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Why I pick stocks [ClearOnMoney]
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Commentary

Why I pick stocks

3 Feb 2011 by Jim Fickett.

Most people view the picking of individual stocks as something in between making a brilliant chess move and purchasing a winning lottery ticket. Not me. In my view a large fraction of all companies have serious issues, and the only responsible way to invest in something narrower than the whole market is to carefully research individual companies.

If you mention stock-picking, most people think of trying to pick the winning horse. There is an element of chance, but if you are smart, and a little lucky, maybe you can pick tomorrow's Coca-Cola, or Starbucks, or Apple. In other words, its all about striking it rich.

That's not why I pick stocks. I spend a lot of time researching individual companies in order to manage risk. Generally I have an investment thesis, e.g. gas prices will recover, or medical spending will rise in developing markets, or fast food always drives out slow food. Then I look for a solid company to invest in; one that will earn money in any case, but will also benefit from the trend.

There are other ways. Many people like ETFs, and there are certainly good things about ETFs. It is both a good thing and a bad thing that they relieve you of thinking about individual companies. In other areas of life you can also forgo critical evaluation of the individual. You can hire someone who has passed the bar exam and not worry about trying to decide for yourself if the person is a good lawyer. Or you can hire a PhD molecular biologist, and hope they can progress your research program. But you will do better to think about what competence you really need, and hire someone who has demonstrated that competence.

I want to invest in trees. Many people would buy one of the two timber ETFs, WOOD or CUT. I've mentioned before that some of the companies in these two ETFs don't own trees and don't benefit in any way from trees keeping or increasing their value – International Paper is an example. But it goes further than that. The third largest holding in WOOD is Rayonier. It turns out the resemblance of the company name to “rayon” is not fortuitous. Most of the company income is not from managing forests, but from manufacturing fibers. In other words, it is far from clear that there is any strong correlation between buying WOOD and investing in trees.

I am surprised at how often, when I investigate companies, I find something really dreadful. Statoil is running down its reserves, i.e. spending its capital. Weyerhaueser has quite a serious pension problem and is trying to make up for it by putting the pension assets in hedge funds. Plum Creek Timber Company has such an opaque structure that I don't believe anyone outside the company actually knows whether they are earning money or not (um, remember Enron?). Many people like the gas company Chesapeake Energy. In 2008 the CEO had to sell all his shares in the company to meet margin calls; then the company bailed him out. Do you really want that board and CEO managing your money?

Not me. My philosophy is closer to this statement from David Swensen, the famous developer of the “Yale model”:

Swensen says his criteria for selecting outside money managers are simple: “The most important thing is character and the quality of people. That’s also the second most important thing and the third most important thing. It’s everything.” Assessing character involves such deep background checks that, says Swensen, “Some of our managers will tease us about having tracked down their high school geometry teacher.”

I wish I could do that, but there are limits to the time of the individual investor. Still, the character of a company and its leadership do show quite strongly in the 10-K.

The cardinal rule of investing is not to lose money or, almost equivalently, not to do anything really stupid, or invest in anything you don't understand. In my opinion there is really not much between the very simple option of using index funds, and the much more time-consuming option of carefully choosing solid companies. The much more common options of investing on the basis of someone's one paragraph argument, or of investing in narrow, specialized ETFs, both violate that cardinal rule.

So that's why I pick stocks – it's the only responsible way I can think of to invest in anything narrower than the whole market.