Good stock selection is very simple in its essence, and the phrase “ruthless reduction and pruning” does a good job of summarizing it. This article lays out three basic principles to orient on when selecting stocks, a process that I consider a crucial exercise to hone in on stocks that can be described as exceptional opportunities.
Principle 1 – Extreme selectivity
This is a more abstract, procedural, and outright foundational principle. There are thousands of stocks to choose from, so why waste time with anything but the very best in a given metric, be it fundamentals, entry-points, performance, chart quality, etc.?
Think of it as a gardener would that inherits an old garden full of thousands of weeds and a few pretty roses growing here and there. Do you water everything equally? Of course not – you throw out the thousands of weeds, but also the roses that are damaged, ill or dead. You weed out and prune, until only that remains which makes your new garden a den of beauty.
In the stock market, you need to throw out anything from your analysis that does not fit the narrow description of an exceptional outlier. Most people will go to any lengths to get their children the best education possible. You should go about stock selection with the same rigor – almost no stock should be good enough for your money
Regarding whatever criteria, you need to reduce your selection at least down to the top 10% ranking ideas. But even that is not enough, quite frankly. If you want to outperform, you need to do more … or you might as well buy a market ETF. The best speculators reduce the list of stocks that the market offers to them so much that they will end up picking only the top-ranking 0.05 to 0.1%. This will lead to maybe 5 to 10 preferred ideas in over 10,000 publicly traded stocks!
I’m showing the below somewhat simplistic schematic to make a point of the extremity of the exclusion that needs to be applied. Superb stock selection isn’t just “find the better stocks in the market that you somewhat like” – it is actually more like “consider nothing short of a prodigy”.
On the surface, almost everybody will agree with this idea. Who wouldn’t say yes to only buying what they consider the best ideas? No problema compadre, a walk in the park.
Plot twist – Oh yes, that is a problem! Because operating in the stock market ceases to be a rational endeavor the moment most humans cross the threshold to seriously consider a financial commitment. That applies to the buy & hold “investor” as much as it does to the day-trader, or anyone else in the market. Personal preferences, anchoring bias, character flaws, FOMO (that’s a big one), opinions, media “experts”, or tips from friends or family all lead us astray in selecting the best commitments and abandon our clear-cut rules. Wanting to buy something, anything, now, dilutes our stringency in selection. The true challenge here is a psychological one – to lay out our rules of selection, and stick to them no matter what our own opinion or that of others might be.
Selecting only the best means saying no, no, no hundreds of times, over and over sometimes long time-frames. That can be mentally exhausting, because it is against our nature – plus, every rejection is a conscious decision we have to take, which takes intellectual effort and energy. Hence, an excessively stringent process of elimination is an overarching principle that needs to be applied to metrics such as relative strength, liquidity, activity, price-volume signatures, fundamentals, and many more.
Principle 2 – Latch onto a strong young trend
There is no point in trying to reinvent the wheel, there is no point in “valiantly fighting” for your favorite company that you’ve been adoring for years but which stock just won’t go up.
To make exceptional returns, you need exceptional stocks. I’m not talking about the Microsofts and Apples of this world, no blue-chip stuff that’s now long past their prime. I’m talking about true alpha. Doubling or tripling your money in 6-9months or so. In a nutshell, exceptional stocks are those that have started outperforming the market recently – and the huge conundrum to many individuals is the fact that those stocks can be expected to very likely keep doing so in the near future. There is a reason why most people don’t make money in the stock market, and that is because almost everything works the other way around than we think it should.
As physical objects keep moving with momentum, but for different reasons, stocks also tend to keep momentum. This has to do with an array of crowd-psychological effects of large money interests owning the stock, market participants wanting to take profits, and those eager to join the move. As the veteran stock trader and broker Loeb commented, “The safest investments of all are more often than not in stocks that have gone up, are going up, seem high, but continue to go up. Really good stocks always appear overpriced”.
For a stock to be worth considering, you need proof that it will make you money … and not in 10 or 20 years, but from the moment you buy. You do this by insisting that it is already making money for its holders, i.e. is in a strong up-trend. Ask yourself, why would you buy something that might make a return at some point, but might also fall in price for a loss, or severely under-perform the market while other stocks are already making money for their holders and are likely to continue to do so?
Many amateurs cringe at this idea, as they project the “summer sale” bargain mentality from real life onto the stock market, or remember reading somewhere on the internet from their investing guru about shunning “over-valued” stocks. While there is such a thing as over-valuation, classical number-based valuation models fail to incorporate human nature – a natural force to be reckoned with in the stock market. Stocks can trend much further than any model would suggest.
The truth is that stocks trade at any time near their current value, or whatever the market perceives to be their current value. It’s an old principle from real estate, luxury goods, and really any asset class, that expensive things tend to get more expensive. Anybody can buy a cheap piece of art, but there is a reason why a Rembrandt commands a premium price – and that is because its value can be expected to keep rising and rising. Demand for it is high, and supply low. Demand that will most likely persist, which keeps driving prices up. No mathematical model can tell how far an overvaluation can go, considering the human element. On the other hand, a cheap stock has no demand, and there is a reason for it – it has been and likely is still being sold on balance. Supply is taking over. It is shunned by the big money, and only exceptional circumstance will be able to turn its down-trend around.
Remember that the world of stocks is based on probabilities – a stock that is trending up might also roll over and start dropping in price – but over any time-horizon, it is just less likely to do so than continuing to trend up. A stock that is heading down might also head up again, but over any selected time-horizon it is less likely to do so. If we buy down-trending stocks, we need to be OK with the possibility of losing nearly all our money, because every 90% stock decline, initially in its first days, started off as a 5%, 10%, 15% etc. decline that some bargain-hunters and value-chasers would consider worth buying into. Of course, you should never hold a stock dropping in price, as risk management is always your job #1.
We need to think in likelihoods, and align ourselves with the best odds of something happening, because returns and losses only matter if they are consistent over long time spans – a domain that is reigned by probabilities.
But finding up-trends is not the whole equation. One also needs to be careful not to buy too late into an up-trend – just buying the stocks that have advanced the furthest is an equal rookie mistake. When a trend is obvious, you hear its name everywhere, and when everybody who could have bought has already done so, look out below. Trends persist when more money is on the sidelines than already in a stock – money on the sidelines is potential buying power that can still drive up the price via demand.
When there is no buying power left, the market is boiling, and everybody is happy, all that is left for anyone to do is sell. And large selling supply will bring price down. That means, you have to find the right timing, when a trend is strong but still young. Look for stocks that are ready to start or have recently started moving out of periods of relative quietude.
Principle 3 – Look for the hoof-prints of big buyers refusing to sell
Another important basic principle is to look for signs that the big buying interests and holders of a stock are not selling their shares, i.e. expecting the trend to continue. And if the majority of the capital that sits in a stock does that in harmony while demand stays high, such will become a self-fulfilling prophecy.
High liquidity stocks that display orderly trading (“tightness” in price dynamics), low selling volume, large volume in up-moves, and the ability to move fast (something I call virility) are useful qualifiers. Here, it’s also important to be sure that you can expect large buying demand to keep coming for a while, keeping the larger price trend intact. Think about what attracts large fund managers to start acquiring stock in a company in the first place, and what would entice them later to re-evaluate a stock and encourage them to buy even more of it. For almost all institutional decision-making, the expected future profitability of a company plays a major role. In real estate it’s location, location, location – in institutional stock evaluation, it is large expected and/or actual increases and surprises in organic earnings. Seek stocks that trend up strongly, whose companies show a mouth-watering bottom-line.
Stock picking is only the start
Of course, you can’t just buy these stocks anytime you want – you need to find a low-risk entry point, where likelihood of trend continuation is much higher than price volatility leading to a loss and/or stop-out. Grab a free copy of my chart-reading factsheet to get started.
A word of caution though – most of the time, the viability of entry points into a stock are conditional on the state of the general market. One could say once you’re done stock picking, you’ll be busy market-waiting. Once you’re entering a stock you need to understand the details of position-, money- and risk-management to make profits worthwhile and success consistent. Later, you need to understand exit rules that tell you when to end a commitment. There is a lot more to understand – keep learning with an open mind.
Stock picking, although in its essence simple, is a topic that requires study and detailed analysis. Sign up here for a step-wise and uncomplicated course to learn how to become expert in this discipline, and all the other elements of successful speculation.
