How to pick stocks

The Austrian business cycle theory suggest that investors buy stocks in the capital goods sector, or cyclical stocks, in the early years of an expansion and switch to consumer goods makers in the later years. Investors can do that easily with exchange traded funds (ETF) which cluster stocks in a dizzying array of industries, commodities and countries. For example, one of the better known tech stock ETFs is QQQ, which contains the stocks of a lot of capital goods companies.

But as happens with any grouping of large numbers of companies, most will be dogs. Only a few will be excellent companies whose profits grow well and whose stock prices reflect that growth. Most of the members of the ETF will act like an anchor on the value of the ETF. The only solution is to buy individual stocks, but analyzing thousands of individual companies takes more time than most part time investors enjoy.

Hundreds of web sites have sprung up to help investors by providing expert analysis and promotion of individual companies. Most of the investment advice on the web contains experts pontificating on the prospects of individual companies. However, the experts get it wrong most of the time. Bloomberg.com published a story in January titled “Almost All of Wall Street Got 2012 Market Calls Wrong” in which the author wrote, “From John Paulson’s call for a collapse in Europe to Morgan Stanley (MS)’s warning that U.S. stocks would decline, Wall Street got little right in its prognosis for the year just ended.”[1] In other articles on the site, the authors suggested that investors would do better shorting the stocks recommended by the pros and buying the ones they snubbed.

That shouldn’t be surprising. Many studies have shown that experts, from doctors to investment pros, tend to be biased. Ian Ayers in his book SuperCrunchers gives many examples, one of the funniest being the biases of wine experts. He shows that simple regression models beat the pros at forecasting just about anything. The main advantage of the models is objectivity.

Investors can take a similar approach by using objective criteria for choosing stocks and most of the work is already done for you. A lot of academics and professionals have used statistical analysis and other techniques to distill the myriad of features of successful companies to produce manageable models that predict which stocks will see an increase in value in the near future. 

The American Association of Individual Investors, AAII, has automated over 60 such models on its web site and without subscribing visitors can read about the stock screening criteria of each approach. With a subscription the web site will tell you which stocks the method recommends. AAII runs the models once a month.

For example, recently the AAII featured in a newsletter the Cash Rich Firms screen. This approach is value-oriented that screens for companies with a high level of cash compared to its current share price. It passes over companies with a lower market capitalization and has a monthly turnover of around 25%.

The screen filters companies according to these criteria:

•             Those companies that are in the financial and utilities sectors and real estate operations industry are excluded.

•             Earnings per share from continuing operations over the last 12 months and for the last fiscal year (Y1) is positive.

•             Market capitalization for the last fiscal quarter (Q1) is greater than $50 million.

•             The stock price is higher than $5 per share.

•             The total liabilities to total assets ratio for the last fiscal quarter (Q1) is less than the industry’s median total liabilities to total assets ratio for the same period.

•             The ratio of long-term debt to total capital for the last fiscal quarter (Q1) is less than the industry's median long-term debt to total capital ratio for the same period.

•             The cash to price ratio is greater than 20.

•             The cash per share is at least 20% of the stock price per share.

•             The net cash to price ratio is greater than 20.

•             The net cash (cash minus current liabilities) per share level is at least 20% of the stock price per share.

Investors should be able to find several methods in the AAII list that allows them to combine the ABCT, their level of risk tolerance and need for diversification. I have had great success with the Piotroski: High F-Score screen in the past, but I am sitting in cash right now.

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[1] http://www.bloomberg.com/news/print/2013-01-04/almost-all-of-wall-street-got-2012-market-calls-wrong.html.