The Stock Selection Process

By on May 13, 2006

Originally published on:

November 3, 1996

It is election season and I’d be remiss in not mentioning something about it. Unfortunately, I can’t bring myself to endorse any of the candidates. They each have at least one fundamental flaw that I can’t stomach. Mr. Dole is O.K., but he seems to view the military as a jobs program and can’t even admit that nicotine is addictive. His biggest contributor is Philip Morris, so his consternation about tobacco is not surprising. Mr. Clinton demonstrates much loyalty to the trial lawyers, who have singlehandedly set us back approximately 5-10 years economically with their nonproductive waste of the court’s time. Could it be that the president of this country can be bought? On to Mr. Perot, who is a protectionist to the core, which is so plainly wrongheaded he can’t be trusted to make a wise decision on anything of remote importance. Mr. Nader and Mr. Browne are so out in left field that I won’t even consider delving into their vices. So there you have it, The Stock Market Advantage’s non-endorsement of the current presidential candidates. They’re not 100% corrupt and there is some good in what they are trying to do, but they could be a heck of a lot better.

The Stock Selection Process

I received a question via E-Mail a while back asking what method I used to select stocks with the Tactical Timing System. The answer to that question is simple because the system was not designed to tell me which securities to purchase. It only provides a signal when it is an opportune time to be purchasing equities. The system was designed so that stocks be held a long time and adequate diversification be maintained. This reduces transaction costs and anxiety. It’s very difficult to develop a formula that will pick good long term holdings. I believe it’s more art, than science, to pick great stocks.

There are several investigative steps that investors should take before they consider any stock for purchase. Investors should look at major trends at least five years out in the future and try to conceive of industries that can capitalize on the trend. They should then narrow their focus down to companies that are selling at reasonable valuations in these industries, have good balance sheets and management that is focused on improving shareholder value. It’s not easy to find stocks that meet these criteria. It takes a lot of research and imagination. I’m still working on improving this area of the investment process.

The Tactical Timing System does specify when and which stocks to sell. The biggest mistake I made as a beginning investor was selling my successful stocks prematurely. Typically, I would buy a stock that was beaten down to what I thought was a bargain level. This would occur for various reasons whether it be a cyclical earnings drop or or just plain bad management moves. I figured these unfortunate circumstances were only temporary, and the companies would come back to life eventually. Of course, in most of the instances, the price I paid for a stock was not the ultimate bottom. Many of the stocks would continue to move lower and I would hang on to them not wanting to finalize my mistake by selling at a loss. Whenever they came back to my original purchase price, or had a small gain, I would most likely sell the entire position. Quite a few of them soared after I sold. This self-defeating process is one that many investors experience. Needless to say, it is very detrimental to their financial health, as it was for mine.

Some of my “mistakes” can still be seen in the Conservative Portfolio at the “real world” portfolios page. I converted the Conservative Portfolio, which happens to be my IRA account, to the Tactical Timing System on August 6, 1996. Some of the losing stocks I purchased and held through thick and thin are still there from as far back as 1990. When a sell signal is given by the system the stocks/funds with the worst relative strength will be weeded out.

Six years ago I discarded my old “helter skelter” method of investing and developed a systematic approach which has served me well so far. The Tactical Timing System forces me to buy and sell when most investors are doing the opposite. It also provides discipline so that the winning companies are held and the losers discarded. Emotionally, this culling process is the hardest thing an investor can face. A mechanical method of trading that works makes it much easier.

Portfolio Activity

On October 24, half the Merck (MRK) position in the aggressive portfolio was sold at 76 1/4. MRK became 10% of the portfolio and following the rules, 30-50% of it had to be sold and replaced with another security. Pepsico (PEP) was purchased at 29 7/8 with the proceeds from the sale of MRK.

PEP appears well positioned to grow at a reasonable rate in the future. PEP has a balanced business with well known brand names in snack foods (Frito Lay), soft drinks (Pepsi, 7 Up, Mountain Dew, etc.) and fast foods (Taco Bell, Pizza Hut, Kentucky Fried Chicken). Profits are fairly equally divided amongst these three main businesses. There are many more consumers in the world today than there were 5 years ago and PEP makes well known products that they can readily buy now. It is conceivable that profits can grow at a rate of 15% a year for the next 10 years. PEP could become a nifty fifty type stock with the double whammy of growing earnings and a growing price to earnings multiple. The stock price has been basing in the 28-30 area and seems to be poised to break out to the upside.

Recommended Allocations

The aggressive portfolio is invested in 90% stocks, 10% cash. The conservative portfolio currently is 70% stocks, 30% cash.

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