How to Pick Shares

So you want to start investing or grow your wealth and you’ve heard you gotta get into this “stock-picking” thing. How do you go about it, there’s a lot of listed companies in the world to consider! Well, read on friends.

You usually find that investors choose companies in one (or more) of the following ways:

Someone you know or trust gives you an inside word; they have heard or know that Company X is about to be huge. Even if they are right, you risk the following:

• The market has already priced in that information – i.e. the share price has risen to accommodate this information. Ever think that other people know this ‘tip’ too?

• You are trusting their research or rumour, which isn’t necessarily credible or extensive

• Some inside information is not all inside information, you might just have a small piece of a large puzzle.

• If they could predict the future why are they telling you and have they done this in the past (successfully or otherwise!)

Apparently, looking at the past shape of the share price graph (known as Technical Analysis) for trend lines, ceilings/floors/support can help you predict the future of a company. It’s laughable pseudo-science, but many gamblers think they can successfully read the collective attitudes and actions of unknown crowds, comprising thousands of people, each with their own attitudes, emotions, heuristics and requirements. Best of luck, we say.

The “most appropriate” technique would be to look at the financial statements and announcements of the company and build your own financial model of the company’s future profitability (known as Fundamental Analysis). This is what analysts do to create a company valuation. If (a big if) you can construct what the future free cash flow and profitability of a company will be over the next 5-8 years you can multiply to estimate what the share price should be. This is where a broker or analysts Buy/Hold/Sell recommendation comes from. We see a couple of problems with this:

• the largest component of a valuation model is the long run growth rate (g) which you tweak by 0.1% and it makes a huge difference to the final valuation

• The multiple is based on the equity risk premium which is broadly pegged to the risk-free rate (the government’s interest rate), if this changes, the whole model changes

• Things change – the company’s environment, the economic conditions, the strategy of management

The news is full of headlines which promote or attack companies, that ultimately can sway investor conclusions. We buy companies that we think are good companies because we shop there, we like their brand or we believe in the cause. None of these actually mean the company is a good investment.

Take Nokia as an example – many of us would have owned one of their indestructible phones, unless you were born after the mid 90’s… Media headlines were regularly promoting their global growth (including one iconic Forbes headline), how popular their brand was plus they had Snake II! It’s easy to jump to the conclusion that this would be a great investment. And then, in 2007, the industry changed forever – the release of the iPhone.

We react to the words of politicians, economists, and commentators or the events of yesterday, which encourage behaviour that is not justified, but goes with the flow (sentiment). The trouble is you might be too late to the dance and all the good seats are taken.

This is not to say that some of the above strategies won’t work; there are always the success stories (usually getting the headlines). Plenty of “big fish” stories are also told at weekend BBQs, but we don’t talk about the poor fishing days, the squalls or the breakdowns. Often these successes are no more than gambles or a belief in information asymmetry (I know something that others don’t).

Most importantly, these stock picking methods are a lot of work and I don’t know about you, but we certainly plan to spend our summer enjoying the beach with the family, not analysing the NZX50.

This is why we are advocates for index investing. The research shows it works (like, really properly works), it’s not going to take up hours on your weekends and it’s easy to understand. We’re here for it and think you should be too.