What it means
Every stock pick is a claim that a share is mispriced, meaning its current price differs from what the business is truly worth. The picker might believe the company will grow faster than expected, that its profits are undervalued or that a risk is overstated.
If nobody holds such a view, there is no reason to choose one share over an index that holds them all. Pickers use different methods.
Fundamental analysis studies a company's accounts, competitive position and management to estimate its value, while technical analysis studies price patterns and trading volume. Many professionals combine the two, and others use quantitative screens (rule-based filters) to narrow the field before reading anything.
For a business reader, the important question is how a pick is judged. A single successful pick proves very little, because luck plays a large part over short periods.
Track records should be measured over many picks and over several years, against a sensible benchmark such as a market index. Picks are published in many places, including broker research, newsletters, television and social media.
The incentives behind them differ, and an adviser who earns commission or owns the shares recommended has an interest in the outcome. Always check whether the source discloses its holdings and how it is paid.
A sound pick is accompanied by the reasons, a target price or value, the key risks and a stated point at which the idea would be abandoned. Without those four elements it is an opinion rather than an investment case.
Position size matters as well, since a good idea sized too large can cause more damage than a bad one sized sensibly.
In practice
Real-world examples.
Example
An analyst at an asset management firm recommends a regional bank because its loan losses are lower than peers and its shares trade below the value of its net assets. She sets a target price of $30 against a current price of $24. The investment committee approves a position of 2% of the fund.
Example
A founder with surplus cash is tempted by a friend's tip about a small mining company. Her finance adviser asks for a written case covering the reasons, the risks and the exit price, and the friend cannot provide one. She leaves the tip alone and invests in a diversified fund instead.
Example
A financial newsletter publishes a monthly top pick and advertises its track record. A reader checks the results and finds that the figures only count the picks that did well and leave out those that were dropped. He cancels the subscription.
Formula
Calculation
Total return on a pick = (selling price - buying price + dividends received) / buying price
Excess return = return on the pick - return on the benchmark
An analyst picks a share at $40 and sells it a year later at $46, having received $1 per share in dividends. Total return = (46 - 40 + 1) / 40 = 7 / 40 = 17.5%. The market index returned 10% over the same year, so excess return = 17.5% - 10% = 7.5 percentage points. The pick beat the benchmark by 7.5 points, though one year is far too short to prove skill.Case study
Seen in the real world.
Westbrook Capital is an illustrative, fictional small fund that makes about 15 stock picks a year. The head of research insists that each pick has a one-page note stating the thesis, the target price, the main risk and the price at which the position will be cut.
In one year the fund buys shares in a logistics company at $20 with a target of $28 and a stop at $16. After six months the shares reach $25, then a customer loss pushes them to $15.
Because the exit rule was written down in advance, the fund sells at about $16 and takes a loss of roughly 20%. The illustrative lesson is that the discipline around a pick, such as sizing and exit rules, matters as much as the choice itself.
Watch out
Common mistakes.
- Judging a stock picker on one good result, when luck can easily explain a single year or a handful of trades.
- Following a pick without knowing the source's incentives, such as commission or personal ownership of the shares.
- Putting too much money in one pick because it feels certain, when no single share is ever a sure thing.
Questions
People also ask.
How do I know if a stock pick is any good?
Look for a written thesis, a target value, stated risks and an exit rule, then judge the results across many picks against a benchmark.
Are stock picks the same as investment advice?
Not necessarily, because a general pick published to many readers does not consider your circumstances, whereas regulated advice must.
Do professionals beat the market with stock picking?
Many struggle to do so consistently after fees, which is why low-cost index funds are popular, although skilled managers with a clear process do exist.
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