More About Process

My post the other day called Evolution of Process was in response to a reader's email. The post has generated more questions that I'll try to answer.

The follow up questions, if I properly understand the intent, are along the lines of how do I decide what I think will happen and more specifically how do I pick stocks to position around this expected probability. I'm not sure I can answer this satisfactorily but I can try.

The way a new (new for me) stock makes it into one of my clients accounts is first I will read about it or hear about it. This creates some awareness and I begin to watch it. I am curious to see how it does when the market rallies or sinks. I also want to see how well it correlates with the rest of the sector. I also want to know how it trades after its own good or bad news. Then I will try to learn more about the company. Eventually, after I think I know what the stock is capable of, it might go into client accounts. A while back I went through this process with Cummins Engine (CMI). This stock is no stranger to getting smacked down hard on bad news, same with SPX Corp (SPW).

To me both companies have obvious investment merit but I have never bought either one. These names have the potential for very sharp drops all at once. I'd rather own industrial stocks that don't seem to have the capacity for violent sell offs, there are plenty of them. If I devoted some time to it I might be able to figure out why this happens, but what good would it do?

CMI was had some great moves over the last couple of years but I would give up a little of that upside for a name that does not have the capacity to drop more than 50% as it did in 2002. Again there were plenty of similar names that did not cut in half. Usually I don't look to the industrial sector to add a lot of beta. That may change in the future but not in this environment.

Remember that I am not trying to pick a bunch of stocks that I think will move up 20% in two months and then flip them. Occasionally that happens and I may take the trade. But forcing my clients to rely on my ability to do this regularly would dramatically increase the risk I expose them to. It should be obvious why this would be a bad idea.

If you believe, as I do, in top down management, the notion of right stock in the wrong sector or wrong stock in the wrong sector becomes very important. As an example of this, back in October I wrote an article for Motley Fool about Ely Lilly. My take was this might be the right stock in the wrong sector (although I never considered buying it). That was right for a while but Lilly has dropped with a lot less news than the other names in the group. To me, knowing that the back drop for big American pharma was lousy was much more important to that article than the few positive things Lilly had going for it back then.

I should throw in that my feel for this has come from paying attention to things like this for my entire adult life. Even more important is that I know I can not get them all correct but that I have learned from experience success does not hinder on getting them all right. I've written many times that I am just trying to get more right than wrong.