Three Criteria For Picking Winning Stocks

In our weekly “Ask Todd” series, a reader asks: “Todd, can you give me three quick criteria to sort individual stocks worth investigating from those that have no merit?”

The quick and dirty answer is “your question has an underlying false premise.” The objective from investing is consistent profits – a favorable risk to reward ratio. Every study ever commissioned agrees that 80-90% of the returns from a reasonably well diversified portfolio result from asset allocation – not individual security selection.

What that means is focusing on individual security selection is focusing on the last 10%-20% of investment return. It is Pareto’s Law in reverse. You are spending 90% of your time focusing on 10% of the results. Instead you want to spend your time where 90% of your returns come from – market and sector analysis.

The reason it works this way is simple: individual securities within any given sector or market exhibit a fairly high degree of correlation. When they are highly correlated it is difficult to add value.

However, with that said, the one exception where individual security selection holds merit is when it is valuation driven – classic Graham/Dodd, Warren Buffett, and Dogs of the Dow type stuff. Valuation is a valid risk management tool and does add value, but it is still not a replacement for what drives the bulk of portfolio returns – market and sector analysis.

If you are not clear on this then just examine the returns for any of the current “Deans of Valuation” – Warren Buffett included. The current declining market environment has caused a massively damaging draw-down of huge mathematical significance. Individual stock valuation is no savior for the value kings because market risk overwhelms individual security selection. It’s just the way the math works.

In summary, the order of importance for performance drivers is as follows: market risk then sector risk then individual security risk. Don’t disrespect Pareto’s Law by spending 90% of your time on the last 10% of return (individual securities). There are very few investors who can succeed with stock picking, and even the best get overwhelmed by market and sector dynamics.

Hope that helps.