How to Be a Successful Stock Picker

Active stock picking isn't for everyone, but engaged and disciplined stock investors with long time horizons can achieve good results, says Morningstar's Matt Coffina

Matthew Coffina, CFA 22 April, 2015 | 1:18PM
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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. On Morningstar.com this week, we're helping investors decide if they should be active, passive or choose something in between. I'm here with Matt Coffina, he's the Editor of our StockInvestor newsletter for why he thinks active management can make sense at sometimes.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: So Matt, when it make sense to think about active management to pursue an active strategy versus an index one?

Coffina: So I think investors really have to have three qualities for active management to make sense for them. First and foremost, you need to be very disciplined. You need to not be the kind of investor that chases performance; that's always going after the next hot fund, or hot sector, that that's not going to panic in a downturn. So discipline is very important.

Also patience, often investing in a company you know the common reason that we invest in a company is because we think it as a wide moat, a sustainable competitive advantage that's going to last many years into the future and because we think it's trading at a discount to its intrinsic value. But sometimes it can take years for other investors to realise that a company's intrinsic value is greater than its stock price.

And so you really need to be very patient to pursue an active strategy. You need to have a long time horizon and really be willing to stick with your convictions, even if the market may be going against you.

And then the third quality is I think active investors really need to have an interest in investing. You know if this wasn't my job, I would still probably be researching companies in my spare time on the weekends and the evenings just because I find it really interesting to learn about businesses, learn how they work, what makes them tick, what gives one company a competitive advantage over another and to learn how to value those businesses and to determine when they're undervalued. If that's not something that interests you and probably 85% of people out there who aren't interested in this sort of thing, than passive management I think is perfectly fine and acceptable.

And if anything you're likely to do more harm than good by trying to actively manage your portfolio. That said for investors that do have these three qualities that are interested in investing, patient and disciplined I think that there can be substantial rewards as we've demonstrated over time with the StockInvestor's Tortoise and Hare strategy.

Glaser: So did would you decide that active management is right for you and you're going to pick individual stocks. How do you go about doing that? How do you make sure that that's successful?

Coffina: So our strategy and I'm not saying that it's the only one that works, I'm certain that there are other strategies out there that have been very successful over time. But our strategy is to focus on companies with very strong competitive advantages, what we call wide economic moats or improving competitive advantages, what we call, positive moat trends.

Companies also that have exemplary stewardship management that you can really trust to look after shareholders capital, and then to only buy these high-quality companies when they are trading at a reasonable price, which generally means they have to be trading at a discount to our estimate of its – of those companies fair value, discount to intrinsic value and the greater the uncertainty surrounding those fair value estimates, the greater the margin of safety we generally require before investing.

It's for instance worked very well for us, StockInvestor now has about 14 years of history under our belt, during that time we've outperformed the S&P 500 for the combined Tortoise and Hare by about four percentage points per year which over 14 year timeframe that adds up actually to about 140 percentages points of cumulative outperformance.

So in other words, if you had invested $100,000 in an S&P 500 index fund at our inception 14 years ago, you would have about $140,000 less today than if you had followed our strategy.

Glaser: So you talk about looking for companies that have great competitive advantages. How do you find those, how do you look for companies with wide economic moats?

Coffina: So there are few signs of an economic moat or really sources of an economic moat. We look for things like a cost advantage, does the Company have a cost structure that's sustainably lower than its competitors, the competitors just can't match. Intangible asset advantages for example brands or patents things like that to keep competitors at bay. Switching costs, you know sometimes it's very difficult for customers to switch to competitors products.

You could think of for example software, that's very deeply embedded in a business as operations and so on there are five sources of an economic moat along these lines, and that's the first thing that we look for from a qualitative standpoint.

And then from a quantitative standpoint, if we think there is a competitive advantage for a given company, we try to back that up by looking for returns on invested capital, as well as other metrics operating margins relative to peers, revenue growth relative to peers. Really, returns on invested capital in excess of a company's cost of capital is the gold standard for determining if a company has an economic moat. So if a company can take dollar of invested capital and their cost of capital is say 10% and they can earn a 15% return on that dollar, then that's going to create shareholder value over time.

And if investors don't realise that and it's not being priced into the stock price, and hopefully over time that company can continually compound that value as its investing more and more capital at higher rates of return, that can create a very powerful engine for shareholder value creation over time.

Glaser: Price is an important component then, how do you know you're not paying too much?

Coffina: It's very challenging, I mean I think it requires a lot of judgment. It requires being very familiar with a company as well as its competitors. Morningstar employs about 100 analysts to cover about 1,500 global companies. So, it's definitely not a task that we take lightly, we build discounted cash flow models for each of those companies. We are constantly updating our assumptions as new information comes in. We've seen recently the dramatic change in oil prices for example; currencies have been all over the place.

Economic growth rates have been fluctuating globally, so there's always a flood of new information, not to mention company-specific information, companies filing quarterly earnings reports, is their growth better than you expected, worse than you expected? Are margins improving or they contracting? What our returns on capital look like? Is the company investing more than you thought it would be? So there are so many things that go into valuing a company.

Definitely not for the faint of heart or for someone that's not passionate about it, but we love this kind of stuff. And again, we employ 100 analysts to help work on this and we're certainly not right all the time, but we do our best and we are just constantly refining our assumptions and trying to get better understanding how a company generates free cash flow over time and what that means for its intrinsic value.

Glaser: So you've already narrowed the universe down by moat. You're looking for things that are well priced, so that could be a small subset of socks, and particularly in an overvalued market, how do you think about holding a portfolio than if you're not finding anything to buy?

Coffina: Well, that's definitely a challenging in the current market environment, so we have very few five-star stocks. In an ideal world I would only own wide moat five-star stocks, but really very few high-quality companies are trading at material discounts to fair value.

Fortunately, we are not quite in a situation where everything is massively overvalued. As of the end of last month, our Tortoise portfolio is trading at about 5% discount to fair value on average, the Hare portfolio is trading at about a 10% discount and also fortunately over time our companies are compounding their intrinsic value.

So, again they're generating earnings, they are reinvesting those earnings at relatively high rates of return, they're returning cash to shareholders through dividends and share purchases and all this is building intrinsic value over time, such that when you hold even a fairly valued stock if it's a high-quality company that's creating value over time, time is really on your side, the longer you wait the more intrinsic value will tend to increase, earnings tend to increase, dividends tend to increase and so given enough time, companies can start to look attractively valued again. But you definitely have to be choosy in a market like this. I think you want to be especially careful about taking on too much risk in taking on too much cyclical exposure for example, without being adequately rewarded with the sufficient margin of safety.

So in a market like we have today, I would save if anything I'm leaning more and more on the conservative side and I'm even willing to hold the cash if it comes to it, that's sort of our default option if we can't find enough companies with attractive risk reward trade-offs than will just hold cash and ideally I would be fully invested but in the current market environment we don't really have that many option. So inevitably that does lead to building up cash, but also just looking harder and harder for those opportunities that are out there.

Glaser: Matt thanks for your take on this today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

 

This article originally appeared on Morningstar.com

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Matthew Coffina, CFA  is a stock analyst at Morningstar.