The Projection and Protection Approaches to Stock Selection

“Researching and selecting your own stocks is not necessary; for most people, it is not even advisable. However, some investors do enjoy the diversion and intellectual challenge of picking individual stocks – and, if you have survived a bear market and still enjoy picking stocks, then nothing that Graham or I could say will dissuade you.”

That’s a comment made by Jason Zweig on Graham’s writings on Stock Selection Criteria in his legendary book “The Intelligent Investor”.

With this backdrop in mind, assuming that you still want to take a shot at individual stock selection, there are, perhaps, two broad mindsets or approaches towards stock selection – the approach of projection and the approach of protection. And which approach to apply when, is dependent on the investor and the object of analysis, namely the company, itself.

The stock selection criteria that the investor chooses therefore is a combination of three factors: Firstly, fundamentally what type of investor you want to be, Second, what bucket of the market does the company you are considering belong to, and Thirdly, whether you should apply the projection or the protection approach.

past-present-futureJust to clarify this a bit further, here it what this distills to.

If you have made a choice to be a ‘defensive’ investor and still want to select individual stocks, your attention should largely be restricted to the small universe of companies that have adequate size, performance history and dividend record. Some degree of projection can then be applied, simply because there is a long historical record on the basis of which projection can be justified. You are unlikely to get these companies selling really cheap, except in exceptional circumstances, because they are likely to be established good businesses that the market values at a premium. These would generally include Index or Large Cap Non-Index companies. So, your attempt should be to purchase good businesses of adequate size and historical performance (i.e. high margins and return on equity, low debt compared to equity, and dividend paying record), when they are available at reasonable valuations.  The mindset being that of projection that these companies will continue with the same in the future.

If you have made a choice to be an ‘enterprising’ investor, your choice of stocks can, then, be from an unlimited universe. The same criteria of projection will continue to be applied by you when looking at large, established good businesses. But once you step out of that bucket of the market, your mindset needs to be essentially that of protection rather than of projection.  Purchases in these businesses should be made when the downside is protected both from an earnings and assets perspective (Low Price/Earnings and Price to Book Value), thus using the approach of protection.

The largest mistakes that investors make are not of buying good businesses when market levels are high, or buying not-so-good businesses when market levels are reasonable or low. But they are when they buy not-so-good businesses at high market levels and are stuck with them. i.e. applying the projection approach on non-established businesses. Hence, outside of the ‘projection’ bucket of the market, the mindset of protection should be dominant – the primary assumption being that, in normal course, most of these businesses are likely to be non-existent after a few years.

Broadly the approach of projection boils down to buying good businesses at reasonable prices, and the approach of protection boils down to buying reasonable businesses at good prices. It is debatable which one works best in terms of investment results – but it is disastrous when an investor mixes the two.

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