Picking Stocks

Many active portfolio managers describe themselves as “bottom up” investors, by which they mean that their process begins with picking individual stocks that are fundamentally mispriced. However, the evidence shows that successful investing does not start with stock picking, but rather with a firm set of principles and exploitable factors. For example, Warren Buffet, considered by many the best stock picker of his generation, has been known to buy a stock after only a brief conversation because he can quickly fit the idea into his very defined philosophical framework.

The investors first task should be to define an investment policy and a process which is simple and replicable. The second task, refered to as asset allocation, is to construct a portfolio of assets that matches risk appetite and tolerance for drawdowns by diversifying into non-correlated cash flow streams. The third task is to identify the securities, including stocks, to implement the strategy. It is at this point that stock picking acumen comes into play, giving the investor the opportunity to use skill to garner excess return (“alpha”) beyond what is available through indexing strategies.

Quant strategies are already very good at exploiting at very low cost the market return (beta) and factors such as value, size, momentum and quality. Therefore, the successful stock picker needs to focus on segments of the market that are “inefficient” because of the behavioral biases of both institutional and individual investors. Computers are not particularly adept at reading human emotions, judging human character and seeing the future, so in these matters portfolio managers still have a significant advantage.

The behavioral biases that can be exploited are:

  • Short-termism – the great majority of institutional investors and all of the Wall Street “sell side” brokerages are focused on the next 3-6 months. Enormous resources are spent on this time frame, so the market is extremely efficient and alpha is scarce. But if the investor can look forward, the competition for alpha declines precipitously as duration increases. Time-horizon arbitrage is a lonely occupation in the investing world, so there is alpha to collect.
  • Herding – Investors like to move in herds. As Keynes once noted, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to success unconventionally.” Contrarians are rare in the investing world, so they can harvest alpha through mean-reversion strategies, which go against the herd.

The independent investor should also narrow his focus to segments of the market that are richer with alpha. Buffett, for example, says that from the start he eliminates 90% of the stocks in the market, the “too difficult” pile. He focuses all his attention on the remaining 10%. This pool of stocks, which he names his “circle of competence,” are companies that have simple business models and returns that are both high and sustainable. The sustainability of high returns exists because of a “moat” that defends against competitive pressure.

While most investors have portfolios heavily laden with market risk (beta) and factors that can be easily replicated by quants, the skilled stock-picker should focus on high-return prospects; “fishing where the fish are,” so to speak.

The key to alpha generation is to exploit human foibles in areas of the market that offer high potential, following strategies that cannot be easily replicated by the quants and their computers.

The first step is to define the “circle of competence.” In my emerging markets investments I initially reduce the universe to the 10% of profitable companies (historical basis). These companies, which have shown the ability to makes good returns on capital over the past 5-10 years , can be called the “Legacy Moat.”

The second step is to run a value screen on the Legacy Moat, and eliminate the more expensive stocks. This can be done simply with something like Greenblatt’s “magic formula,” or, for example, by eliminating high PE ratio or high price-to-book stocks. The list of stocks, narrowed to 5% of the universe, already should provide significant alpha based on the value and quality factors. Unfortunately, up to now the process can also be easily replicated by a computer.

The third step is to subjectively review the stocks on qualitative grounds, entering into issues where computers provide little insight.

The questions to be asked are highly subjective in nature:

  1. Is the moat sustainable?
  2. How much can the business grow and for how long can capital be redeployed at high rates?
  3. What is the “character” of managers/owners? Do they have integrity? Will they make good capital allocation decisions?

None of these questions is easy to answer, but this is where the portfolio manager can add  value.

The third step will narrow the list to 1% of the total stock universe. These businesses which have high returns, sustainable moats and the ability to reinvest can be called “moat compounders.”  These are the most extraordinary businesses if they have long runways (e.g. Walmart in 1970, Indian banks today.) Particularly in the medium-cap world and in emerging markets, these opportunities are not well followed and can be very under-priced. Typically these businesses have one of three moats: network effects (e.g. Facebook, Tencent); scale advantage (E.g. Amazon, Alibaba, Ambev); or valuable intangible assets  like brands (e.g. Coca Cola, Banco Itau).

Identifying moat compounders is not easy, but skillful investors do have an edge. First, by being exclusively focused on this “fishing ground,” they improve their chances from the start. Second, by  studying the nature of moats they become experts at identifying them. Third, they can take a long-term view, allowing for compounding effects to materialize. Fourth, they can exploit the moods of the market, as the herd moves on the “fear and greed” spectrum.

There is one additional segment worth mentioning that can provide significant alpha for the stock picker.  This is the “legacy moats” that do not have reinvestment opportunities but do have exceptional capital allocators. These legacy moats can be great investments if capital is redistributed to investors or redeployed effectively in M&A. This is the model followed over three decades by Brazil’s Jorge Paulo Lehman, as he buys mature businesses (e.g. beer) and redeploys cash flow into M&A opportunities.

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China Watch

  • China’s new winter sports resort ( WIC)
  • China cannot be a global leader (China File)
  • China forms a Cement giant with eye on Silk Road (SCMP
  • Starbucks opens its largest store in Shanghai (FT)
  • China and India lead in growth in parcels shipped (Business Wire)

China Technology Watch:

  • China’s two largest trucking aggregators merge (WIC)
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  • China-U.S. competition for AI (AXIOS)
  • China’s AI Awakening (MIT Tech Review)

EM Investor Watch:

 

  • GMO goes all-in on EM (GMO)
  • The end of globalization as we know it (Barclays)
  • Demographics will reverse major trends (BIS)
  • Venezuela’s farming disaster (Bloomberg)

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