Be Imperfect When You Pick Stocks

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When an investor like Warren Buffett amasses a fortune of tens of billions of dollars in large part due to his stock market savvy, or a mutual fund manager like Peter Lynch doubles the market average for over a decade, it's easy to imagine that they are close to infallible when it comes to stock-picking. After all, to be that successful, an investor has to be correct the vast majority of the time, right?

Nope. While they likely make good calls more often than bad calls, the truth is that even great investors lose money on a lot of their stock picks. When you are dealing with a financial machine that has as many moving parts as the stock market, expecting to be right on 100% of your picks (or 90%, 80% or even 70% of your picks) just isn't realistic.

It's also not necessary -- and, in fact, it can be quite dangerous.

One of the gurus I follow who stressed this point is Martin Zweig. During the 15 years it was monitored, Zweig's stock-picking newsletter was ranked number one according to risk-adjusted returns by Hulbert Financial Digest, averaging gains of 15.9% per year. But Zweig wasn't perfect. He didn't try to be.

Zweig chose stocks using what he termed a "shotgun" method, which involves screening thousands of stocks against specific quantitative investment criteria to find those that make the grade. This was in contrast to what he called the "rifle" method, which involves analyzing a small number of stocks very thoroughly, looking not only at fundamentals but also at non-quantitative aspects.

When you're screening through thousands of stocks, you're going to end up buying some that turn out to be busts, and Zweig found that his approach had a built-in error rate of about three-eighths over the long term. "That is, out of eight stocks that I pick, three, or 38%, will underperform the market," he wrote in his book, Winning On Wall Street. Of course, it would be great if you knew ahead of time which stocks fell into that 38%. But no one can do that -- and Zweig showed that you don't have to. Beating the market 62% of the time netted him huge profits.

Tilting the scales

Other great investors (Buffett comes to mind) use something of a rifle approach -- and they make plenty of mistakes, too. In fact, Buffett often discusses his mistakes quite candidly in his annual letters.

But Zweig said the shotgun approach is probably more suitable for most people. I agree. Most investors don't have the time to perform in-depth research on numerous different companies. Plus, a shotgun approach helps keep dangerous emotion out of your decisions, since you're sticking to the numbers -- a stock's financials and fundamentals.

Zweig isn't the only guru I follow who used a shotgun method. Top hedge fund manager Joel Greenblatt does, too. His strategy targets stocks that are often beaten down but have strong fundamentals -- though they could have non-quantitative factors that are driving them lower. "That's why you really have to buy a basket of 20 or 30, because I'm not sure anyone really knows the answer to each individual one of these companies," he once said. "On average they'll do quite well over a period of time, but I wouldn't want to select one or two individual stocks from that group."

Both Zweig and Greenblatt thus knew no stock-picker is perfect -- they succeeded instead by tilting the odds of success, based on historical data, in their favor. That's what I do with my Guru Strategies, each of which is based on the approach of a different investment great, and my experiences with these shotgun-type methods have been in line with what Zweig and Greenblatt say. For example, since I started tracking it over 11 years ago, my 10-stock Zweig-inspired portfolio has averaged gains of about 9.7% per year, while the S&P 500 has gained just 6.1% per year. But the portfolio's accuracy (the%age of picks it makes money on) is 56.9% -- far from perfect.

Similarly, my Greenblatt-based portfolio, which I started tracking in late 2005, has gained 10.3% per year vs. just 5.0% for the S&P 500, but it's been right on just over half (53.8%) of its picks.

The bottom line is that you're going to make plenty of losing stock picks. If you try or expect to be perfect, you're much more likely to get rattled by those mistakes, making it more likely that your emotions will cause you to ditch a good strategy at just the wrong time.

But while you can't be perfect, "you can, however, be right more than you are wrong," Zweig wrote. "If you are right 60% of the time, ride your profits, and rein in your losses, you'll find that when you're right you're very right, and when you're wrong you're only moderately wrong. In the long run, a 60% success rate translates into huge gains, a 50% rate into solid gains, and even a 40% rate can beat the market."

These are the types of stocks my Zweig- and Greenblatt-inspired models are high on right now. I know that not all of them will be winners, but by investing in a basket of such stocks I put the odds in my favor.

Zweig Model Picks

Spirit Airlines ( SAVE ): This low-cost airline ($4.8B market cap) operates more than 250 daily flights to over 50 destinations within the U.S., Latin America, Caribbean and Canada. The Zweig-based strategy likes that its earnings growth is accelerating (52% last quarter, vs. 19% long term) and its sales growth is accelerating (23% last quarter vs. 18% the previous quarter), and that it has no long-term debt.

Paychex, Inc. ( PAYX ): This firm is a provider of payroll, human resource, and benefits outsourcing solutions for small to medium-sized businesses. Its earnings and sales growth rates have been accelerating, and it has no long-term debt.

Cognizant Technology Solutions ( CTSH ): Cognizant is a provider of custom information technology, consulting and business process outsourcing services. The firm ($27 billion market cap) has grown sales at a 26% clip and earnings at a 22% pace over the long haul.

LKQ Corporation ( LKQ ): LKQ ($8 billion market cap) provides replacement parts, components and systems needed to repair vehicles (cars and trucks). It has grown sales at a 25% clip and earnings at a 23% pace over the long haul, and both those figures accelerated last quarter.

New Oriental Education & Technology Group Inc. ( EDU ): This $3 billion firm is a provider of private educational services in China. It has grown earnings at a 28% pace over the long haul and sales at a 30% clip, and has no debt.

Greenblatt Model Picks

Ebix, Inc. (EBIX): Ebix ($500 million cap) supplies software and e-commerce solutions to the insurance industry. It has a 13.9% earnings yield and 205% return on capital, excelling on both tests used by this model.

PDL BioPharma, Inc. (PDLI): This $1.5-billion-market-cap biotech has a strong 23.4% earnings yield and whopping 1,216% return on capital.

Valero Energy Corporation (VLO): This petroleum refiner ($27 billion market cap) has a 15.5% earnings yield and 74% return on capital.

GameStop Corp. (GME): Based in Texas, this video game retailer ($4.6 billion market cap) has a 15.1% earnings yield and 86% return on capital.

Outerwall Inc (OUTR): With an earnings yield of 14.5% and return on capital of 58%, this parent of Coinstar and Redbox makes the grade.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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