Sunday, March 25, 2007

Three Steps Toward Successful Stock Picking

After my recent participation in the CNBC show concerning the Million Dollar Challenge, I received several emails asking a good question: How do you choose stocks to invest in if you're not just trying to go "all in" for a big score? In other words, if you're a real-life stock investor putting his/her capital to work, what do you look for in a good stock?

Let's break it down into three steps to find good stocks for your money:

1) Find The Sizzle - Psychologists have found that narratives are more likely to stick in people's minds than straight information. Perhaps that's why, since the days of the Greeks and Romans, the world's great lessons have been conveyed in myth, fable, and parable. A stock with a story is more apt to attract--and retain--investor interest than a stock that merely has a nice chart or earnings. As restaurant owners know, what brings people in the door is the sizzle as well as the steak. For my illustration of sizzle, I chose Manor Care (HCR). The story is compelling: With the aging of the American population, there will be a burgeoning need for assisted living. This is particularly the case with respect to care for the dementias, including Alzheimer's disease. The StockPickr site is particularly good at finding sizzle, citing the 24/7 Wall St. site regarding the appeal of the nursing home stocks.

2) Find the Steak - Sizzle is great, but there has to be some meat on the bones. I went to the InstantBull site and found that, according to Yahoo! Finance, analysts are expecting earnings of $2.77 for HCR in the current year ending December, 2007 and $3.14 for the following year. Indeed, over the past five years, earnings have grown 26.8% per year on average for HCR. The current (first) quarter is expected to see increased earnings of 27.5%, compared with a 5.5% gain for the industry overall. The fourth quarter of 2006 logged an earnings gain of over 50%. As we can see from the chart above, the stock price (dark blue line) is in an uptrend, with pullbacks at successively higher price lows. Analysts I tracked through InstantBull note that, because nursing home beds are regulated by strict Certificate of Need criteria, there are barriers to entry into the field. Rising demand and regulated supply makes for profitable steak, not just sizzle.

3) Find the Customers - OK, so we have sizzle and we have steak; we just need customers ready to dine! In stock terms, that means that we want to find evidence that investors are *buying* the story and are attracted to what's behind it. Once again we turn to the StockPickr site and its coverage of nursing home stocks. We find that three professional money managers have recently added HCR to their portfolios and one firm, Matrix Research, has upgraded its profit estimate. The above chart shows 20-day Dollar Volume Flow for HCR (pink line). Note that the flow of funds into the stock has been increasing over time. In fact, spikes in trading volume have also corresponding to spikes of buying (red arrows). This tells us that large market participants are putting funds to work in HCR. Pullbacks in Dollar Volume Flow (blue arrows) have provided good buying opportunities on average. Note that such pullbacks have been at levels above zero. Thus far, there has been no net outflow of dollars from HCR--a sign of strong underlying demand.

Finally, note that HCR has shown great relative price strength during the recent market scare. We've seen a pullback of dollar volume flow into the stock, but very little price retracement. That suggests to me that the desire to unload HCR is not there among institutions, a happy development that should bring new highs before too long. When you have a stock with sizzle, meat on the bones, and hungry institutional customers, good things can happen for your portfolio!

2 comments:

AnaTrader said...

Hi Brett

Great way to look at your portrayal of stock picking like the ancient Greeks or Romans teaching through mythology.

Finding the sizzle, then the meat on the bones, and last finding the institutional customers - will lead to a good portfolio.

So easy to recall. BTW your stock picking reminds of Trend Trading - Timing Market Tides by Kedrick Brown (Wiley 2006),who is a professional equity trend trader.

Brett Steenbarger, Ph.D. said...

Hi Anatrader,

Thanks for the book recommendation!

Brett