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Tuesday, September 18, 2007

Stock Selection 101

Deciding which equities to buy is the single most important decision for the stock market investor. It is also the single most important decision for us covered call investors. So this article is devoted to presenting the approach to stock selection favored by the Covered Calls Advisor. To convey the preferred approach, consider the following hypothetical, but instructive Q&A session between a covered calls investor and the Covered Calls Advisor. Try to place yourself in the position of the covered call investor who is asking the questions in this discussion.

Question 1: Where should I get my ideas for which stocks to buy?
Answer: First, the approach used by most people in identifying what they will buy is often by what I like to call a ‘whimsical’ means. Perhaps they hear that a particular brokerage firm is recommending Company X; or they’ve read an article in a magazine or newspaper that describes an interesting development in Company Y; or a friend recommends ‘getting into’ Company Z. These are absolutely the wrong approaches to stock selection; and I used the term ‘they’ on purpose rather than ‘you’ since ‘you, the reader’ don’t use this ‘whimsical’ approach. Well you don’t, do you?
This advisor advocates using a top-down approach wherein a wide universe of equities (approximately 5,000) are all considered and are relatively quickly narrowed down to a more manageable number (about 250) of good candidates for potential purchase.

Question 2: How can I possibly hope to analyze 5,000+ investment opportunities to identify the ones that are the best buy candidates?
Answer: Not surprisingly, the answer is that you can’t do it alone. Fortunately, there are myriad stock advisory companies that have numerous research analysts and high-powered number-crunchers (i.e. computers) that work full-time at analyzing which companies should be included on their ‘Buy’ list.

Question 3: Then which stock advisory companies should I use to help me narrow the field from 5,000 to 250 potential purchase candidates?
Answer: This advisor recommends that you use two stock advisory services to help with this narrowing process. And this advisor is not going to tell you which two are the best for you. Why? Because ultimately, it is your choice and only you know the style of investment analysis that is most appealing to you. You will need to do some research on your own in this regard to identify the two services in which you have a good comfort-level with the approach they use in making their investment recommendations. Moreover, if you make your own choices regarding the two particular services, you will likely be more motivated to work diligently to make sure your own personal choices work successfully for you as you are managing your own covered call investments.

Question 4: What factors should I consider in identifying the services that are right for me?
Answer: Two basic factors: (1) First, make sure the services you evaluate have a performance history of at least 5 years. Also, make certain that they have beaten the performance results of a stock market benchmark (such as the S&P 500 or the Russell 3000) during the most recent 5-year period. You might be surprised to know that about three-fourths of advisory firms will fail in this critical measure and thus they can be readily eliminated from your further consideration; and (2) Learn as much as you can regarding the detailed methodology used by the firm in making their Buy, Sell, and Hold evaluations to see if you agree fully with their approach. It is much easier to get this methodology information from some firms compared with others since they all consider their methods as proprietary; and that’s okay. However, this advisor has found that the firms that are the most forthright in providing substantial detail about their stock evaluation methods tend to have the most thoroughly developed strategies and usually achieve the best long-term results.

Question 5: Why 2 services?
Answer: This may sound trite, but the short answer is simply ‘two heads are better than one’. In addition, the practical reality of the matter is that most comprehensive stock advisory services have several hundred stocks rated ‘Buy’ and a method is needed by the individual investor to reduce the huge number of ‘Buy’ ratings to a more manageable number. By identifying those stocks that are rated ‘Buy’ by both of your two favorite stock advisory services, your list of potential investments is narrowed considerably, from 5,000+ down to around 200-300 possibilities.

Question 6: If 2 services are good, then aren’t 3 even better? Or 4? Or …?
Answer: It is counterintuitive, but more than 2 is not necessary. In fact, it is actually counterproductive. Remember, ultimately we are seeking 10-20 covered call positions for our portfolio. Phase I is what is being described in this article, namely how to select stocks that will be included in our Phase II analysis. The Phase II analysis takes the 200-300 stocks identified in Phase I and then analyzes them in conjunction with the call options for those stocks to identify the 10-20 best-ranked covered call investment opportunities.
200-300 stocks may seem like a large number to evaluate, but this advisor has found that this range of candidates is actually an ideal number (neither too few nor too many), so adding a 3rd advisory service and selecting only those stocks rated ‘Buy’ by all 3 services decreases the number of stock selection candidates to around 45-75, far too few in this advisor’s opinion. Fortunately, with the use of covered calls screening software, the task of evaluating 200-300 stocks is simplified immensely. This reason alone makes 2 services the right choice. But in addition, from a practical viewpoint, 3 services simply take too much time to administer; not to mention the additional costs of maintaining the extra subscription. It’s good for you to conduct thorough analyses; but it’s nice to keep the process as simple as possible as well. Two services seem to provide just the right balance.


Question 7: Which services do you use?
Answer: The diagram below shows the 2 services used by the Covered Calls Advisor. There are currently 287 stocks with ‘Buy’ recommendations from both services. The Covered Calls Advisor’s brokerage account is with Charles Schwab. Schwab was selected because in a study conducted by Zack’s Investment Research for Barron’s, the stock selections made by Schwab Equity Ratings were ranked first in comparison with other major brokerage firms over the most recent 5-year period. The second service used is MarketGrader.com. They also have an excellent long-term record, and they were recently selected by Barron’s to provide the stock selections for the newly formed Barron’s 400 index, through which Barron’s plans to achieve a market-beating performance. Barron’s has been tracking the performance of independent stock advisors for years, and it is a tremendous vote of confidence in MarketGrader.com for Barron’s to put their reputation for excellence on the line and to contract with MarketGrader.com for their stock selection services. I also really like the detailed descriptions and methodology descriptions provided by both services; and although both companies methods incorporate both fundamental and growth components, the fundamentals definitely predominate -- which is fine with me!
However, remember the advice provided in answer to question #3: Do your own research and select the companies that match your own investing approach and philosophy. In short, perform your own due diligence. In addition to the 2 services used by the Covered Calls Advisor, others you might consider while conducting your own review might include Argus, Investors Business Daily, Morningstar, The Oxford Club, Standard & Poor’s, StockScouter, Value Line, and Zacks.



Question 8: Okay. So now we have a list of about 200-300 stocks (currently 287). So how does the Covered Calls Advisor narrow the 287 down further to the 10-20 covered call positions to be established?
Answer: Stay tuned. This will be the topic of another blog post coming in the near future.

Regards and Godspeed

4 comments:

  1. Hi there, you are doing a good job on your newly-created blog.

    Keep it up!!!

    Cheers

    ReplyDelete
  2. I've heard about Morningstar and ValueLine through the just covered calls Yahoo group.

    Do either of these services qualify as a potential source, or do I misunderstand the uses of these two services?

    ReplyDelete
  3. Oh! there I see Morningstar & even ValueLine explicitly mentioned later in your post.
    Sorry for commenting before completely reading your post.

    ReplyDelete
  4. Looking forward to "Stock Selection 102". This is great stuff for those of us just starting.

    Thanks

    ReplyDelete