Join our community of smart investors

Secrets to successful stock picking

When I decided to write Stock Picking for Profit my objective was simple: to write a book that could demonstrate how to successfully invest in equities by shrewdly picking shares. The book had to be practical and needed to cover all the important areas of equity valuations. It also had to show how investment theory can be put into practice. To this end, I produced no fewer than 32 case studies throughout the 20 chapters in the book to provide readers with a step-by-step guide to explain the rationale behind my winning investments. I have also outlined the lessons to learn so that you too can implement the same techniques in your own stock picking.

The book includes important Warren Buffett and David Dreman-derived stock screens in the areas of value investing and contrarian investing, respectively. I have also given the 10 rules I use for screening my annual bargain shares portfolio (using a Ben Graham-inspired stock screen). The aim of these specific chapters is for you to be able to do the same and enjoy the gains my portfolios have achieved over the years.

I believe Stock Picking for Profit is substantially a unique publication. There have been many academic titles published over the years, but my book differentiates itself in that the investment techniques highlighted have generated significant returns for loyal readers of Investors Chronicle who have followed the share recommendations in my weekly columns over the past decade.

By detailing the investment analysis that went into each recommendation, and showing how to carry out the analysis for yourself, Stock Picking for Profit is a book that offers the opportunity to learn from my knowledge of companies and financial markets. For example, successful stock picking involves understanding a variety of different things, the most important of which is to be disciplined and to follow a set of rules that should help improve the chances of success as a stock picker. That's why I have outlined my 20 golden rules of stock picking in the opening chapter of the book.

It is also critical to understand accounting principles and valuation techniques. That's why I have demonstrated how to weed out companies where business is actually low growth, despite the apparent growth in the headline numbers, which can only be expected to generate low long-term returns as a consequence, setting them apart from those whose prospects are far brighter.

Cash flow generation and balance sheet strength

Analysing a company's cash flow, cash generation and cash is critical in my opinion to avoid the horror stories that litter the stock market. You can then take this a stage further and consider how cash on the balance sheet effects valuations, too. In detailed case studies I show how companies trading on relatively full looking earnings multiples can offer compelling investment opportunities simply by using certain well-tried valuation techniques.

But clearly not all companies are cash-rich and I have dedicated a whole chapter to balance sheet strength and debt. That's because some of the most spectacular gains I have racked up on my stock picks over the years have been made from shares priced on large discounts to book value. If you purchased shares in Trading Emissions (TRE:19p) on my advice anytime in the past 18 months, for example, you will be aware of the potential returns from this particular technique. It was not an isolated example, either, as shares in BP Marsh Partners (BPM: 132p), Aurora Russia (AURR: 32.25p), LMS Capital (LMS: 78.5p) and Spark Ventures (SPK: 11.75p) have provided us with substantial gains this year, too.

It's also important to differentiate between companies that are being undervalued by the market even though their finances are sound, and those where the financial risk is far greater, and so warrant a lower rating than peers whose finances are in better shape. The importance of debt structures on valuations and how to uncover undervalued companies is another key area I discuss in detail.

Capitalise on capital returns and bid targets

Capital returns form a major part of shareholders' investment returns. There are several ways companies can do this. Fortunately, it's possible to make money from all of them. Share buy-backs, tender offers and special dividends are the three I focus on most in my stock picking, which is why I show how you can make money by specifically targeting companies in the process of making capital returns. A classic example is online gaming company 32Red (TTR: 59p), which has provided us with a near 20 per cent total return, including a special dividend, in the past month since I advised buying the shares ('Game on', 8 Jul 2013).

It is fair to say that my investment style is that of a classic value investor. In particular, I look for companies being valued well below net asset value or where the sum-of-the-parts valuation reveals hidden value. That explains why shares in Inland (INL:32p), Terrace Hill (THG:22p), Daejan (DJAN: 4000p) or Mountview (MTVW: 6050p) have all done so well this year after I highlighted their potential. It was no fluke, either, as there are key things I look out for in my stock picking to identify companies with the potential for sharp re-ratings.

Another benefit of my balance-sheet-based approach to stock picking is that it uncovers investment opportunities that are also potential bid targets. One method of seeking out likely bid targets is to focus on good-quality companies with strong balance sheets offering potential for an earnings recovery, but where the assets are being modestly priced relative to their book value. Even if this is the case, a takeover is unlikely to happen unless the majority shareholders can be persuaded to part with their paper and there is a willing buyer. It's therefore important to know what to look for in bid targets and how to play the merger arbitrage game profitably, a subject I discuss in the book.

Spark a re-rating

Ultimately, it doesn't matter how lowly a company is valued, you need a spark to ignite the share price to re-rate. The most likely one is the most obvious: an improvement in the trading performance. It pays to know the important signals to look for to identify recovery plays. Moreover, when a company's operational performance starts to gain momentum, it also pays to monitor key indicators. That's because substantial gains can be made by riding on the coattails of a company in an upgrade cycle. For example, shares in Walker Greenbank (WGB: 137p) and Netcall (NET: 41p) have risen six-fold and three-fold, respectively, after I initiated coverage. The key here is to uncover these recovery stories at an early stage as I did with online shopping channel Ideal Shopping Direct a few years ago. In some detailed analysis, I explain how you can do this for yourselves.

Director buying can be a great buy signal, too, especially in recovery plays. But director share dealing in small caps and the lower end of the mid-cap segment of the market is always worth investigating. That's because it can be an amber signal that trading prospects are far better than outside investors think. When a number of directors are all buying at the same time the message is clear: the board believes that the company is being undervalued and aims to exploit this in a big way. I have a decent record of spotting the gems by following the lead of insiders, which is why I dedicated a chapter in the book to this very subject.

Technical indicators

As regular readers will know, I always have a close look at the technical details as part of my investment analysis. A company may tick all the right boxes, but if the chart is telling you something different then this should raise alarm bells. So, in order to identify shares that have a positive set up on their charts, and to avoid the ones where it is unfavourable, I use a number of tried and tested systems to determine whether investing in a company is warranted. This has consistently uncovered great buying opportunities, which is why I outlined the specific signals and techniques I use in my book. Some of my recent winners include Jarvis Securities (JIM: 365p) and Treatt (TET: 590p).

Risk assessment

It is also important to be aware of the risk embedded in a company's valuation as any two companies will have a different risk profile. The aim is to maximise the return available by taking as little risk as possible. Personally, I carry out 16 different risk assessments on every company I analyse to get a picture of the level of investment risk. It's not an exact science, but this process has served me well, which is why I have dedicated a whole chapter to the subject of understanding risk.

A company may appear undervalued based on fundamental investment analysis, and the chart set up may be relatively positive, but investing in the wrong sector at the wrong time of the year is like running up a down escalator. To avoid this, it's best to know which segments of the market perform best and at which points of the year. This is one risk some investors overlook.

I also set some fairly stringent rules in my stock selection process to maximise the chances of making the greatest returns by taking the least amount of risk. These rules help me avoid the pitfalls of selecting shares where the odds of generating a positive return are less than favourable for the risk being taken. I believe that all investors should employ risk management techniques in order to maximise gains and minimise losses, which is why I outline the ones I use in quite some detail in Stock Picking for Profit.

Understanding the macro back drop

In recent years, equity market gains have largely been driven by the unconventional monetary policy of the world's central banks, otherwise known as 'quantitative easing' (QE). If you ever doubted the power of the US Federal Reserve (Fed), the past four years have been a textbook case of how the world's leading central bank continues to have a massive influence on financial markets. Assuming these QE programmes work, this will raise consumption and drive economies back into growth as appears to be the case right now. My own view is that when economies achieve escape velocity, so that growth is be sustainable without QE, then it is only reasonable to assume that inflation will ultimately rise. This has obvious implications for equity markets since some sectors do well during periods of rising inflation and some should be avoided at all costs. Fortunately, I have a good idea how equities are likely to behave in such an environment, as I highlight in one of the chapters in the book.

The world's greatest investor, Warren Buffett, whose Berkshire Hathaway investment vehicle has proved itself to be the most successful investment company of all-time, undoubtedly does, too. I have been a keen follower of the investment guru and have studied his investment style more than any other investor, dead or alive. That's why I reveal the important lessons I have learnt from the sage of Omaha and how I use them in my investment analysis.

Finally, past success in stock picking is no guarantee of the same in the future, so don't expect to have a profitable outcome every time you apply the investment techniques outlined in this book. However, what these techniques should do is to shift the odds in your favour and improve the chances of success as a stock picker in the long run. It has certainly worked for me.

My next column will appear at 12pm on Tuesday 6 August. Please note that I updated the investment case on 18 small-cap shares in nine online articles last week: Small-cap wonders; Deep value plays; Small-cap trading buys; Undervalued and Unloved; Running profits; Capitalising on capital returns.; Indigovision shares slump on warning; Expecting seismic gains. and Broking for a successful recovery.