Stock Picking: Follow a Process Not TV Talking Heads

11/07/2019 9:04 am EST


Landon Whaley

Editor, Gravitational Edge

When it comes to stock selection, it is important to following a time tested repeatable process, not simply follow the tip of the day, notes Landon Whaley.

This week’s “Headline Risk” comes courtesy of everyone’s favorite circus leader, Jim Cramer. In classic Old Institution-style, Cramer breaks down the “buckets” investors need to focus on to successfully navigate the Q3 earnings season. 

Understanding that I don’t have it all figured out, I’m always interested to see how other people distill economic and financial market data to drive investing decisions. With curiosity, I wanted to see how Cramer categorizes stocks to figure out which ones are worth owning. Are you interested in Cramer’s buckets too?

Here’s what he said: “These are the buckets you need to be sorting [companies] into: Who’s doing so well they don’t notice the environment, who’s thriving in spite of the environment, who’s treading water, and who’s getting steamrolled?”

I couldn’t make this up if I tried.

Cramer then goes on to recommend ServiceNow (NOW) based on a conversation with the outgoing CEO who announced he’s leaving the company. Cramer also recommends Microsoft (MSFT) after “[reading] Microsoft’s conference call [transcript]” as well as Chipotle (CMG), PepsiCo (PEP), and Coca-Cola (KO).

There is nothing more Old Institution than believing that talking to C-suite executives gives you an edge in trading stocks. This kind of stock picking process is outdated, dogmatic, and provides no trading edge. As for Cramer’s “buckets,” it may make for good television (although I’m not sure that’s true), but it’s got zero viability as part of an investing process.

Rather than Cramer’s buckets of portfolio death, we evaluate the bullish (or bearish) potential of a stock by assessing how their sector or industry historically performs in the prevailing Fundamental Gravity. The sector (or industry) level performance has a significant influence on the performance of individual companies over any given time frame. For instance, if the Fundamental Gravity is bearish for the consumer staples sector more broadly, or the beverage industry specifically, then it’s going to be very difficult for Pepsi or Coke to break away from that sector-level reality and perform well.

As we discussed in the Oct.  21 Gravitational Edge note the U.S. is undergoing a transition from the current Winter Fundamental Gravity into Fall. So, let’s run Cramer’s stock recommendations through the Fundamental Gravity gauntlet and see how his recommendations hold up.

ServiceNow is in the IT services industry, and in Fall, IT companies typically average a +0.6% three-month return, and only post positive returns 55% of the time, little better than a coin flip. If we are wrong on our call for inflation to accelerate and the U.S. remains in Winter, the performance of IT companies gets noticeably more bearish, with average losses of -1.4% and positive performance just 30% of the time.

Of all Cramer’s picks, Microsoft is the tallest of the pigmies, but still leaves a lot to be desired if you’re looking for longs that are going to perform well. During Fall, software companies are positive 56% of the time, which is also a little better than coin toss odds, but they do earn an impressive +2.3% average quarterly return. If Winter persists, the stats for the software industry fall off with just 47% of periods posting positive performance and an average return of only 10 basis points.

As for PepsiCo and Coca-Cola, the beverage industry has pretty blah performance in both Fall and Winter. The average beverage stock post gains 56% of the time in both environments with a +0.5% gain in Fall and -0.8% loss in Winter. Cramer doesn’t know that Spring is the best FG for these companies; they post positive returns 83% of the time and gain an average of 4.8% every three months. Of course, we don’t think Cramer subscribes to our Fundamental Gravity outlook. For him—like many others—it is always a bull market. And when markets fall, it is a buying opportunity.

Another stock Cramer believes can “weather the storm” is Chipotle. Here again, restaurants aren’t bearish in Fall or Winter, but they leave a lot to desire if you’re bullish. In Fall, they only post positive returns 44% of the time, only 50% of the time in Winter and an average three-month return of just + 60 basis points in both FG environments. As with beverage companies, Spring is the FG to back the truck up on Chipotle and other restaurants because they post positive returns 84% of the time with an average gain of 8.0%!

Unfortunately for Cramer, and those of his stock-picking ilk, it ain’t Spring, and there’s no chance it will be for at least the next two quarters.

The headline risk bottom line is that reading earnings call transcripts and talking to corporate executives from publicly traded companies may be great fodder at cocktail parties, but it has no place in an investment process.

If your goal is to earn positive absolute returns in any economic environment with minimal peak-to-trough drawdowns in your portfolio, then you don’t need transcripts, an executive-level social network, or even your own TV show with sound effects. All you need is the Fundamental Gravity.

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