How To Be An Ace Stock Picker

There is a perceptive paragraph in Jared Diamond’s Guns, Germs, And Steel. It goes something like this.

“Domesticable animals are all alike; every undomesticable animal is undomesticable in its own way”

If you think you’ve already read something like that before, you’re right. Just make a few changes, and you have the famous first sentence of Tolstoy’s great novel Anna Karenina – “Happy families are all alike; every unhappy family is unhappy in its own way.” Essentially, Tolstoy is saying many things need to fall in place for a happy and successful marriage – sexual attraction, agreement on money, child discipline, religion, in-laws, and other vital issues. Failure in any one of these areas can doom a marriage even if it has all other ingredients necessary for happiness. This principle can be extended to understanding much else about life besides marriage. We tend to seek easy, single-factor explanations of success. For most important things, though, success actually requires avoiding many separate possible causes of failure.

Now in the above paragraph, just replace domesticable animals with investible stocks and undomesticable with un-investible. And you get some deep insight into stock picking. Let me add a bit of insight from Malcolm Gladwell (whether I agree with him or not is not important). Gladwell says that to gain expertise in something, we need to spend 10,000 hours learning and practising it. Imagine if you applied this rule to investing. If you worked 10 hours a day, you could become an expert in three years. If you spent 3-4 hours every week (given we all have day jobs), you could end up taking 50 years. Thus, stock-picking expertise lies somewhere between three and 50 years of learning and practising. Most of us will fall somewhere in the middle (as with most other things in life) and 25 years is almost the entire income-earning period of one’s life and we will therefore be left with very little money in the end (learning and practising is an expensive activity). Is it that grim? Is there something that history tells us that we can learn quickly enough? There seem to be some very successful stock market investors in the world. How did they do it?

I have no idea how they did it. What we have done is investigate history to hunt for patterns. The challenge for investment professionals is similar to what historians, astronomers, and several other disciplines face. It is impossible to replicate the past or experiment, given the complexity of a large number of variables that influence outcomes. Thus, controlled experiments in the field of investments are not possible. We cannot hold all variables constant and then evaluate the effect of a change in one variable on stock prices. What causes share prices to move in one time frame may not hold true for another. Formulating universal laws is almost impossible.

That said, history reveals something useful. Our work shows that it does not pay to have a single investment strategy – like people who buy only quality or only value stocks (I refrain from defining these terms since that would consume another essay). What seems to work over time is if one straddles these investment strategies – quality, growth, value, and momentum. If one packs all of these approaches into stock selection, some method to the madness seems to emerge. Simultaneously, “investors” (notice the quotes) need to avoid too much financial leverage in the companies in which they buy stocks. High beta seems to be avoidable as well for the obvious reason that high beta is generally a good sign of high popularity apart from the argument that it also lifts the hurdle rate and therefore drives down return. So simplifying what we learnt into quantitative metrics, history tells us the stocks of companies that combine the following attributes more often than not make money for investors:

• Strong growth – EPS, book value, and dividend growth
• Positive change in return on capital ratios (return on equity and return on capital employed)
• Low EV/EBITDA
• Conservative capital structure
• Falling financial leverage (if it has been high)
• Positive free cash flows
• Beta < 1.1

The general perception is that quality as a style has been a clear winner since the global financial crisis. While this perception is supported by some of our work (low financial leverage, positive free cash flow, and positive change in return on capital), other parts of our work (such as the absolute level of RoE, RoCE, change in free cash flow) suggest that what connected the winning dots was more than just focusing on quality. Our work concludes that it was about picking businesses exhibiting sustainable growth. Here are the seven surprises from our work:

• Starting level of RoE and RoCE did not affect returns; what mattered was the positive change in the level of the two ratios.
• Dividend payout is an important signal of a company's growth strategy and authenticity of profits, but it does not necessarily help predict stock returns.
• At different levels of positive FCF/sales, returns do not vary. That said, when FCF/sales is negative, there is a positive correlation between the level of FCF/sales and returns.
• Fall in financial leverage mattered more than its level.
• Starting points of price-to-equity and price-to-book did not affect returns.
• Starting point of beta matters for long-term returns.
• Small-cap stocks give the maximum returns.

It goes back to Tolstoy’s point. To win at stock picking, you need the stock of a company with a moat, good governance, supportive macro environment, robust corporate strategy, and execution leading to above-average return on capital and growth, all available at a reasonable price. If any of these are missing, making money becomes onerous. Even as we confidently reveal this secret mantra, there is a very big catch. All this presumes that we will accurately forecast the financial performance of companies. Forecasting financials is tougher than forecasting almost anything else in this world and this is where the struggle begins. Just look at my index forecasting track record if you are not convinced.

Ridham Desai is managing director at Morgan Stanley India and also serves as head of equity research and India equity strategist.

The views expressed here are those of the author’s and do not necessarily represent the views of Bloomberg Quint or its editorial team.