Selecting Individual Stocks? 4 Questions to Consider
MODERNIST’S ASSET CLASS INVESTING PORTFOLIOS ARE STRATEGICALLY INVESTED WITH A FOCUS ON LONG-TERM PERFORMANCE OBJECTIVES. PORTFOLIO ALLOCATIONS AND INVESTMENTS ARE NOT ADJUSTED IN RESPONSE TO MARKET NEWS OR ECONOMIC EVENTS; HOWEVER, OUR INVESTMENT COMMITTEE EVALUATES AND REPORTS ON MARKET AND ECONOMIC CONDITIONS TO PROVIDE OUR INVESTORS WITH PERSPECTIVE AND TO PUT PORTFOLIO PERFORMANCE IN PROPER CONTEXT.
Picking stocks, or trying to choose the companies that will outperform the broader market, has been an ambition of investors for years. And even the professional fund managers struggle to pick the winners from year to year. (1) For those inclined to try, consider this framework first. Although the questions may be simple, they provide tremendous insight into designing a stock portfolio and what to expect from its performance.
1. What to buy
The first question to consider is what do you want to buy. Although you can find numerous pages in financial textbooks and even more eye-catching headlines dedicated to this topic, making a decision can be complicated.
That’s because we must make a distinction between a company and its stock price. Every company’s price is determined first by the current value on its financial statements. For this, we can look at the company’s assets minus liabilities, also called book value or shareholder’s equity. If that was all that drove the stock price, prices would be relatively stable.
But stock prices tend to be anything but stable. Rather, prices not only depend on the company’s cash flows and earnings today, but also those we expect the company to generate. The more earnings or cash flow someone predicts or the more confident someone is in those cash flows, the higher price they’ll pay for the stock. Put simply, stock prices are driven by the stories we hear about a company – and how believable we find them.
2. When to buy
We have two simple ways to make money in the stock market: We can buy low and sell high. Or we can buy high and sell higher.
When we buy based on the stories we hear about companies – whether how great they are or will be – we run the risk of buying high to sell higher. Prices already reflect the optimism from those stories. Good stories dominate headlines, which, as much as we may try to resist, will influence our expectations for a company.
The other approach would be to try to buy low and sell high. To do this, we could try to find the best deal available today. Figuring out a “good” price for a company can be challenging, but research shows we can get close by comparing the price to the company’s financial statements. For example, we can look at the price compared to the book value, earnings or cash flows. Historically, focusing on the less expensive companies has been a better recipe for long-term performance than buying something at a premium and hoping to sell it for more down the road.
3. How much to buy
Once you have a list of companies trading at competitive prices, you will need to figure out how much of your portfolio to allocate to each. Being intentional about how much we choose to invest in each company, and how that amount compares to the broader stock market, can have a big impact on returns.
The graphic illustrates how. Both lines represent indexes invested in S&P 500 companies. The light blue line represents the S&P 500 index weighted by market capitalization, meaning that larger companies get a larger allocation.2 The dark blue line represents the performance of the index if each company was weighted equally (so that the index invests approximately 0.2% in each company).
Hypothetically, an investor that opted for equal weights of these stocks would have had much better performance over the 30-year period than those that allocated more to the larger companies. This underlines a key point: Your performance is dictated not only by what you own, but also how much you choose to own of each company.
4. When to sell
The final question to answer is when to sell. Often overlooked, even by professionals, answering this question in advance forces us to be more thoughtful in our decisions, which is good because history shows us very few companies are worth holding forever.
An article published in the Journal of Finance in 2019 looked at all companies in the Russell 3000, an index that represents the totality of the U.S. stock market. From January 1987 through December 2017, a hypothetical $1,000 investment would have grown to nearly $22,000 by the end of the period. Not too bad.
However, when the authors looked at the companies within the index, they found that the bulk of the index returns came from just 7% of companies, and 47% of the stocks would have been unprofitable investments. Even more startling, 30% of the stocks lost more than half their value and never recovered. Imagine if you were holding mostly those stocks – would you have known when to sell? Markets typically recover from downturns. But the same can’t be said for an individual company or its stock.
Bringing it together
Building a portfolio of individual stocks is tough. Although these four questions are simple, answering them is challenging. Rather than attempt to build a portfolio of single stocks hoping for outsized returns, the simpler and more dependable approach is to own a little bit of every company. If you want to try for better returns, you can emphasize less expensive and profitable companies. This is easier to do through mutual funds and exchanged-traded funds. Then, instead of spending all that time trying to find the best stocks, you can enjoy the life you have worked hard to build.
