (if not more) about the stocks you already own, as it is about the stocks you wish to buy…

Fortunately, I believe there’s plenty of stock selection techniques, or filters, you can employ – some of these are all about focusing on your existing (and/or unconscious) negative investing biases, while others are more about promoting positive biases. But I’ll warn you now, they’re all pretty much about diversification – no surprise there, eh?!

Avoiding Home Bias:

Oy vey, what a place to start..! But there’s any number of studies out there which illustrate (& prove) the benefits of diversification, vs. the obvious dangers of home bias. And this may hurt the pride, but there’s just as many papers demonstrating the majority of portfolio returns are actually derived from asset allocation, not stock picking! [And if you protest you’re a brilliant stock picker, I have to ask…why aren’t you devoting some of that brilliance to asset allocation?!] I could add a blizzard of links here, but why bother..?

Anyway, I’ve already devoted an entire series to essentially the joys of diversification & the perils of home bias (see Portfolio Allocation I to XV!). And debating home bias simply means you’ve already lost the argument…it’s like arguing evolution with a cretinist creationist. [Never argue with an idiot. The best possible outcome is that you win an argument with an idiot.’] That being said, I have to stress: I’m certainly not arguing against a meaningful over/under-weighting of specific sectors, countries, and/or asset classes – well, that’s presuming you continue to observe some prudent limits, and that you approach it in a deliberate & reasoned manner. The sad fact is though, investors who exhibit the worst home bias are often oblivious (and ignorant & fearful) of the alternative(s) available to them – and there’s nothing worse than a bet you don’t even realise you’re actually making!

But aside from the more obvious benefits, there’s another compelling reason to avoid home bias & embrace diversification – it can actually simplify your stock selection process! Because the stock offering the greatest diversification is almost inevitably the stock offering the best risk/reward equation, even if it presents less obvious upside potential than your other buy candidates. [Why should I choose between a bird in the hand & two in the bush…yes, I’m greedy, I want both!] And that kind of diversification’s dependent upon & unique to your current portfolio, so one can obviously expect two investors looking at the same stocks (& with a similar approach to stock valuation) will probably arrive at a very different end-result in their stock selection.

Bottom-Up Stock Picking:

Craving a little more respect? Just look off into the distance, claim you ignore the market & the macro fundamentals, and opine ‘It’s all about picking stocks, man…’ I guarantee you, everybody will nod sagely & fight over buying your next beer. It’s really a crock though, you’re no more believable than that homeless guy failed ex-rocker dude propping up the bar, who at this very moment is saying ‘It’s all about the music, man…’.

Because most of the time, like home bias, bottom-up stock picking is just another excuse for laziness (or ignorance) – in fact, they regularly go hand-in-hand. Yet people wear it like a badge of pride…of course, your precious value purist is usually the worst offender! Am I really supposed to take him seriously? And what exactly is he proud of? Surely not his portfolio…a totally haphazard lucky dip of cheap stocks he’s stumbled across in the past couple of years. [Rest assured, his (growth investing) evil twin has his version too – his portfolio’s a teetering collection of the most over-priced & over-hyped story stocks he’s been sold in the past three months!]

But taken to its logical extreme, shouldn’t a bottom-up value investor’s portfolio (for example) actually be focused solely on a mere handful of the cheapest stocks, in the cheapest sectors, in the cheapest countries?! I might have a sneaking admiration for such dedicated rigour, but I’d still argue getting a few decent puffs out of those cigar butts might prove very bloody difficult with a possible gale force wind blowing in his face. But really, how often do you see such a portfolio..? No, you don’t – what you usually see is really some half-hearted & half-arsed attempt at a genuinely diversified portfolio.

Not to forget the giant wedges of cash you often find in such portfolios, because your average bottom-up investor just can’t find any more decent stock picks. Sigh… But why not look at new sectors, new countries, new asset classes? Why not think about event-driven investing? Why not admit cash is really just another bet? And usually just another unsuccessful form of market-timing (do I need to quote those studies?). Why not work a little bloody harder..?! 

In reality, bottom-up stock picking is a horrible way to arrive at a decent all-weather portfolio. It’s not just about cheap value stocks, and it’s not just about interesting growth stocks either. Chase one at the expense of the other, and the overall risk/reward of your portfolio will inevitably suffer. If you’re hoping for a real edge, you’re going to have to work that much harder to assemble a portfolio of Cheap AND Interesting stocks.

Concentration Risk:

And while we’re at it, we should tackle the other bogeyman of stock selection – a bias towards a concentrated portfolio, which further undermines the very idea of a diversified portfolio. Most of us have suffered this one, at one time or another – in fact, it may ultimately be the hardest to shake, since it tends to strike in two distinct phases.

The first comes at the beginning of an investor’s career, when you’re brimming with a confidence born mostly of ignorance. Why on earth should you assemble some fuddy-duddy diversified & low return portfolio, when you can simply focus on a handful of the top stock ideas you’ve gleaned from your favourite newspaper, blogs, magazines, etc. to maximise your returns. Your biggest holding is 40% of your portfolio, and you’ve no idea of the world of pain that’s coming if/when it suddenly gets sliced in half within the space of a week.

But you have a plan & you’re sticking with it – well, until you get punched in the face, that is… Eventually you’ll learn to start dancing, when you realise it’s about going the distance, not a first round knock-out – diversification’s the real key to a long & rewarding investing career.

[Unfortunately, there’s also those who stay punch-drunk forever. You have the players – once they pop a new stock cherry, they just get bored & want to move on to the next big score. And the dreamers – always ready to fall in love (again) & throw their money at some handsome silver-tongued stranger who promises them blue sky & snake oil. They’re still boasting about the 10-bagger they had back in ’06 (but never mention they only sold out after it collapsed back to a 3-bagger). None of these ‘investors’ ever learn to diversify away risk & create a real investment portfolio – they just save, bet & lose, save, bet & lose…]

Despite some painful lesson(s) along the way, there’s actually plenty of investors who eventually come full circle. Knowledge & experience breeds confidence, which gradually curdles into arrogance. [Wall St offers up the most egregious & expensive examples on a regular basis]. I mean, why should you waste all that hard-won expertise, and all that valuable & time-consuming research, on such puny bets…a diversified portfolio is just holding you back!

God damn it, you’re a silverback alpha gorilla – let’s hear you roar! Suddenly Berkowitz, Ackman, Buffett (in his heyday) & the like are your brand-new heroes all over again – a 25%+ holding doesn’t scare you any longer, because now you have the necessary investing savvy & insight, the understanding of risk, and the brass cojones that allow you to really swing for the fences with your very best ideas.

Yeah, except I really don’t…do you?!

OK, we all know the argument: Why on earth would you invest in your 10th best idea, not to mention your 20th best idea, when you can just buy more of your best ideas?! Yeah, that’s a terribly seductive & persuasive come-on line, but one that’s divorced from the often messy reality. Personally, I don’t want to even imagine the pain of a 25% (let alone a 40%) position going horribly wrong…

But I’ll stick my neck out here: Maybe I could pick what I’d consider an ultra-safe stock (in most likely circumstances) – I’ll admit to that arrogance. But what are the chances I’d actually pick, for example, a bona fide growth stock? No, I’m just not that smart, or that confident… And the greater my belief I’ve chosen a growth stock, the less confidence I’d necessarily have that it’s actually a safe stock. So if I was betting big, I’d inevitably be forced to opt for safety vs. growth – which could well mean I end up betting on a stock that goes absolutely nowhere for years to come! How palatable an outcome would that be, really? And am I completely confident I’d keep holding my nerve (& the stock) in those circumstances? Would you be..? Again, I have to concede discretion (and deliberation & diversification!) is the better part of valour.

Looking ahead to my next post, I’ll be highlighting more positive biases/filters you may want to consider & employ in your stock selection process. I also plan to circle back specifically to this idea of concentration – I firmly believe any investor, with the necessary hard work & the right stock selection, can combine the advantages of both diversification and concentration in their portfolio.

To Be Continued…