Rules for selecting the best stocks remain the same

The question posed to Stan Lock, stock picker from Brewin Dolphin: "What do you think about these newspaper adverts claiming to make loads of money for delegates from attending a stock picking seminar?"

The answer, in short, is "not a lot", and Stan's four golden rules on the art of stock picking (see table).

"The game hasn't really changed," says the veteran of 45 years of stock picking, "the rules that applied to good stock selection after World War II apply today". Echoing Warren Buffett, Lock continues, "Maybe these seminars are selling technology but, other than improving your ability to time the market, I haven't seen any technology that can make the subjective decisions that constitute a good selection."

Art

So here is the point: despite the range of strategies and seminar glossies, there is no recognisable fool proof method of stock selection. Yes, you can expand your wealth by buying stocks, but the healthiest strategic view of the market is one that sees the skill of stock picking as an art rather than a science.

"Stan's Four Golden Rules" help stress this point. The important background, though, is Lock's personal view of a market as being made up of individual stocks. "It's a market of stocks not a stock market," says Lock. A critical distinction this, as Brewin Dolphin, like many stock pickers, will manage monies and funds on two different bases: the first would be one that seeks to outperform a market by a few basis points. The result of this approach is that the macro-economic forces that push a market up or drag it down will inevitably influence results.

The second is the view that Lock prefers, the one which ignores the market and seeks to find the particular companies that are currently under priced and most likely to reward investors for the risk of being out of the market.

So to the rules, all characterised by subjectivity. Rule One states that there are no rules. Lock is driven by intuition and not data. He can't thus be boxed into the momentum or value debate, and doesn't resemble any of the large cap, mid cap or small cap specialists. "I don't have too much time for theory. My new stock picking fund will be one that seeks positive results and I will take any strategy to get it". Paraphrased, data of course is important, but which data at which time? Lock prefers to avoid being bogged down with any one sided view to all stocks.

Rule Two: Build a library of good contacts. A stock broker these days is a "social engineer". Making friends with the right people is the way Lock gets his information. "I make sure I look after my friends," says Lock. Is it Merrill Lynch, JPMorgan, and Goldman Sachs that are important or the people in them? "Definitely the people, it's their judgment that I get to understand," says Lock.

"People also influence price; look at what companies like Redleaf do. They manage information on a professional basis and as a result get very close to many of the subjective issues that effect price. But I rely on their judgment in terms of the companies that they bring to me."

Rule three: Establish responsibility. One of the biggest areas of stress for stockbroker and investor occurs when the price falls and nobody sells. It is absolutely critical that investors are clear on who is in charge of making decisions. "Our new stock picking fund is very definitely a discretionary animal. Good stockbrokers will have many investors to look after and the reality is that, unless an investor has large sums of money invested, it is difficult to justify spending lots of time with one investor." Lock's honesty is telling us that, unless you take the discretionary management route and outsource all decisions to the stockbroker, or, you have about a million dollars invested providing fees that cover management costs, investors should really accept that using a stockbroker is all about accepting self-responsibility.

Rule Four: pray for a bull market. As the saying goes: "when the tide comes in, the big ships and the small ships bob up". Of course, anyone can make money in a rising market. The stockpickers believe that the risk they take by not tracking the market and avoiding the blue chip big stocks is rewarded by superior performance. Lock's Gulf News predictions are testament to this, the UK FTSE meandered in at around 14 per cent for 2006, but Lock's Gulf News average for 2006 was way over 50 per cent from stocks within the same market!

Tide

Of course, the saying continues "when the tide goes out, the big ships and the small ships bob down". This would be the point when the investor would want Lock to sell. Only trackers and equity funds are largely driven by rules that mean the manager must stay in the market despite the falling price. During these times, Lock's best return might be cash deposit rate, "but it's better than losing 30 per cent," says Lock.

The alternative expectation would be negative market expectation which would "take my selections down purely because of illogical human reaction to the market direction, if I stayed in the market my selections would often under perform the market purely because I will have less diversification within my selection. It's not a good option," Lock says.

Fast facts: Stan Lock's four golden rules

Rule One: There are no real rules

- There are so many variables within a corporate success or failure that it is impossible to construct a foolproof formula.

- Subjective qualitative performance issues can't be measured, for example, company reputation, competitive advantage and so on.

Rule Two: Build a library of good contacts

- Buying an under priced company is all about getting information before everybody else.

- A good library of contacts provides, in time, a stable of reliable judgment.

Rule Three: Establish responsibility

- Ensure you know who is making the buy and sell decisions. There are three principal relationship types:

- Execution Only: Occurs when an investor employs a stock broker to execute a deal without any advice. Performance responsibility is with the investor.

- Advisory Relationship: One in which the investor listens to the stockbroker's advice and makes the decision accordingly. Performance responsibility here is with the investor.

- Discretionary Relationship: One in which the stock broker has a free rein to make buy and sell decisions without contacting the investor, thereby taking performance responsibility.

Rule Four: Pray for a bull market

- Stock pickers seek to out perform market indices when markets are rising.

- In falling markets stock pickers will seek to sell in order to avoid under performing a falling index.

- The writer is Chairman of Mondial/Financial Partners International.