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Stock screening - your questions answered

Created:
12 May 2008
Written by:
David Stevenson

What's the optimum number of shares for a portfolio? When should I sell? What's the right balance of growth and value? Here are my responses to some typical stock screening questions:

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How many different shares should I buy using a stock screen?

Stay focussed. Don't buy too many shares or you'll trade away the benefits of focus for diversification. If your screen suggests buying upwards of fifty stocks it's

a) impractical for most investors and

b) you might as well buy a tracker, which buys a big bunch of stocks much more cost effectively than you ever can.

The debate about exactly how many stocks to hold is varied. Buying over twenty stocks every year for each screen might sound reasonable if you were, say, a Ben Graham fan looking for safety in numbers above all.

Experienced investors like Jim Slater recommend holding no more than 15, and preferably 12 stocks in a portfolio. That might mean only buying three to five shares every year using a screen. He believes that number of shares will get you all the benefits of focus without too much diversification. Ten to fifteen stocks also seems a sensible number for most private investors, who operate limited portfolios and have only a small amount of time to monitor them and screen for new shares. A portfolio of much below ten implies buying less than two or three shares a year, which increases your risk of buying the wrong share, and it comprising a large proportion of your portfolio. Then again, this kind of very selective stock picking is exactly what great investors like Warren Buffett recommend. Do your research, be confident of your results and be incredibly focussed.

Also, be willing to vary the proportions allocated to each share. If a share seems particularly strong based on your screen, be willing to increase the percentage you invest in it. If you have ten shares in your portfolio, this might mean increasing the proportion of funds invested to 15% for a particularly strong share. But don't go overboard and invest more than 30% in one share - you immediately open yourself up to greatly exaggerated risk, potentially jeopardising your rewards.

When should I sell?

One of the most entertaining investment books of the last few years is "Why smart people make big money mistakes, and how to correct them" by financial journalist Gary Belsy and psychologist Thomas Gilovich. It's a highly readable romp through the rapidly emerging discipline of behavioural economics, and has an awful lot to teach about the discipline of selling shares; when to take a profit and when to cut losses.

One of the concepts discussed in this is Prospect Theory, developed by Daniel Kahneman and Amos Tversky. Prospect theory concludes that too many of us are guilty of what's called "sunk cost fallacy". Put simply we're too ready to throw good money after bad and will stick with bad decisions too long. Then there's the tendency to hold losers too long and sell winners too soon. "Most people are much more willing to lock in the sure gain that comes with selling a winning stock or fund than they are willing to lock in the sure loss of selling a losing invetsment, even though it generally makes sense to sell the losers and keep the winners."

That last comment is vitally important, and leads to a number of important conclusions:

VALUE portfolios

a) With more risk-averse screening strategies, we should, all things being equal, stick with our profits up to at least 100 per cent but also be willing to stick with our initial hypothesis that the share was too cheap as it falls. Operate a relatively deep 40 per cent stop loss, but immediately sell if either the share no longer meets the criteria set out in the screen or if the company makes an unexpected profits warning.

b) With these more conservative, risk averse strategies, we should be willing to trigger an alarm if the share drops by more than 15 per cent, but before it hits the stop loss. Take time to see if the company and the stock still passes your tests. Does trading seem to be worsening ? If the answer is no, and the story remains much the same as it was when you first bought the stock, stick with the share.

c) Don't be too concerned with relative strength and momentum moving against you unless it's very sharp. You're buying shares the market dislikes anyway, and so you should have the courage of your convictions and stick with the share

d) Be aware that that some value gurus have much stricter stop loss and gain criteria than set out here. Ben Graham, for instance, suggested taking profits at 50%. The risk with this though is that you might lose out on future profits.

GROWTH portfolios

a) Be much quicker to sell and cut your losses. Remember that the name of the game is to find that ten bagger and not stick with shares that are running out of steam.

b) Don't be afraid to run your profits. The extra risk involved in buying growth shares means you need to ratchet up your rewards. You might want to consider top slicing your holdings and then go in search of other growth stocks.

c) If relative strength starts to turn, think about selling. If relative strength over one and three months is moving deeper into negative territory, sell immediately.

d) A big earnings dissapointment that points to longer term structural issues - slowing markets, for instance - is a bad signal. Sell all shares immediately.

Should I mix and match screens and portfolios?

The short answer is yes! A sensible investor has to recognise that markets change rapidly and sentiment moves with the economic cycle. The only way to protect yourself against this real risk is to diversify and mix and match styles. That means for every two value screens you operate, have one growth screen. Or for every two value stocks have one growth stock. Maybe even think about switching this ratio the other way - two growth stocks for every value share if it seems the market generally is very bullish.

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