Value Investing

Guidelines For Stock Selection – Too Much Information

With so much information available about a company and its stock price, how much information do you really need in order to make a decision? Is too much information a wonderful thing when it comes to selecting stocks to buy?

If you ask the average stock analysts how much information they need to evaluate a stock, I’m sure you will hear numbers that reach into the mid teens and higher.

The Value Line Investment Survey has been published for over 70 years, and tracks 1,700 stocks. A Value Line stock page provides a wealth of information on a given company. The page has over 50 pieces of information. In the statistical array table alone there are 23 different pieces of historical financial data going back at least 10 years.

Guidelines For Stock Selection - Too Much Information

Source: valueline.com

Looking at the Value Line page for the first time can be very intimidating when trying to value a business. But have no fear, you don’t have to focus on all 50 pieces of information. In fact, studies have shown that more is truly less in this case.

Using experts in a variety of fields as test subjects, experimental psychologists have examined the relationship between the amount of information available to the experts, the accuracy of judgments they make based on this information, and the experts’ confidence in the accuracy of these judgments. (Heuer Jr., Richards J., Psychology of Intelligence Analysis. Center for the Study of Intelligence, Central Intelligence Agency, 1999, p. 51.)

They did the experiments by controlling the information they made available to the experts and they checked the accuracy of their judgments based on that information.

And They’re Off…

One such experiment was done on horse handicappers.

Similar to stock investing, there is a myriad of past performance data on horses. For this experiment, they chose eight experienced horse handicappers and showed them a list of 88 variables found in publications like the Daily Racing Form.

Guidelines For Stock Selection - Too Much Information

Data such as races won, speed ratings, weights carried, etc. are published on each horse. Out of the 88 variables, each handicapper was limited to using only five variables that they felt had the greatest importance to handicap a race. They were then asked to limit their selection to the most important 10, 20 and 40 variables.

After they selected their most important variables, they were then given true data (no way for them to identify the horse and the actual race) for 40 past races and asked to rank the top five horses in each race in order of expected win. Each handicapper predicted each race four times–using 5, 10, 20 and 40 variables. In order to measure the confidence of their selections, each handicapper was asked to assign a value to their prediction from 0 (not confident) to 100 (a sure thing).

The result of the handicappers’ predictions compared to the actual results was counterintuitive. The accuracy of the predictions remained the same regardless of how many variables they used. In other words their accuracy using 5 or 40 variables was more or less the same.

However, as the number of variables used increased, so did the confidence level of their judgments. They had more confidence in their selections when they used 40 variables than when they used fewer variables, yet their accuracy remained the same. The more data they used to predict the outcome of a race, the more confident they felt about their selection.

The results were not isolated to horse handicappers. Similar tests were done on clinical psychologists asked to make judgments on subjects, medical doctors asked to diagnose patients, and stock market analysts asked to make long-term predictions on stocks.

The conclusions were all the same; the accuracy of their predictions was similar regardless of variables, yet the more variables used the more confident they were about their predictions. The conclusion from these studies was an eye opener.

Experts overestimate the importance of factors that have only a minor impact on their judgment and underestimate the extent to which their decisions are based on a few major variables (editor-italics mine). [T]he analyst is typically unaware not only of which variables should have the greatest influence, but also which variables actually are having the greatest influence (Heuer Jr., Richards J., Psychology of Intelligence Analysis. Center for the Study of Intelligence, Central Intelligence Agency, 1999, p. 56).

Keeping it simple

Benjamin Graham is considered by many to be the father of security analysis. Graham with co-author David L. Dodd wrote Security Analysis in 1934 and over 82 years later, it is still referred to as “the bible of security analysis”. The book was so popular that during Graham’s lifetime four editions of Security Analysis were published. The most recent is the sixth edition, which was published in 2008.

Graham’s approach to analyzing stocks is to first view them as what they really are: pieces of a company. Instead of viewing them as wiggles and jiggles on a chart, understand that they represent a company that sells products or services, has managers, customers, and employees and produces financial statements. A stock investor should analyze a stock the same way a private investor would analyze a company.

Living through the Great Depression, Graham was most concerned about not losing money. He said that the “first step in making money is not losing money” and that investors should always protect themselves from adversity. He also said, “people don’t need extraordinary insight or intelligence. What they need most is the character to adopt simple rules and stick to them.”

Just a few Rules

Late in his life Benjamin Graham pared down all his guidelines for stock selection to two simple rules. These two rules were that the result of 42 years of constantly searching and refining his stock selection criteria.

Graham first wanted to make sure that he was purchasing stocks for less than they’re worth. He identified stocks that were trading cheaply by only looking for stocks that had a low P/E.

Paying a price far less than a private owner would for the company is a “sound touchstone for the discovery of true investment opportunities”, yet Graham cautioned, “a reasonable ratio of market price to average earnings is not the only requisite for a common stock investment.” In addition to a low P/E he went searching for another guideline.

He wanted to make sure the stocks he was buying also were financially sound and only focused on the company’s balance sheet. If a company passed the first rule than it had to pass the second rule, which was to have a financially sound balance sheet. He didn’t want to own a company that was too highly leveraged.

Another reason Graham focused on the balance sheet was to give the investor a level of comfort regarding the safety of their investment. Graham wanted to build a portfolio of unpopular companies that had a strong balance sheet but were out of favor by Wall Street.

By purchasing a basket of these unloved and unwanted but financially sound companies, great rewards would come to those who bought them at the right prices and had patience.

Guidelines For Stock Selection – Too Much Information by Charles Mizrahi, Insider Wealth Alert