The Art of Stock Picking

Cover Story, by Kim Butcher, Guest Damsel May 1st, 2015

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Finding stocks and especially faster-growing and smaller company stocks with the potential to become great investments is an art.

Kim Butcher serves as one of our guest damsels for the monthly Round Tables. She also serves and supports educational programs, including active demonstrations of years of successful stock selection for regional and national investing conferences. More importantly, she has served as a labor & delivery nurse and helped to bring a number of newborn Hoosiers into the world in southwestern Indiana. Never missing an opportunity to take some notes or share lessons learned with students of investing, we’re grateful for her continuing contributions and formidable stock ideas. This month, she shares some observations gleaned from the likes of Berkshire Hathaway’s vice chairman (and Warren’s right hand) Charlie Munger.

Warren Buffett has also referred to Charlie Munger as his wingman and expresses strong feelings that Buffett and Berkshire Hathaway would not be what they are today without the significant influence and guidance of Charlie.

Finding stocks and especially faster-growing/smaller company stocks with the potential to become great investments is an art. Berkshire Hathaway’s Charlie Munger has written an article (based on a speech) titled The Art of Stock Picking. [A version of this speech will be available in the Manifest Investing Forum. It can also be retrieved via http://www.grahamanddoddsville.net.]

In our long-term investing community, most are aware that our own Ken Kavula is renowned for his small company discovery skills. The art of finding small caps is part of his circle of competence. Warren Buffett and Charlie Munger are the current management team of Berkshire Hathaway. Buffett has written many times in his annual letters about a circle of competence. In the simplest of terms, a circle of competence is investing in businesses which you understand.

“I don’t think it’s as difficult to figure out competence as it may appear. If you’re 5-foot-2, you don’t have much of a future in the NBA – and if you weigh 350 pounds – you shouldn’t dance ballet. If you can hardly count cards at all, you shouldn’t try playing blackjack. But competency is a relative concept. What I need to get ahead is to be better than idiots … and lucky for me, there were a lot of them.” — Charles Munger.

Munger wrote in his stock picking article that, “Warren and I don’t feel like we have any great advantage in the technology sector. In fact, we feel like we’re at a big disadvantage in trying to understand the nature of technical developments in software, computer chips or what have you. So we tend to avoid that stuff, based on our personal inadequacies.” What is your circle of competence? As an accountant it may be financial stocks due to the understanding of the financial statements. As a health care worker, possibly medical stocks.

Charlie Munger believes that to be a good investor you must be a lifelong reader. By continuous learning you then can recognize the patterns of great businesses. I read the book by Peter Ricchiuti titled “Stocks Under Rocks; How to Uncover Overlooked, Profitable Market Opportunities.” Ricchiuti is a Professor at Tulane University A.B. Freeman School of Business in New Orleans and he is the founder of the Burkenroad Reports, an approach to studying stocks, designing and managing a portfolio that has significant similarities to our investment clubs. Under Ricchiuti’s leadership, 200+ business students learn how to analyze the stocks of overlooked and undervalued companies in the southern region of the U.S. The public companies followed by his classes are in the states of Louisiana, Texas, Mississippi, Alabama, Florida and Georgia.

In the stock research program, students actually go on field trips to the businesses in question, meet with top management, develop financial models and finally write and publish investment research reports. These reports, as well as a free video of presentations given at the (free) annual spring conference, are available free of charge at the website www.burkenroad.org.

Munger cites models and the understanding of relationships and characteristics across a spectrum of models. Arithmetic and basic algebra are essential and can’t be avoided but at the same time, advanced mathematics (like differential equations) are far from necessary.

The website http://www.stocksunderrocks.com was developed from student presentations and provides you with a source of small cap stock ideas you can check out. Some of the criteria sought for these stocks include a market cap of between $50 million and $2 billion, profitable in at least two of the past three years and a following of five or fewer analysts per stock.

Learn and Earn

In the chapter titled Plant and See, Ricchiuti writes that of the best ways to utilize some of the best parts of the Burkenroad Reports is by forming an investment club. One of his Ten Good Ideas, stated elsewhere in the book, is to go to NAIC (Better Investing) and find the “great materials available on how to correctly set up an investment club and avoid the legal and personality issues that can doom a group”. Does this sound familiar?

Is your portfolio or your clubs portfolio needing a small cap stock in it? If you’re like many others and you would benefit from more good, small company holdings, you might want to check out http://www.burkenroadreports.com.

We’ve taken the portfolio report for the mutual fund based on Stocks Under Rocks — Hancock Horizon Burkenroad Small Cap D (HYBUX) and created a tracking dashboard to support the quest for new stock study ideas.

Some of the return forecasts are subdued. But this is for a good reason — the performance has been strong. Plus, the next fundamental update might bolster a few of these. The overall return forecast at this time pretty much matches the overall market and we’ll confess that we’d like to see more emphasis on quality (particularly under current market conditions.)

The fund is hailed as “small cap” but we note that the overall growth forecast is 7.3% — again suggesting that a little more small company discovery and ownership would be a good thing. But it’ll serve as a source of a number of ideas … the type of ideas we look forward to sharing at future Round Tables.