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In the second part of our series on how to pick shares, Ed Croft, the founder and chief executive of Stockopedia, explains how to establish rules that will help you pick winning companies and avoid those that turn out to be duds.
He runs through why he considers certain elements important and how the site built its StockRanks system that spotted opportunities such as Rolls-Royce, Jet2 and Games Workshop shares before they took off.
Flying high: Rolls-Royce shares have soared over recent years after their pandemic slump and Ed Croft says a rules-based stock-picking approach could have spotted the opportunity
In the first article of our share picking series, we tackled the problems many investors face – story-driven speculation, tip chasing, and the trap of seeking more and more information, which often brings overconfidence rather than better results.
One answer is using a rules-based approach, based around the characteristics of shares proven to identify winners.
When you know that there’s a persistent pay-off to buying the highest quality, value and momentum shares, there can be a real mindset shift.
But for many, that’s where the journey stalls.
Because once you realise that rules matter, the next step is to create your first set.
Price to Earnings Ratio of less than 12? Tick. Return on capital above 15 per cent? Tick. Debt under control? Tick. You build a rational set of logic, and it feels good.
Until you hit a wall.
Checklists can be powerful – don’t underestimate them. They add discipline to your investing and help filter out the noise. But they can be extremely restrictive
Rules are essential – but they can be restrictive
I still remember the buzz of creating my first stock screen. Stock screens are essentially checklists of rules that can narrow a universe of thousands of stocks down to a manageable list.
My first was based on Jim Slater’s criteria from his excellent Zulu Principle book. I had a whole list of ‘must have’ criteria which would find me reasonably priced, quality growth shares. But how many candidates did the screen produce?
Just three. Two were rather small and illiquid and the third was some obscure foreign-listed firm. It was quite disappointing. And it certainly wasn’t an investable portfolio.
Checklists can be powerful – don’t underestimate them. They add discipline to your investing and help filter out the noise. But they can be extremely restrictive.
If a stock has a P/E of 12.4 but you’ve screened for less than 12, should it really be cut out? Of course not. But a strict set of rules won’t catch it.
So what do you do?
You start raising all your cutoffs – you find a broader set – but something feels amiss. You know your cutoffs are keeping out some of the best candidates in the market.
Ed Croft is the founder and chief executive of Stockopedia.
Scoring every stock in the market
The breakthrough for me came when I stopped thinking so binary – in pass/fail terms – and came across the idea of scoring. It was Joel Greenblatt, in his excellent ‘The Little Book that Beats the Market’, that sowed the seed.
What if, instead of demanding that a company have a P/E of less than 12, you scored every stock in the market for how low the price to earnings ratio was? And another for how profitable it was – using its ‘return on capital’.
Rather than just having a hard cutoff for ‘cheap’ or ‘good’ shares, you could create a gradient – with ‘cheap, highly profitable’ stocks at one end, and ‘expensive, unprofitable’ shares at the other.
It’s a fundamentally different approach. You’re no longer left with just a few stocks, you have a score for every stock in the market. And what’s even better, you can then compare any stock against any other.
How will you score stocks?
You can do this even if you are a stock picker, looking at stocks on a case by case basis. You can build a set of solid rules, which can even include qualitative assessments like ‘how experienced and trustworthy is the management’, and grade stocks between zero and ten for each rule.
I know some of the best investors in the UK that do this. It does require judgement, but it removes a lot of bias from your investing process, and helps you avoid getting too sucked into a story.
But a…
Read More: How to create rules for picking winning shares like Rolls-Royce before they take