How to Pick the Next Great Stock

I’ve written often about how the best investors beat the market.

It’s not by guessing whether to be in the market or out. It’s by owning individual stocks that give higher returns than the broad market.

Ask an auditorium full of investors “Who’s the greatest stock picker of all time?” and you’ll get a variety of good answers (starting with Warren Buffett).

But ask that same auditorium “Who’s the greatest market timer of all time?” and you’ll hear some low murmuring and then… crickets.

It validates Vanguard founder Jack Bogle’s famous quote…

After nearly 50 years in this business, I don’t know anybody who has [timed the market] successfully and consistently. I don’t even know anybody who knows anybody who has.

If market outperformance is your goal, drop your subscription to the psychic network and pull out your calculator instead.

Because analyzing businesses is partly about evaluating products, processes and quality of management. But it’s mostly about numbers.

Companies that experience rising sales, increasing market share, double- or triple-digit earnings growth, and high returns on equity see their share prices rise.

Those that don’t… don’t.

However, just as individuals experience an awkward start (adolescence), a period of mastery and success (maturity), and then a slow or sudden decline (old age), companies have a limited number of prime years too.

We saw this in June 2018 when the last original Dow Jones Industrial component, General Electric (NYSE: GE), was dropped from the index after more than a century.

Hard as it may be to believe, someday other corporations will replace market leaders like Apple (Nasdaq: AAPL), Amazon (Nasdaq: AMZN), Netflix (Nasdaq: NFLX) and Google’s parent, Alphabet (Nasdaq: GOOGL).

But almost certainly not anytime soon.

Readers who have run businesses of their own recognize that companies often find a profitable niche and work it for all it’s worth, then something changes that completely alters their outlook.

That “something” could be a disruptive new technology, the rise of tough new competitors or just changing consumer tastes.

But once a company starts losing market share – for whatever reason – it is often difficult (if not impossible) to get it back. That’s why few companies are worth hanging on to forever.

(Just ask any buy-and-holder of Montgomery Ward, Circuit City, Borders, RadioShack, Shearson Lehman, Kodak or Sears, to name just a few.)

The two things every investor needs to beat the market with individual stocks are a strict set of criteria for what to buy… and a strict discipline for when to sell.

In my 37 years in the business, the three best methods I’ve found for selecting stocks are momentum investing, value investing and riding the coattails of industry insiders.

Momentum stocks are companies that lead the market in sales and earnings growth, product innovation, and price action. They tend to rise faster in a bull market and fall harder in a bear market or correction.

Value stocks are companies that are cheaper than most on the basis of price-to-sales, price-to-earnings and price-to-book value. They often pay bigger-than-average dividends too.

These stocks may rise less in a bull market but hold up better in a bear market. They are a fine example of why the tortoise beat the hare.

But there’s no better indicator than insider buying…

Insider buying is when the officers, directors and beneficial owners are buying substantial amounts of their own companies’ shares with their own money at current market prices.

Given that these individuals have access to all sorts of material, nonpublic information about their companies’ business prospects, it’s no surprise that these stocks tend to outperform in good times and bad.

These are three different approaches requiring entirely different metrics. Yet they all work over time… and none involve trying to outguess the market.

Of course, anyone can plunk for a few shares of stock. Successful investing also means knowing when to get the heck out.

That means implementing and adhering to trailing stops.

Liberty Through Wealth‘s publisher The Oxford Club advocates for a 25% trailing stop. The Club also encourages investors to never invest more than 4% of their portfolio into one position.

With these two disciplines, you minimize your downside (you’ll never lose more than 1% of your portfolio value) and maximize your upside.

Good investing,

Alex