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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How should I select which stocks to invest in?

In the area of finance and investing, like many other fields, the questions you ask are perhaps more important than the answers to them. But again in this area, even the simplest of questions can have a variety of complex answers. So something as basic as how should I decide which stocks to invest in – can have multitude of answers. In my view, this kind of question will, perhaps, have at least 3-4 questions as its answer to start with, when asked to an expert. When individual investors ask this question (or of a similar kind) to a financial planner or an advisor or an expert, the investor is most likely to get either unclear answers with a number of riders; or a set of additional questions like how long can you hold, what is your risk appetite, etc. And do not get me wrong. These are perfectly valid questions from the point of view of the advisor, as the expert is trying to assess the investor before giving a customized answer. But it will still leave the investor confused – specially the next time he wants to take a similar decision on selection on stocks. So, I am going to try and attempt simple answers to this question in this note.

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My first answer is – if you can help it, do not invest in stocks directly at all. Invest in an index fund instead (or if you like a fund manager – invest in an actively managed well performing fund). Despite that, if you still want to invest directly in stocks, my second answer would be restrict yourself to the Index stocks or the top 50 stocks by market capitalization, and simply construct a portfolio by buying companies that have high return on equity, low or no debt compared to equity, high profit margins over time and consistent dividend paying history; and buy them when their valuations as measured by Price to Earnings or Price to Book are lower or reasonable compared to long term averages. And better still, buy them regularly over time to build a portfolio.

Beyond this, if you still want to expand your universe of stocks, then the only reason you need to go outside the top stocks by market capitalization is if you can beat the index. And for that, you will need hard work, continuous research, adoption of an investing approach that is not followed commonly and lots of patience. Once you decide that you are prepared to do that, I think the parameters you look for in stocks for investment change. You then enter a territory where there is lack of credible historical performance, unpredictability, unproven business models and perhaps low liquidity. You are then buying a promise for the future, and your interests are then best served if you strictly buy value. In such a scenario, you should then look for stocks that are cheap in relation to assets and/or earnings. And cheap would mean different benchmarks depending on margins, growth expectations and debt – but essentially the focus should be on buying cheap.

So in a nutshell, the simple answer to this question of ‘how do I select which stocks to invest in?’ is firstly this – do not do that selection at all, leave it to the index or a fund manager who is smarter than you and the index. If you think you are smart, go ahead and buy index stocks over a period of time – you are then buying into good businesses at reasonable prices. If you think you are even smarter, go ahead and buy stocks outside of the top stocks family, when they are cheap by earnings and asset measures – you are then buying into reasonable businesses, so be sure you get them at a good price.

Using this simple framework, you will perhaps be in a position to answer this question on ‘how should I select which stocks to invest in?’ Though not precise, but at least, I hope, it provides a decent guideline to arrive at a stock selection decision.

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