Methodology: Here's How I Pick Stocks

Valued commenter Mike C. asks for a change of pace from my regular topics and a focus on more specific stock picking. He notes that I have said several times that there are plenty of opportunities. So what are they?

This is a thoughtful question, so let me start down the path to a complete answer. I cannot get there in one article, but this will be a start.

Mission and Audience

Anyone who is a regular reader knows that I have not catered to the existing Internet audience. If you follow blog statistics, it is pretty obvious how you should get a big audience, and I do not do it! Here is a list of things that I am doing wrong in a marketing campaign:

• I do not think the world is coming to an end;
• I do not see the immediate application of Austrian economics (but I watch the debate carefully);
• I do not hate Obama (nor did I hate George Bush);
• I do not hate the Fed, nor do I see them as responsible for everything that has gone wrong;
• I do not see a conspiracy around every corner;
• I do not think that government is a unilateral force organized to lie to us, and manipulating data.

Putting this into a positive statement, I think that government leaders, whatever their party, are attempting to avert a deeper recession and to create employment. Presidents Bush and Obama both did their best, given the circumstances, the existing law, their teams, and their ideology.

The government is on a mission. You may not like the policies, but as an investor, you fight it at your peril.

This is an unpopular viewpoint in the Internet audience. This audience has had an undue influence on mainstream media, where writers are under pressure to get readers, comments, and page views.

It reminds me of the Truman versus Dewey polls, where newspapers all predicted the Dewey victory based upon their letters to the editor. People need to realize that Internet blog ratings, Seeking Alpha popularity, and CNBC viewer polls, are all culled from a special audience. If I were to take this seriously, I would quit writing!

My real audience consists of people who are not even following the Internet debates. My ideal client is an expert in what she does in her work and is looking for an expert to help with her investments. I use the feminine gender advisedly, since guys (including me) do not like to ask for directions. People who want to read a few Internet articles, ask about last year's performance, and think they have a "feel for the market" are not my best potential clients.

Briefly put, I am writing a book for people who are not currently reading my blog, but who need help. Having said this, I am delighted that some current readers find my material useful, and I value their comments and contributions. I know from my email that many readers are other investment advisors who share the challenges I face.

Also, I write at night, after my day's work is done. My list of blog agenda items grows more rapidly than I can work. It is a labor of love, and one that I will never complete.

My Approach

The approach that I use is not a secret. Anyone writing to me gets a nice description and a performance update. I am not allowed to advertise this (so say my lawyers), but the excellent results are available upon request. I talk to every potential investor. If someone wants overall advice on asset allocation, I provide that. If they want a good long-only approach as part of the portfolio, I screen them for risk tolerance and suitability. That is part of being a Registered Investment Advisor.

With this "disclaimer" in mind, here is an overview of my stock-picking approach.

Find a Theme. I look for themes where there is excessive skepticism. I use my extensive background in economics (where I have real training, used to follow actual data and opinions), in politics (where I have built a sister site to track everything relevant), and in valuation (where I relate forward stock potential to alternative investments). I use daily analysis of data to challenge and review these viewpoints.

My current themes include the following:

• Recognition that public policy initiatives, from all government sources, are focused upon economic growth and recession concerns. You can worry about inflation and excessive government, but the concern is too early for practical investment purposes. There is plenty of stimulus in the pipeline, and more is about to be enacted.
• Health care companies. The uncertainty about the final shape of a bill, and whether something will be passed, have cast a pall over the entire sector. It will not end badly for all of these stocks, despite the day-to-day market reaction.
• Growth stocks. There are always growth opportunities, if one looks at data and trends. I always have some growth in the portfolio.
• Energy stocks. When economic growth was more promising, we were near a tipping point in energy prices. There are many forces providing a bottom in these sectors, and the upside is significant.

There are other themes, but let us stick with those for the moment. I am always adding or adjusting themes.

Find a stock. I look for stocks with the themes in mind. At the moment, here are some considerations I have in mind:

• International exposure. Many US companies have a balance between US and foreign sales. They are less exposed to a weaker dollar, and may even benefit.
• Cost cutting. Companies that have reduced costs are well-placed to enjoy a revenue rebound and extra earnings.
• Analyst disfavor. I like stocks that are unloved by the analyst community. Unlike others, I think that analysts do a reasonable job on earnings forecasts. They are too slow in changing official ratings. I often buy when the consensus ratings are low, and sell when they are high.
• Resistance to risk. Some companies have a business model that can dodge the apparent pitfalls.
• Stocks that have lagged the market in the rebound from the pre-Lehman levels, a point that I am using as an initial target.

Specific Ideas

I have revealed and recommended some of our holdings in past articles, especially in my 2009 preview piece. I still like Transocean Energy (RIG), Apple Computers, Inc. (AAPL), ResMed (RMD), and Caterpillar, (CAT), for reasons that should be obvious from the above analysis --- energy, growth, health (with resistance to skepticism) and global economic growth. I also own Intel (INTC) which I may not have mentioned before.

While the stocks have all rallied, they are all still buyable right now. I own them for myself and for clients.

I take a fresh look each day. Is this a stock that I want to own for the next month, next six months, or the next year?

I recently recommended Research in Motion (RIMM) as a good post-earnings candidate, when the stock sold off sharply. The thesis is growth in the mobile Internet space, but I like holding it along with Apple to avoid changes in market share.

A Final Thought

I mention these stocks as examples. Obviously, my actual analysis involves much more detail. In a future article, I will take a single example and show how it fits the criteria.

Thanks again to Mike C. for the suggestion. Tomorrow night I have a fine birthday celebration planned in Chicago for my wife and my son (birthdays two days apart). That means no article tomorrow. While I love to write about stocks, it is not something I can do every day.

Comments

[chap08:]

Good article Jeff, it rang a lot of bells for me. My approach has a lot of similarities with yours. I like your theme of "excessive skepticism", but I broaden that out to "what's being ignored?". So let me say - look at international defensive stocks e.g. telecom, pharma, tobacco, utilities. There are still some outstanding valuations and they tick all your boxes.

Oct 15 07:31 AM

[Berninvestor:]

Thank you for your great article Jeff. You sound like a very sane and stable voice in these uncertain times. I've just added you to my "follow" list. Happy Birthday wishes to your wife and son!

Oct 15 11:15 AM

[bassmaster17:]

Well said article, totally agree, RIG is either gonna break out or down soon. Given the fundamentals of the company and the location of new oil finds with a declinig production curve and an expanding middle class where the majority of people live...I'm assuming they'll be able to raise prices on their deepwater contracts in the future. If it breaks down I'll buy more RIG it has a terrific long term story and I think its dirt cheap.

Oct 24 08:02 PM