Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Simple Wins for Picking Great Stocks
11/13/2014 6:00 am EST
In both trading and investing, for Jim Farrish, on Jim’s Notes, it comes down to trying to keep the process simple. Jim’s not saying trading or investing is easy, but he’s found that if he starts to try to keep the process simple, there’s a greater likelihood everything else will follow suit.
Since starting my career in the investment world more than thirty years ago, I have struggled, labored, and stayed up many late nights fighting for one specific level of accomplishment in my investing process…simple. If nothing else, I have found there to be a strange power in simple that isn’t achieved with complex. The challenge, however, comes in the process, implementation, and consistency in keeping it simple. The tendency is to drift towards complex. Why? For whatever reason, I feel I can improve on the process, make it better, tweak this, and add that. What really happens is it becomes more complex and less effective. The goal of investing unto itself is simple…make money. Then we make it complex by saying, ‘Make money with the least amount of risk possible.’ That is where the problem begins, making money isn’t good enough, we have to make it with less risk. Less risk relative to what? A benchmark like the S&P 500 index (SPX). We then assign the index a beta of one, a what? A beta of one…what is beta? Well, that is…you get the point, what we thought was making the process better while keeping it simple actually opens up Pandora’s box and we fall into a trap of adding layers of research and study in an effort to make money, the original goal, but we added less risk. Therefore, we take the simple and make it complex, and in so doing, we forget the original goal…make money. Maybe I should add, “As simple as possible.”
Twenty plus years ago, I designed a strategy for investing in the S&P 500 index. It was simple, buy the index. Fidelity had an S&P 500 index mutual fund that held the stocks of the S&P 500 index. We used an easy-to-understand tracking method for owning the fund and selling the fund. In fact, we still use this strategy to manage our 401k money and allocations for clients. It has work very well over the last 20+ years. We have a similar program that uses the ten sectors that make up the S&P 500 index and allocates according to strength and/or weakness of each individual sector. Likewise, this has done very well historically and keeps the available holdings to a scan of 15 items, the ten sectors, treasury bonds, the index itself, the volatility index and an inverse fund of the index. In managing these two portfolios, I have discovered one thing…simple works. Why do we need to do more if this accomplishes the goal? Simply put, we don’t.
In a similar fashion, the quest to find winning stocks has always been a goal of our investment philosophies and one simple way to accomplish this is to find the winning sectors first. Over the last year, one of the winning sectors has been healthcare. Digging further, we could see that biotech stocks are one of the key leaders within the sector. If we look at the iShares NASDAQ Biotechnology index ETF (IBB), we would find it consist of 119 stocks. If we scan them, we would find the leadership—or winning stocks—of the sub-sector. Which, if we compared those to the universe of stocks that make up the NASDAQ composite index (2458 currently), we would find it would be one of the top leaders for the universal index. Thus, finding winning stocks can be simplified into a process of finding the winning sectors (only ten), then finding the winning sub-sector (limited number), and then scanning the stocks (again limited number) within the sub-sector to find the leaders…we would find the winning stocks to invest our money into. A simple process of digging into the market part-by-part to find what we are looking for…winning stocks.
I am not attempting to make this sound easy, it isn’t. I am attempting to keep the process simple, which it is. If I start with the process and I can keep it simple, there is a greater likelihood that keeping the investment simple will follow suit. We make life too complex, and if we can find a way to keep it simple and accomplish the goal, it makes it all the better. Investing is one of those areas of life that too many people find easier to delegate versus addressing in a manner that is simple enough to accomplish.
By Jim Farrish, Founder & CIO, Jim’s Notes
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