What Is a Stock Pick?
A stock pick is when an analyst or investor uses a systematic form of analysis to conclude that a particular stock will make a good investment and, therefore, should be added to their portfolio. This is also known as active management. The position can be either long or short and will depend on the analyst or investor's outlook for the particular stock's price.
- Stock picks, which fall under the umbrella of active management, are stock selections made by investors using systematic analysis of various factors affecting stocks.
- Active management differs from passive management, in which investors buy passive investment vehicles such as exchange traded funds (ETFs).
- When picking a stock, investors and analysts study a company's financial statements, looking at key line items and financial ratios.
- Investors and analysts also study the industry and sector of a company as a whole and its peers before making a stock pick.
Understanding a Stock Pick
Stock picking can be a very difficult process because there is never a foolproof way to determine what a stock's price will do in the future. However, by examining numerous factors, an investor may be able to get a better sense of future stock prices than by relying on guesswork. Since forecasting is not an exact science, an investor or analyst who uses any forecasting technique should include a margin of error in their calculations.
Active management funds utilize teams of analysts who pick stocks for investment and constantly update the portfolio depending on how market conditions and the company's conditions change. Active management is different from passive management, which looks to replicate an index and does not have much turnover in the portfolio.
Picking a Stock
These active management exchange traded funds (ETFs), mutual funds, or separate accounts, can utilize a bottom-up or top-down strategy to pick stocks. It is common for a fund company to offer a "high conviction" fund that includes a small number of stocks that analysts have picked as their best high-performance bets for the next several years. Usually, these high conviction funds hold 20 to 40 stocks. This is a much smaller number than the average actively managed fund, and certainly a smaller number than a fund that tracks an index.
As mentioned, active management (stock picking) can be contrasted with passive management, where there are no teams of analysts picking individual stocks. The investor that buys a passively managed ETF or mutual fund will automatically be invested in the underlying basket of stocks that that ETF or mutual fund invests in. These baskets of stocks are usually based on an index, such as the S&P 500 Index, or a sector, such as healthcare.
Picking a stock requires a great deal of analysis. Investors and analysts pour over a company's financial statements to study its balance sheet, income statement, and cash flow statement. They look at a company's revenues, costs, and profits. They examine its cash levels and debt levels and study financial ratios, such as the debt-to-equity (D/E) ratio and the price-to-earnings (P/E) ratio, among many others. They then compare all of this information to the company's peers to see the company's standing within the industry.
In addition to examining the company's financial statement, it needs to be aware of other related items, such as any company litigation or future patents if applicable. Investors and analysts also need to examine the entire industry and sector that the company is in to understand any strengths or weaknesses in that sector and its outlook for the short term and the long term.
Example of a Stock Pick
Jay is an investment analyst with a firm and he is focused on the tech sector. Jay picks the stock of company ABC, which is a social media network, as his pick after careful analysis. He considers a number of factors while analyzing ABC's stock. These include the company's revenues and profits during the previous year and the current regulatory climate for tech companies across various jurisdictions.
He notes that ABC is in hot water in some of the geographies it operates in but that those problems will not have a significant impact on its bottom line. ABC has also diversified away from its core product to include offerings that span a range of emerging technologies. As a result, even if the company loses market share in social media, it has other sources of revenue to mitigate those losses.
Jay believes that the upside potential of company ABC outweighs any downside potential, and that company ABC is poised for growth and strong earnings; he decides to purchase shares of company ABC.