Selecting Shares That Perform 1 – Strategy and Personality

Selecting Shares That Perform

Today’s post is our first visit to a book recommended by a reader – Selecting Shares That Perform, by Richard Koch and Leo Gough.

Selecting shares that perform

This is a book I’d never heard of until I asked for suggestions when completing our look at The Naked Trader.

  • It’s the fifth (and recent) edition of a book that has been around for more than 20 years, so it will be interesting to see how well it has aged.
  • It’s an FT book, from back in the days when they were still part of Pearson.

Richard Koch

Richard Koch is a prolific author, having written more than 20 books, mostly about the Pareto principle (the 80/20 rule).

  • He’s also a successful investor, mostly in private equity, and worth more than £100M.

Leo Gough

Leo Gough is a financial journalist that I couldn’t find out too much about.

  • He’s written several FT books and has also edited investment newsletters.

It’s a fairly slim volume (219 pages), so I hope that we can get through it in four articles.

Strategy

The first section of the book is called “Strategy for the Individual Investor.”

  • This section has seven chapters, and the unifying theme is that the individual investor need not be afraid of going up against the institutions.

There are good reasons why you should be able to do better.

Stocks

The first chapter deal with why most of your money should be in the stock market.

  • Because it has the best (long-term) returns.

Of course, there will be downturns and crashes, so you need a long-term outlook, and a long investment horizon.

  • The book says five years or longer is long-term, and you should have 90% to 100% of your spare cash (outside your home) in the market.
  • For 1 to 3 years, try 25%.
  • For 4 years, try 75%.
  • For less than 1 year, avoid stocks altogether.

They also recommend regular investing, to avoid putting all your money in at the top.

  • And you should use the same approach to taking it out – a bit at a time.

They also recommend avoiding the stock market when everyone else is.

  • This means at new highs, or when the market is in the news, or your cleaning lady is talking about it.

They go further and suggest that you shouldn’t invest in the market its PE is above 17.

  • I think this is a bit draconian, and would keep you out of a lot of bull markets.
  • To be fair, they don’t say “sell everything”, just “don’t add more”.

They recommend UK stocks (plus some US ones) and the FTSE-100 in particular for beginners.

  • I think this lack of global diversification is a mistake.
  • It’s easy to access international markets through ETFs and investment trusts, though stock-picking abroad is more difficult and expensive.
Index-tracking

Chapter two looks at index tracking.

  • They look at both tracking using a fund, and DIY tracking.

DIY tracking is hard work and expensive, compared to ETFs that will do it for 0.07% (FTSE-100) or 0.20% (FTSE All-Share).

  • They suggest making things simpler and easier by starting a club to share the burden, or by randomly sampling say 20 stocks from the FTSE-100.

The authors aren’t keen on index tracking and use a few examples from the second part of the book (Ten Ways That Work) to illustrate how you could do better with carefully chosen stocks.

  • But they recommend that you try out their methods gradually, with small amounts, or by paper trading for six months.
See also:  Selecting Shares That Perform 2 - Rainmakers, Winners & Specialisation
David and Goliath

Chapter three looks at the advantages that private investors have over the institutions:

  1. long-term investment horizon
    • fund managers often “churn” stocks to justify their value-add
  2. liquidity
    • selling a large block of stock will move the price against an institution
  3. small stocks
    • many funds are not allowed to buy very small stocks, and will in general avoid less liquid stocks
  4. focus
    • most funds cover all sectors and types of stock, whereas the individual can focus on the best sectors and stocks
  5. real-world exposure
    • you can find out about things (particularly consumer stocks) before the City does
  6. no herding
    • the City is adversely affected by consensus thinking
  7. no shareholders to please
    • you only have to justify your decisions to yourself
  8. it’s your money
    • a third party can never care as much about your money

For me, the key advantages here are the lack of a short-term focus, and the ability to buy smaller companies (which outperform in the long-run).

Don’t lose

Chapter four covers rules to stop you losing:

  1. don’t over-diversify
    • they recommend a maximum of 15 stocks, reducing to 10 or even 5 as your expertise increases
    • this means you can focus on your best ideas and get to know your stocks well
  2. ignore tips
  3. don’t follow the crowd
  4. never average down
  5. cut your losses
  6. keep a trading log, and learn from the characteristics of your winners and losers
    • the author’s winners were companies he knew personally, in industries he understood, run by people he knew
    • his losers were penny stocks, tech companies and tips
  7. avoid penny shares
  8. don’t invest within 3% of a market high

[hr]

This is mostly good stuff, but I don’t agree about:

  • diversification
    • I usually aim for 30 to 50 stocks per portfolio, and
    • I run several portfolios designed to outperform in different circumstances
    • my smallest portfolio (Bonkers – a momentum portfolio) has 13 holdings, but even that will be increasing soon
  • penny stocks
    • my lower limit is more like 50p
    • but it depends on other factors like market cap and the spread on the shares
  • market highs
Record keeping

Chapter five covers what information you need to record, for tax and feedback purposes.1

  • When the first edition of the book was published, this record-keeping would have been on paper, but today you would use a spreadsheet – preferably one that can provide live pricing.

This is what you need for a (quarterly) portfolio valuation:2

  • purchase date, current valuation date, previous valuation date
  • purchase price, previous price, current price
  • index value at purchase, index value at last valuation, index price now
  • quantity, cost, value
  • change in value (£ and %) since previous valuation
  • index change (%) since previous valuation

Order the stocks in descending %age gain (since the previous valuation) order, and mark in red the ones that are lagging the index.

The authors recommend recording the ranking of stocks at each valuation, so that you can identify the laggards through a sequence of low placings (perhaps as few as two), and remove them.

Your own approach

Chapter six covers why you need your own approach, and how to choose one.

  • Not all approaches are suitable for all people.
See also:  Selecting Shares That Perform - The Lessons

Here are the seven ways investors differ:

  1. timescale for investment
  2. current financial standing and future objectives (motivations)
  3. risk profile (tolerance) – you can find out yours here
  4. time they can devote to investing
  5. range and type of personal contacts (in business or industry)
  6. financial and quantitative skills
  7. personality

And here are the ten approaches that we will be covering in Part Two of the book, together with the kinds of people that the authors think they will suit:

  1. Rainmakers – anyone
  2. Backing winners – those willing to monitor daily share prices
  3. Specialisations – investors with expertise in an area
  4. Earnings acceleration – those with an understanding of accounting
  5. Outsider information – risk-taking extroverts
  6. Good businesses – long-term investors
  7. Value investing – patient and analytical investors
  8. Emerging markets – long-term, risk-seeking investors
  9. Contrarian investing – well-heeled risk-takers
  10. Star businesses – sophisticated, calculating investors
Personality

Chapter seven looks at personality in more detail.

  • Richard Koch was taught about this area by Hal Leavitt, and it is a version of Leavitt’s framework that the book uses.
  • The framework was originally designed to classify leaders, but Koch believes that it works for investors, too.

There are three types of leader:

  1. the visionary – bold and charismatic, eccentric and brilliant
    • examples include Kennedy and Churchill, as well as Thatcher
  2. the analyst – a rationalist who deals with numbers and facts
    • examples include Harold Wilson, Bill Clinton, Clement Atlee and Lord Weinstock
  3. the doer – a man of action and a pragmatist
    • Lloyd George, Stalin and Tony Blair are examples

[hr]

The authors provide a quick 20-question test to work out which type you are.

Examples include:

  • Do you believe in God? and
  • Are you most like Hitler, the Daleks or Attila the Hun?

I took the quiz on your behalf and scored 40% for visionary, 50% for doer and the maximum 100% for analyst.

  • This makes me suited to all but the first two investing approaches from the book (rainmakers and backing winners).

You can further refine your selection by using your answers to the questions in chapter six on how investors vary.

Here’s a (bad) picture of the decision tree from the book.

Decision tree

I have a long-term investment horizon, so I still get to pick from any but the first two Ways.

And here’s a (not quite so bad) picture of the table highlighting the characteristics of each Way.

table

Looking at this, I can also rule out Way 3 (Specialisations) because I lack the contacts.

  • So I am now down to seven of the ten ways.

[hr]

That’s it for today – we’ve covered 60 pages, or around 27% often book.

  • I’ll be back in a few weeks with our first look at the Ten Ways That Work in detail.

Until next time.

  1. Of course, if your stocks are all in SIPPs and ISAs, you don’t need to keep records for tax purposes []
  2. I’ve modified their process slightly to make it easier to understand without diagrams []

Mike Rawson

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 35 years, with some success.

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Selecting Shares That Perform 1 – Strategy and Personality

by Mike Rawson time to read: 5 min