Richard Beddard: why picking shares can be easier than we think

23rd December 2021 10:13

by Richard Beddard from interactive investor

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In seasonal spirit, our columnist reviews a book promoting a fuss-free yet useful investment approach. Is this the world’s simplest stocking filler?

Since Christmas is almost here, I want to give you a small present. The present is an idea – that picking shares can be easier than we think, easier, dare I say, than I have described in my many articles (and I try very hard to keep things simple).

The present comes wrapped in a book review. The book is The World’s Simplest Stock Picking Strategy by Edward W Ryan, henceforth TWSSPS.

I wanted to love this book. As I read it, I began to feel disillusioned, and thought it might be worth nothing, but then I began to warm to it, and I ended up kind of loving it. That is quite a journey in only 200 pages, nearly half filled with generic pointers on financial planning, case studies and a glossary.

The financial planning aspect seems sensible: we should put half our equity portfolio in a global index tracker in case it turns out we are not good at TWSSPS, and consider parking money in other assets as well, particularly cash so we do not need to tap into our shares for spending money when prices are low.

The case studies are meant to be instructive, not prescriptive, because TWSSPS is rooted in what we as individual consumers know.

Investing without numbers

The promise of the stock picking strategy is attractive. It focuses on what we know about the products and services we use.

“Your job”, Ryan says, “is to follow companies that you are the most excited about and utilise regularly.” The more we use these products and services, and the more excited we are by them, the more we invest. As our interest wanes, we reduce our holdings in favour of other companies we are more excited about.

The book contains a performance table with cherry-picked examples of big obvious shares that we might have thought about investing in over the last decade or so (companies such as Alphabet (NASDAQ:GOOGL), Amazon (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT) and Costco (NASDAQ:COST)). But anyone can put together a table of shares that have gone up a lot in price, and to my mind it is worthless.

The author says: “I have been using this investment strategy successfully for several years with my own money, and I believe strongly in its merit.” In the time he has been using it, the gains from his biggest winners far exceed the losses of his biggest losers.

He invented TWSSPS because he was fed up with missing out on “obvious” winners such as Amazon, Facebook/Meta (NASDAQ:FB), and Microsoft. Fear Of Missing Out (FOMO) could be a very unhealthy reason to invest. It could inspire the kind of return-chasing and herd-following behaviour that so often gets naive investors into trouble.

Trading the special ones

But this book is not about chasing returns, not at least directly. It is about chasing dreams: buying shares in companies because we dream about being a customer, or we are a customer and could not do without what we are buying.

The special hold these companies have over us means they can charge a lot more than it costs them to provide their products or services, and that quality might endure. Ryan is using this special hold, which he calls pricing power, as a proxy to predict profitable growth without having to dig into the financials.

He talks about cutting losers and running winners, but not in the conventional sense of selling shares that have gone down in price and holding or buying shares that have gone up in price. Losers are companies we no longer consider to be special, and winners are shares we still consider to be special.

“Utilising this strategy means that you do not have to understand the fundamentals of a company”, the author says. “Instead, you rely on the expertise of the CEO.”

TWSSPS is a five-stage process, starting with a “life list” of companies that provide products and services we use. We organise this list into buckets depending on how we feel as consumers. If a company’s products are irreplaceable, for example, we put it in the green bucket. Most, perhaps 85%, of the TWSSPS part of our portfolios should be invested in green bucket companies.

We are also satisfied customers of yellow bucket companies, but they are not as indispensable. We might invest some money in this bucket for the sake of diversification. The blue bucket is for all the other companies we know of. We do not buy them. Having put companies in buckets, we rank them and invest a bigger proportion of our total TWSSPS pot in our favourites.

The trading system involves reviewing the life list, promoting and demoting companies between buckets and ranking them, every quarter. We trade occasionally to invest new money and ensure our portfolios resemble the allocations we have determined.

There is straightforward guidance about how many shares to own, which depends on the total size of our TWSSPS pot.

System design

I spend a large part of my working life trying to establish what makes companies special, and I score shares and rank them. When I realised this is essentially what TWSSPS does, my mind flipped from scepticism back to wanting to believe.

I remain sceptical about bits of the system. It is simple, but maybe not easy. Working out what makes a company special requires us to answer some excellent but quite weighty questions that we may not be fully equipped as consumers to answer. Ryan gives examples: what is unique about the product? How regularly do we use it? How long do we think we will use it for? How much would we miss it if we could not have it? Are there similar alternatives? Do we dream about owning it?

We might decide we like Amazon because of its ability to undercut competitors, but as consumers of Amazon.co.uk we are only exposed to part of its business. The conclusions we draw might mislead us about the company’s prospects, which also depend on advertising, cloud computing, and probably other aspects that are invisible to us as consumers.

Studying the numbers, and gaining an understanding of how the whole business makes money, how it might make more, and what could stop it doing so, validates my personal experience and the company’s spin. I cannot imagine not verifying these things.

I made a life list, and all the companies I identified were privately owned or listed abroad. The UK companies I admire sell things to other people, or more often businesses, and I have learned about them the hard way, by reading annual reports, visiting them, and so on. Things would be easier if I were to invest directly in US shares, perhaps the second most accessible market for UK investors.

The author advocates using a technical (mathematical) indicator called a stochastic operator on the Dow Jones Industrial Average (a UK equivalent might be the FTSE 100) to determine when market prices are low. This adds a timing element to some of his purchases. He does not present much evidence that it works, or explain the maths.

Buying shares when they are undervalued is an alternative, but Ryan says: “Valuation analysis is difficult and you won’t have a competitive edge in it.” He has a point. Discounted cash flow analysis, the favoured approach of many professional investors, requires us to estimate profits many years in the future, which is daunting. Basic ratios, like the price/earnings ratio, are ubiquitous and very blunt instruments.

However, I believe valuation is the ultimate challenge facing system designers. My developing solution is my Decision Engine, which improves on the PE ratio by factoring in the company’s historical performance and the qualities of the business.

The advantage the Decision Engine brings in terms of veracity, though, is lost in hard graft. A more casual investor could not implement it because it would take too much work, and although I do not think it can ever be as simple as TWSSPS, reading the book reminds me of the direction I must travel in.

Who is TWSSPS for?

On the face of it, TWSSPS is a book for novice investors: it is written in words a newbie can understand and it requires no prior knowledge to implement.

Recently, I wrote about how the Decision Engine was telling me to sell leisure airline Jet2 (LSE:JET2), but I could not bring myself to sell shares in a business that I admire, even though it cannot operate in a pandemic.

A reader, Mike, emailed. He retired a few years ago and moved a small part of his pension to interactive investor to invest in companies. Mike’s reasons for investing in Jet2 could be a life list entry. He says: “The reason I bought them is that I am a regular flier to Alicante from Birmingham and the choice of airlines is basically Jet2 and Ryanair. I gradually came around to always flying Jet2, because even though Ryanair would be cheaper, I knew the chances were it would be a miserable experience.

“Then, when Covid came around for the first time, I had several round-trip tickets already booked. Jet2 contacted me to say my flights would be refunded before the flight date. True to their word, every flight was refunded without me having to contact them once. That was when I bought shares. I don't do detailed analysis the way you do, I buy shares in companies I know that treat their customers well.

“We Brits will always want to travel to the Med and I'm sure Jet2 will survive and then prosper again to meet this desire.”

I think many investors use their experience in the way that Mike does and TWSSPS advocates. The strategy adds an element of rigour to the process, and that could be very valuable.

We are more likely to be interested in the companies we admire, and by giving us something to focus on aside from the share price, TWSSPS encourages us to stay the course and invest for the long term. It makes investing more joyful.

Ryan thinks TWSSPS is for experienced investors as well, and while I doubt many will adopt the system wholesale, the book is recommended. As we develop expertise, there is a tendency to complicate things. Simplicity is a worthy goal.

Happy Christmas.

Richard Beddard is a freelance contributor and not a direct employee of interactive investor.

For more information about Richard’s scoring and ranking system (the Decision Engine) and the Share Sleuth portfolio powered by this research, please read the FAQ.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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