What I wish I knew before I became a stock picker

As many of my regular readers know, I like to pick my own stocks rather than invest in diversified ETFs and CEFs like the Schwab US Dividend Equity ETF (SCHD) or the Cohen & Steers Quality Income Realty Fund ( RQI).). While funds certainly come with advantages such as providing instant diversification, less time spent researching and tracking positions, and less risk of letting emotions get in the way of rational decision making, there are also numerous advantages of investment in individual shares. . This is especially true if studying companies and analyzing stocks is something you enjoy and/or do for a living, both of which are true for me. If you have the right temperament to be disciplined and patient while allocating your capital among individual companies, the rewards of picking individual stocks include the potential to significantly outperform broader scholarship, which also applies to me. I have been blessed to significantly outperform the S&P 500 (SP500) over the years I have invested my own money.

That said, there are a few important lessons I wish I had known before embarking on my stock picking journey that would have made the experience even more rewarding. In this article, I will discuss three of them.

Stock Picking Lesson #1

The first big lesson I wish I had known before I became a stock picker is that while the market is often wrong, it is never stupid. What I mean by this is that there are many times when the market misprices a stock and it is overvalued anyway, only to later be discovered as such and underperform significantly, or it is grossly undervalued, only to later climbs significantly higher. While there are many who argue that the market is always efficient—and it probably is quite efficient for big, well-covered names—my experience has shown that this is not the case for many stocks, especially those off the beaten path. As I noted, I have outperformed the S&P 500, with annualized total returns that are roughly 50% higher than those generated by the S&P 500 over my investing career.

However, just because the market can be wrong about many stocks or even the ones they invest in, there is still a good reason why it prices stocks the way it does. As a result, many times stocks that seem very expensive can become even more expensive (eg Palantir (PLTR) and NVIDIA (NVDA)), and stocks that seem like very cheap bargains can become even cheaper (eg AT&T (T) and Medical Properties Trust (MPW)). Therefore, when picking individual stocks, it is really important to do a thorough qualitative analysis of the company and not just look at the numbers and go away from valuation values ​​alone.

Additionally, I have personally decided to never short a stock because the downside is unlimited and the upside is capped at 100%. As a value investor, it can be very tempting to try to short stocks that appear to be extremely overvalued, but often when you do that, you miss some qualitative aspects of the company and/or underestimate the exuberance of market sentiment for the company. and/or wider sector, which can lead to enormous losses.

Therefore, when I invest in stocks now, I make sure that I don’t have too much faith in my bull thesis and try to keep my positions measured accordingly. Additionally, if there is very short interest in the stock or if it has been brutally knocked down, I often approach the stock very gradually and constantly second-guess my bull thesis, looking for all the possible criticisms I can throw at it. . While being a contrarian and disagreeing with Mr. Market has been key to my success over the years, it is absolutely essential that I temper my contrarian tendency with a healthy dose of respect for Mr. Market’s collective wisdom.

Stock Picking Lesson #2

The second lesson I wish I had learned before I became a stock picker is that getting the right balance of diversification in my portfolio is essential. This means that while the fewer stocks you own, the greater your chances of achieving truly outstanding total returns, the chances of catastrophic or poor results also increase. At the same time, if I’m diversifying too much, I might as well just invest in an index fund or an actively managed ETF or CEF, because the diversification will be so broad that I’ll have plenty of choices with lower convictions, which will likely perform in line with the market or even below the market average, thus weighing on my total returns.

Additionally, making any kind of smart choices when I have a large number of holdings will take up far too much of my time, depriving other important parts of my life, and ultimately costing more in time than any additional benefit provided of additional diversification. As a result, I’ve learned that between 15 and 25 picks is a pretty good sweet spot for me, as that gives me enough diversification to split my bets evenly and keep my exposure to any position under 10% , being at the same time a feasible number. of companies to follow. This allows me to make some sizable bets on the first three to five conviction picks at a time.

Another important aspect of diversification to remember is maintaining adequate exposure to various sectors. As recent years have shown, there are periods when certain sectors are extremely favorable, while others are highly disadvantaged due to macroeconomic forces or simply market sentiment. As a result, if I become over-concentrated in one sector – even if I see a lot of value there and have high long-term conviction – I could suffer big losses in a few years and miss out on huge gains elsewhere. .

For example, if in early 2022 or early 2023 I had bet everything on REITs (VNQ) and utilities (XLU) while avoiding tech stocks (QQQ) entirely, I probably would have been hit by Mr. Market, even if I did he invested in high-quality REITs and utilities that trade at compelling discounts. That’s because higher interest rates during that period hurt interest rate-sensitive sectors like REITs and utilities, with tokens like Realty Income ( O ) and NextEra Energy ( NEE ) underperforming that period. period, while technology stocks, powered by an AI. boom, sent companies like NVIDIA, Palantir, and Microsoft (MSFT) soaring to new heights.

This means that even if I choose to focus on a few key sectors to maximize my confidence in a fairly narrow circle of competence, I can still diversify into other sectors by investing in an ETF to increase my diversification the portfolio. . For example, if a dividend investor wants a high portfolio yield and focuses on picking stocks in sectors such as REITs, utilities, midstream ( AMLP ) and BDCs ( BIZD ), he can still have exposure to the technology sector without sacrificing yield dividends. This can be done by investing in a monthly high-yield hedged ETF, such as the JPMorgan Equity Premium Income ETF ( JEPI ), which has significant exposure to blue-chip tech stocks.

Stock Picking Lesson #3

The third major lesson I wish I had learned before picking individual stocks is that while stock pickers must certainly have a different mindset than ETF investors in many ways, particularly in that are willing to roll up their sleeves, take out their magnifying glass and put pen to paper to do proper stock analysis, as well as actively manage their portfolio to optimize risk and reward at all times, is also , it’s essential to maintain the mindset of an ETF investor. What I mean by this is that when you diversify your portfolio by sector and position, you will inevitably have some losers, even big ones, among your stock picks. When you do, it’s important to maintain proper perspective and realize that ETF investors suffer the same large losses on many of their positions. However, they don’t see it directly because those positions are part of a broadly diversified portfolio where the winners largely cancel out the losers over time.

So when managing a portfolio of individual stocks, it’s important to look at your portfolio like an ETF and distance yourself from the individual pain and joy of big losers and big winners. Instead, evaluate your approach against the overall performance of the portfolio over time. This is necessary to remain emotionally detached from your actions and not become too enamored with your winners or too depressed with your losers. This is something I’ve had to do especially as an investment team leader because it’s very easy to panic and think I’m a total failure as an investor when one of my stocks, especially one that I’ve had a high conviction, I get to reach. being a major loser like Algonquin Power & Utilities (AQN) was for me. At the same time, it’s easy to think I’m a genius when one of your stocks turns into a multi-bagger, as Energy Transfer (ET) was for me.

The big lesson here is that maintaining a proper perspective, viewing the performance of the portfolio as a whole and maintaining a long-term perspective is so important. This keeps me grounded, humble and focused on my process rather than dwelling too much on my highs and lows.

Investor Takeaway

With these three lessons—namely, maintaining a healthy respect for Mr. Market, striking the optimal balance between focusing on high-conviction positions and diversifying appropriately, and viewing your overall portfolio as an ETF—picking stocks becomes much easier and much more more fruitful. in the long term. I hope these lessons are as helpful to you as they were to me.