Investors guide to picking stocks
Below is a checklist which provides a general guidance for selecting stocks for the long term.
- Business must possess a durable competitive advantage, this is relatively easy to find out. What is difficult is to agree on a combination of great price and good business
- Follow Michael Porter’s (MP) competitive strategy on forces of competition models
1. Rivalry among existing firms
– Industry growth rate. MP prefers fast growing industries. I believe Micheal Porters model is incomplete for investing success. One needs to be early in fast growing industry and prefer slow or non growing industry, or strongest player in fast growing industry as a general rule.
– Concentration and balance of industry
– Is there customer stickiness to product
– Is there steep learning curve in industry, economies of scale
– Is there excess capacity in industry
– Can industry customer base change rapidly
– Product differentiation
2. Threat of new competitors
– Are economies of scale relevant
– How easy is it for new competitors to enter
– Do existing players have hard to replicate service / product
– What is the moat, network effect, low cost, brand, high switching cost
– Legal barriers or patents
3. Threat of substitute products
4. Bargaining power of buyers
5. Bargaining power of suppliers
One needs to answer above questions to hold stocks for long term.
Industry does not matter
An important lesson unlikely to be well learnt by most investors is, that in picking stocks, it isn’t important to assess how much an industry is going to change society, or how big the industry would grow. Its important to know how a company scored over its competitors and how long it can maintain this advantage.
Economics of the business matters
We need to look for business with good tailwinds and companies that require non linear capital input to grow sales. Nebraska Furniture Mart is lowest cost producer Louis Vuitton is premium brand, both possess moats.
ROE is important, so is Net Income / Sales
No company can grow net profits faster than its ROE over long period without debt, equity dilution or window dressing. ROE in future matters more than what it has been in past, which is a hint.
High profit percentage to sales can attract competition, low signifies poor fundamentals or commodity nature.
An ideal management team should be strong advocate of company’s shareholders. There are no corporate raiders to talk of in India yet, so one is at mercy of controlling family.
Do the owners only reward themselves with high salaries?
Has the management bought shares from open market?
Have they paid rational prices for acquisitions made?
Is there an event risk to businees upon demise of key management personnel?
Discounted value of future cash flows
Rational price a private buyer would pay
Psychology towards investing
Availaibility Bias : Humans tend to have stronger recollection of information recently obtained or information that has had strong impression. An example is when someone tries to bring up a stock on news channel.
Representativeness: If a stock has gone up several years then it is bound to come down the next year, or market is likely to decline simply because it has gone up for the last 6 years.
Gamblers fallacy: Gamblers tend to believe that if a coin has landed on heads five times then it is likely to land on tails the sixth time. Markets behave a lot like tosses of coin. Interesting patterns provide little guidance on how to predict patterns of the future.
Over confidence: Everyone thinks they are smarter than others and have more faith in their capabilities.
Anchoring: We tend to stay on a course of action once its been decided.
Illusion of Validity: Investors tend to ignore evidence that goes against their conclusions and place too high a value on evidence that conforms to their conclusions.
Hindsight bias: False extrapolation of past trends into future. Frame dependence is another area where investor’s perceptions of risk and return and thought processing abilities break down. Loss aversion and loss realisation from poor idea, mental accounting (free shares or free money) and regret complex are three examples of frame dependence.
Loss results in 2.5 times the emotional impact of an equivalent gain. People are not able to take losses, this is the reason why many people sell stocks at worst moment. Lotteries are popular because amount of loss is less. Investors sell their winners too early and hold their losers too long.
We should admit errors and book loss.
When investors lose 70% of their portfolio they would regret having invested anything at all in equity market.
” Now, let me close with a few words of counsel from an 80-year-old veteran of many a bull and many a bear market. Do those things as analyst that you know you can do well, and only those things. If you’re really good at picking stocks most likely to succeed in the next 12 months, base your work on that. If you can foretell the next important development in the technology, or in economy, or in consumer’s preferences, then concentrate on that activity, But in each case, you must prove yourself by honest, no-bluffing self examination and by continuous testing of performance that you have what it takes to produce worthwhile results.”