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Finding Investing Alpha by Selective Stock Picking

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Benjamin Graham once said that the future prospect of a stock’s price is much better after it has declined than after it has risen. Although this isn’t an exact quote, it does capture his intent, which is to say that your chance of profit is better if you buy a good company after a price decline. 

However, if the price declined for a good reason—e.g., if there is something fundamentally wrong with the company, then it’s probably a good idea to avoid the stock. Even though Graham is nearly 40 years removed from this Earth, his wisdom continues to influence investors today.

In my ongoing quest for alpha, I have been giving thought to Mr. Graham’s words. In this post, I’ll share a few opinions as it pertains to buying individual securities versus packaged products. 

This past December, after oil prices had fallen through the floor, I began to survey oil and gas and energy companies. One particular company I followed was Halliburton (HAL). Specifically, Halliburton’s price had fallen from around $73 in July to $38 on December 12. Two days later, on December 14, I purchased it for approximately $39.50. Today, about seven weeks later, the position is up nearly 10%. Moreover, to protect the downside, I added a trailing stop. 

Why do I mention this? In the past, I was always a staunch advocate of mutual funds, even to the exclusion of individual stocks. Then, several years ago I began adding ETFs to the mix. More recently, I have come to realize that packaged products may be a good fit for the core of a portfolio, but individual stocks are a great way to enhance returns.

Of course, this assumes you can get in at the right price, which means buying after a significant decline. Because mutual funds and ETFs are a basket of securities, significant price declines only occur on occasion. Conversely, it’s much easier to find individual stocks which have fallen out of favor. 

There are other reasons to consider individual stocks. First, there are no expense ratios. Second, if you buy a good company after a price decline, its future prospects should be favorable. Finally, because it is an individual issue, performance is less dependent on other securities.

Although this cuts both ways, if you buy a fund for example, it will typically hold some stellar performers, some moderate performers, and some poor performers. It is these poor performers which can be a drag on a fund’s total return. 

At this point, one might argue that my stock-picking prowess is not as good as an experienced fund manager. Perhaps this is correct. However, in a fund, especially one which has experienced great success, fund inflows can increase rather substantially.

If the fund is a diversified mutual fund under the Investment Advisers Act of 1940, it cannot invest more than 5% of its total assets in a single issuer or own more than 10% of the outstanding voting shares of an issuer.

These restrictions and other factors may cause a fund manager to dilute his fund, or buy shares of companies he would normally not purchase. As fund inflows continue to rise, the manager may be forced to buy a specific stock at inopportune times. These are often the consequences of success which I suspect happens more than we might realize. 

This is one example of what I am doing to enhance client returns. Although buying individual stocks is not for everyone, if you are considering it, I would suggest using trailing stops or at the very least regular stops. After all, if we are at a market top, and a near-term correction is looming, this will save your client from excessive losses.

Until next time, thanks for reading! 


For more on how to protect a client’s portfolio, and Benjamin Graham, please see these previous Mike Patton posts:

The Value of Using Trailing Stop Orders: A How-To

Using ETF Trailing Stop Orders in Portfolios: Watch the Price!

Investing Lessons From Rereading Benjamin Graham


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