Picking Individual Stocks: The Odds, the Tools and a Safe Size

Picking individual companies is the part of investing that gets the headlines, the forum threads and the dinner-party stories. It is also where most do-it-yourself investors lose ground without noticing. This chapter does not tell you never to buy a single stock. It sets out the odds you face, the tools analysts use and their limits, and a way to size and judge any stock picks so that a mistake costs you a lesson rather than a retirement.

The odds: most stocks do not carry the market

The stock market's long-run return is an average across thousands of companies, and that average is pulled up by a small number of huge winners. Hendrik Bessembinder's 2018 study in the Journal of Financial Economics looked at every US common stock from 1926 to 2016. More than half had lifetime returns below those of one-month Treasury bills. About 4% of listed companies accounted for all of the net wealth the US stock market created over those 90 years; the other 96% together roughly matched Treasury bills.

That skew is why a broad index fund works: it is guaranteed to own the few great companies, whichever they turn out to be. A portfolio of a dozen hand-picked stocks is more likely than not to miss most of them. A typical concentrated portfolio does worse than the market not because its owner is careless, but because the median stock does worse than the market.

Individual investors face other disadvantages too. Professional analysts and algorithms process news faster. Every trade has costs. Gains on positions held a year or less are taxed as ordinary income. And behaviour works against us: Brad Barber and Terrance Odean's 2000 study of tens of thousands of brokerage accounts found that the households that traded most earned markedly less than those that traded least.

What analysts look at: the fundamentals

Fundamental analysis tries to estimate what a business is worth from its finances and its position, and compares that with the price. A few measures come up again and again.

• Price-to-earnings ratio (P/E): share price divided by a year's earnings per share. It tells you how many years of current profit the price represents, and so how much growth buyers already expect.
• PEG ratio: the P/E divided by the expected growth rate of earnings. It tries to adjust the P/E for growth, but it depends on a forecast.
• Return on equity: profit divided by shareholders' equity, a measure of how well the business uses its owners' money. Heavy borrowing can inflate it.
• Debt to equity and interest coverage: how much the company has borrowed and how comfortably its profits cover the interest.
• Free cash flow: cash from operations minus capital spending, the money actually available to reinvest, pay down debt or return to shareholders. Profits can be shaped by accounting choices; cash is harder to disguise.
• Dividend yield and payout ratio: the yearly dividend as a share of the price, and as a share of profits. A very high yield can be a warning that the market expects a cut.

None of these numbers is good or bad on its own. They make sense compared with the company's own history, with competitors in the same industry, and with the growth the price implies. A low P/E can mark a bargain or a business in decline; a high one can mark a great business or a bubble.

Beyond the numbers, investors look for a durable competitive advantage, sometimes called a moat: customers who would find it costly to switch, a network that becomes more valuable as it grows, a cost advantage rivals cannot match, or brands, patents and licences that keep competitors out. The warning signs are the reverse: products bought on price alone, easy entry for competitors, and shrinking market share.

Chart reading and investing styles

Technical analysis studies price and trading volume rather than the business: moving averages, support and resistance levels, momentum indicators. Most academic research finds little reliable value in chart patterns once costs are counted, and people are good at seeing patterns in random data. One exception is well documented: Narasimhan Jegadeesh and Sheridan Titman showed in 1993 that stocks that had risen most over the past three to twelve months tended to keep outperforming for a while. Capturing that momentum requires frequent trading, which brings costs and short-term taxes.

The common styles each bet on a different source of return:

• Value buys companies priced low relative to their earnings, assets or cash flow. Eugene Fama and Kenneth French documented a historical value premium in the early 1990s; it has been much weaker in the decades since, which shows how long a style can disappoint.
• Growth pays up for companies growing revenue and profits faster than average. The risk is paying for growth that does not arrive.
• Dividend focuses on companies with steady, rising payouts. Dividends are a share of profit, not extra return; a company that pays more out has less to reinvest.
• Momentum buys recent winners and sells recent losers, with high turnover.

Low-cost funds already offer each style in diversified form, which captures the idea without betting on a handful of companies.

Position size: the decision that limits the damage

If you do pick stocks, how much you put in each one matters more than how clever the analysis is, because any single company can fall by half or fail outright.

In a portfolio worth twenty times the smaller holding, a $10,000 position that halves leaves $5,000: a setback of two and a half percent of the whole. The same fall in a $50,000 position leaves $25,000, and the whole portfolio is down an eighth. The concentrated owner now needs the rest of the portfolio to do the work of recovering it.

Common limits used by individual investors:

• Keep any single company to a small share of the portfolio, often 5% or less, and well under 10%.
• Keep all individual stocks together to a set slice, often 5 to 10% of investments, with the core in broad funds. This is sometimes called core and explore.
• Count your employer's stock, including shares from stock plans, as a single-company position. Your job already depends on that company.

Judge yourself honestly

The only fair test of stock picking is whether it beat what you would otherwise have owned, after costs and taxes, over years rather than months. Most people never run that test, and memory flatters: the winners are remembered and the losers sold and forgotten.

Keep a simple record. For each purchase, write down the date, the amount, why you bought it and what would make you sell. Once a year, compare the money-weighted return of your picks, counting every dollar in and out, with what the same dollars would have earned in a broad index fund on the same dates. If after several years the picks trail the index, you have your answer, and it cost you only the slice you set aside.

Before buying any single stock, it helps to answer a short checklist in writing: Do I understand how this company makes money? What advantage protects it? What growth does the current price already assume? Is its debt manageable? What could go wrong, and what would a recession do to it? Why is someone willing to sell it to me at this price?