In Search of Stock Ideas: Passive vs. Active Approaches

by: Jeff Miller

When there has been a nice market rebound, we should expect to hear the familiar refrain: It is a stock picker's market.

This wise-sounding expression means that it is no longer good enough to "buy the market" whether through index funds or market stocks. It is time for some actual analysis.

There is some truth to the claim. Last autumn nearly everything went down. Even the hedge funds with inside information, with managers going to jail, lost on their long positions! At times this year, everything has gone up, no matter how weak the company.

This is not the "new normal" and it is certainly not the old normal.

The ability to find outstanding stocks is important.

The New Weekly Series

As I noted in yesterday's piece about my blog agenda, I am going to write something each week about how the individual investor can find attractive stocks. This is not directed to traders, although they may find a few interesting ideas. Each article will be a building block for my work in progress, a book for people who are not currently reading investment blogs. Since I have investment advisors and individual investors in my readership, I am hoping for plenty of suggestions and comments to keep me on the right track.

Each week I plan to do an article that considers one part of the stock-picking process. I hope that it keeps up with reality, generates ideas and selections, and helps us all make money. I might be too slow in the writing, but you can all join in the criticism.

Passive Approaches

There are many sources of stock ideas, but passive approaches are not the focus of this article, Maybe I will revisit this topic, but there is a big hurdle for most investors. I spend many hours each week reading opinions, analysis, and data about stocks. The individual investor cannot match this.

Those favoring this approach might consider the following:

  • Jim Cramer's work, both on his website and his CNBC program is a source of stock opinion and investor education. I like it better as education, since the many recommendations may be difficult to track. Anyone regularly watching Cramer should have learned the need to do homework -- an hour a week on each stock position. This is the minimum.

There are many other sources of ideas from reading -- the subject for another article. Here is the most important piece of advice about passive approaches:

Beware of Stock Tips

The problem is twofold. The tipster is almost always swinging for the fences -- high reward, but high risk. More importantly, you will not know when to exit. Buying on a tip puts you at the mercy of the continued advice of the tipster.

This is a big mistake of the individual investor, and a common one.

Active Approaches

Stock screening is a great way to find new ideas, if you have a sound approach. The emergence of various screening tools has put dangerous instruments into the hands of the inexperienced.

Let us suppose, for example, that you are worried about the market and decide that a great dividend yield will provide protection. If you screen for the highest-yielding stocks, you might simply generate a list of companies that are about to cut their dividends! It is not so easy.

If you want to explore stock screening you can do no better than paying the modest membership fee and joining The Kirk Report. Charles Kirk is an expert at this technique and he highlights screens that have a proven record. This is a continuing source of great ideas.

Thematic screening is another approach, the basis of my own Great Stocks program. In my first article in this series, I suggested some interesting current themes. If you have not read that article, I suggest that you review it before proceeding.

Pursuing a Theme

I start with the assumption of a theme. For the purpose of this example, the theme is a continuing economic rebound. I realize that many reject this assumption, and that is fine. It actually helps in finding good opportunities.

I am looking for companies that could have explosive earnings growth potential if the economy continues to improve. That is the first screen. I then try to analyze the company in more detail. Most importantly, how much downside might there be if the thesis does not play out?

The point of this article is to find candidates. In future articles I will examine how the investor should be skeptical and challenge the potential stock price increase.

One of the very best sources for this type of screening comes from the companies themselves. What is the business model? How are they developing a strong position? And most importantly, can there be explosive stock price appreciation.

Today's key concept is earnings leverage. A company that has costs under control and a business model prepared to deliver should be talking about earnings leverage.

The key resource is the Seeking Alpha transcripts of conference calls. The Seeking Alpha team covers many calls and it is a searchable database. If you search the transcripts for "earnings leverage" you get 128 hits, and you can sort by date. This means that you can look at companies that claimed leverage earlier this year and see how they are doing.

This is a powerful and valuable resource. A couple of years ago conference calls were a high-priced subscription service, available only to the pros. It is now free, available to us all, if you only know how to use it.

Finding a Case Study

The first step from a screen is putting the stock on your "watch list." You follow the company news, the chart, and the economic backdrop to see if the story is playing out. We are not trying to pick bottoms. It is completely acceptable to buy a stock at a higher price when the reward/risk ratio has improved.

Here are some ideas from the search. I invite reader nominations for our more detailed analysis:

  • Zebra Technologies Corp. (NASDAQ:ZBRA)
  • Lennox International, Inc. (NYSE:LII)
  • Manhattan Associates, Inc. (NASDAQ:MANH)
  • Zep, Inc. (NYSE:ZEP)
  • Applied Materials, Inc. (NASDAQ:AMAT)
  • Varian Semiconductor Equipment Associates, Inc. (NASDAQ:VSEA)
  • Teradyne, Inc. (NYSE:TER)

Other suggestions are most welcome. To be continued.

Disclosure: No current positions in mentioned stocks, but I am watching.