Designing A Simple Stock Picking Strategy for 2020
When it comes to designing a stock picking strategy, we tend to make things a lot more complicated than we need to. We can do well just by using a couple of basic principles.
It is no wonder why so many investors throw up their hands when it comes to picking their own stocks. While there are some professionals that do well at this, consistently picking stocks over time that on balance provide better returns than just a random selection, most fail at even beating the averages. If the pros struggle at this so much, how can we expect to do better using the same tired approaches?
If we cannot even beat a random selection, this clearly indicates that the principles that we are using are off to a certain degree, and this is not a task where we can afford to be using ideas that don’t work. In this case, you can actually win this game just by shorting your picks, which is a pretty sad testimony actually. Here’s our top 10, we think that these are the best but if you really want to have a shot at this you need to short our picks and then you will beat the market because the picks likely won’t.
There are a few key reasons why this happens so much, and we’re talking about the majority of professional stock pickers here so this is not the outliers, as this captures the great majority of the distribution, with the successful ones being the outliers.
We’re now going to see if we can come up with a very simple plan that is actually based upon principles that work and then see how our idea has performed over the last couple of years. 2018 and 2019 are excellent back-to-back years to test the mettle of any strategy, where we get to see how this does in a good and a not so good environment, with 2018 being a losing year and 2019 being a winning one, with both being good examples of each type that are also very proximate, which is very important.
We absolutely do not want to go too far back here, and this is a big mistake that we make all the time, even including data that has become ancient history. The problem here is that with the speed in which investing and markets are evolving, something that may have worked a few years ago may have become very stale.
Principles such as dividends correlating with performance or the reversion to the mean phenomenon are dead or dying, and trying to revive dead bodies and prop them up in our lineup of examples that are supposed to lead us into the future will not give us what we need and will take us in the wrong direction.
Our focus will be on the coming year, looking at the performance of stocks during the past year and providing a list of 10 picks that are pointed toward outperforming the market in the year ahead. This is something that is pretty popular even though few people invest year by year this way, but if one wanted to do this, we want to come up with something that would seek to actually get the odds in their favor rather than relying on what amounts to guessing and usually doesn’t make very good ones.
If you fail to beat the averages, if you could just invest in an index instead, you are not only wasting your time but you are not steering people in the right direction. If index investing is the alternative, we also need to beat all of the major indexes and not just some of them, and this means taking on the mighty Nasdaq and beating it.
This is where the Dogs of the Dow strategy that we recently looked at fails, and in spite of proponents crowing how this beats the S&P 500 and the Dow consistently, getting smacked by the Nasdaq means that you have provided an inferior alternative to what people could easily do without switching horses at all.
What We Need to Do and Not Do
The first thing we need to realize when starting out is that we aren’t looking to predict what will happen 10 or 20 years from now, and we therefore need to focus on the task at hand, what will happen next year. Strategies that may be helpful in predicting stock prices many years from now may not be helpful for this shorter outlook, and may even end up being our undoing.
A one year outlook forces us to think like a trader actually, even though we won’t be trading these plays actively, and for the sake of keeping things very simple, we need something that we’re going to be able to place our orders in January and then just walk away, and count our money a year from now.
There are a few lessons that we need to start learning to at least steer us away from common mistakes, although we don’t need to dwell on them too much either, just enough to just say no to them.
One big mistake that people make is to focus on their beliefs of a company’s business results far too much. It is especially important that we do not make this mistake, even though this sort of thing may be in our nature and hard to turn away from. We see this all the time in all forms of stock recommendations from analysts, who are looking to predict a year out but use strategies that aren’t really that relevant to this time frame and end up with egg on their faces far too often.
The right way to do this, especially with our need for utter simplicity, is to simply ignore business performance altogether. It’s not that it doesn’t matter to next year’s results, but on a 1-year timeframe, the outlook that we know is already built into stock prices, with the ones that are doing very well already reflecting a lot of positivity. If you try to argue with that, you’ll end up with the short end of the stick too often.
This allows us to pull back from this just like traders who trade stocks by way of their charts and symbols and neither know much about the companies nor care. This might seem foolish to investors but if you are going to trade the charts, this doesn’t matter and can be distracting to the task at hand.
While looking at business performance beyond what is currently expressed by the market, is certainly correlated to stock prices in the long run, the correlation is weak in the shorter-run, where momentum is what determines stock prices like nothing else. At any given point in time, we know what the business prospects are, and it is how the market takes these known factors and adds their own outlook to them that determines outperformance or underperformance.
This is certainly what drives stock prices over the next year, and can be used even exclusively. We want to keep this as simple as possible so we will do exactly that, decide exclusively on momentum. When you’re hot, you’re hot, and we want the hot ones, the hottest ones actually.
Another big mistake, and one that is at least focused upon performance, is the idea that we should be betting on underdogs, hoping that things will turn around over the next year. This sometimes can happen, but if we’re looking for a basket of stocks that can be relied upon to outperform the averages, picking a bunch of low performers just isn’t going to get us there and will take us in the wrong direction. This will require multiple reversals of fortune over this time period and therefore stacks the odds against us.
What we want to be focused on is what has been doing well lately, what has beaten the market during the past year and therefore has momentum on its side. If the market keeps its momentum, then the stocks that have more momentum than the market will tend to keep it, where we watch the bulls run and then seek to ride the fastest of them.
Going with the Fastest Horses Works if We Use the Reins When Needed
We can therefore just set our sights on the top 10 performing stocks of the year and then just buy and hold them for the coming year, and this will have us on the fastest bulls right now. However, if this is all we will be doing, this will actually end up being risky to the point of foolishness, so we’re going to need a good way to manage this risk.
This is especially important if the coming year is not kind. Top performing stocks are already prone to big pullbacks even during the best of years. Since we are dealing with the very best performers in the market, we’ve watched them run up a lot, and if their outlook weakens or even if we just see a lot of profit taking, we can get knocked off our bull and take quite a spill. The faster your bull runs, the more you will get injured when you fall off.
In a bad year, this goes from a risk to even an expectation, and when stocks in general are going down and yours has risen in the past so much, there is further room to fall. These picks by their very nature have the most room, starting with the huge amount that they have run up in the previous year to get them on this list.
We need to summon our trader side to solve this problem, and the two things that good trading seeks is to ride momentum in our favor and to cap the risk of shifts in momentum hurting us. One of the real features of hot momentum plays is that they either continue to run hot or they just aren’t worth staying in. If we are in them and they start to lose instead of gain, we can exit with an abundance of confidence, knowing that while some of them may come back, overall this is an ugly situation that definitely requires that we cap our risk.
Since we have to decide on our risk management at the outset to promote maximum simplicity, we can just place a stop 10% below our entry point at the start of the year and see our positions automatically closed if we fall to this point. This will cap our risk at 10% regardless of how bad of a year we get, which serves to shoot for the highest returns that investors generally do not dare to, while managing our risk much better than they do, given that they are willing to lose significantly more than this in a year generally.
Just telling people to buy and hold the top 10 performers of the past year during the upcoming one isn’t even a noteworthy approach, but once we add in our stops, this does transform the strategy from a very risky one to one that can shoot for the same big gains as the risky approach does, while capping our downside at very reasonable levels.
Let’s take this for a spin to see how it did in comparison to the Nasdaq in both 2018 and 2019. 2018 was the tough year of course, especially holding the highest of flyers which are prone to be pounded during more bearish years.
The Nasdaq lost 6% in 2018, and without looking, we know that we could not have done much worse. If all of our 10 stocks stopped out, we’d only be behind by 4%, which isn’t too bad at all considering what this can do in a good year, seeing us leave that small loss in the dust pretty easily.
Sure enough, we had quite a few of our stocks from 2017 stop out in 2018, 6 of them in fact. However, 4 of them stayed in play and provided enough gains to cover our losses and even provide for a little return, where we gained 2% overall for the year, 8% better than the Nasdaq.
2019 was a very different year, and the Nasdaq grew by 33%, the high bar that so many other approaches fall short of. We have some fast horses in our stable though, including AMD which was in the top 10 for 2018 and was far and away the best stock of 2019.
This is actually where the real money is made with stock picking, where one or two will deliver the majority of your returns, and if we just went with a tenth of our money in AMD and held the rest in cash, AMD would have delivered about a 25% return overall and pretty close to what the S&P gained, even watered down 10 to 1.
You don’t always have a good idea of what the star of the market will be next year though, and if you try to be picky here, you will miss out on the big stuff like this too often and be left with a dog far too often, where you lost money on the play in an otherwise good year. If you go with 10 of these very high potential stocks, the chances of you hitting the jackpot goes up.
We saw 3 of them stop out, with an average return of 43%, beating the Nasdaq by a healthy 10%. Even without the stops, and taking the full brunt of the losses with the ones that failed, this still beat the Nasdaq by 4%, but we do not want to ever be exposing ourselves this way lest we get a year like 2018, which would have spilled a whole lot of blood that year without the risk controls.
This is a very simple and elegant approach that does exactly what we are supposed to be doing when investing, which is to aim for the best returns we can get while still protecting ourselves sufficiently. The upside of this approach is considerably greater than the averages, but the best thing about this is that we shoot for that while better managing risk over what index fund investing does, which does not even seek to manage it at all.
The candidates for this plan for 2020, based upon their 2019 performance, are AMD, Xerox, Lam Research, Chipolte Mexican Grill, Apple. MarketAxess, Target, Copart, Arconic, and Coty. Some of these stocks are showing up on other people’s lists, but they also wisely warn of the risks, and in a way that doesn’t provide any advice on how to manage this other than just avoiding them, although we’ve chosen to limit our risk very appropriately. This gives us a completely green light instead of one with shades of red.
Given the strong year that we had in 2019 and the strong way in which the market closed the year, we can throw in a further refinement for 2020, which is to weed out the stocks that did not close the year at a yearly high like the market did. Using such a tool is entirely dependent upon comparing with the market though, although the current situation does allow us an easy way to take the temperature of potential picks to see if they are still running warm.
If the market went forward and our stock didn’t join them, this isn’t exactly a good sign and is indicative enough that we can just drop them and double up on the ones that are still delivering, which are AMD, Lam Research, Chipolte Mexican Grill, Apple, and Copart. These will serve to be our top 5 picks for the year, and we will revisit this list later to see how we fared against the market.
If AMD or Apple or any of these stocks collapse, we’ll only be losing a relatively small amount of the value of the money we’re putting up. This turns these bets from ones where their big potential sees their risk return ratio tarnished, perhaps even to the point that we don’t want to do this, to perhaps as delicious of a risk-return ratio there is, and one that actually does deliver the goods in handily beating the indexes, even the best ones.
Perhaps the best thing about this strategy is that we can use it without fear in any investing climate, with even the prospects of the worst years not scaring us. As well, by going with those who bucked the trend during a bad year, like 2019’s top 10, this will well position us when the good times return, while keeping us safe enough while we wait, and not digging ourselves so big of a hole in the meantime. That’s a pretty sweet proposition.
Editor, MarketReview.com
Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.
Contact Monica: monica@marketreview.com
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