Fundamentals: How To Filter Stocks

What we can learn from George Soros, Stanley Druckenmiller and Herbert Wertheim.

In the Internet age, we are bombarded with a fire hose of information. More content is published each day — across news and opinion sites, social media platforms, Substack, and other outlets — than an individual could consume in her lifetime.

And so we filter. Surely somewhere on the Internet is a fascinating article on, say, life in 15th-century China. Very few of us will ever read it — because very few of us will ever look to find it. Most of us self-select specific writers, specific social media accounts, and specific topics, not just because they cover topics of interest, but because by self-selecting, the experience is superior. Communities sprout, inside jokes are created, and there’s a built-up knowledge base to better appreciate — or better critique — new insights. The choice is between knowing a little about many topics, or more about a few. Most of us choose the latter course.

There are obvious parallels in equity investing. There are about 5,700 companies listed on the New York Stock Exchange and the NASDAQ, and another 3,000-plus exchange-traded funds. Globally, there are roughly 55,000 public companies. Assuming an investor worked more than full-time — 50 hours a week for 50 weeks a year — she could spend 24 minutes on each of the U.S. stocks. Expand her reach globally, and the average drops to about two minutes. And if we assume that a proper deep dive takes about ten hours (a round and arbitrary figure but one that doesn’t seem that far off), each year she can cover 250 companies: less than 5% of the U.S. total and less than one-half of one percent of the global universe.

For investors, as with consumers, there simply isn’t enough time. We can know very little about many stocks, or a lot about a few. Most investors choose the latter. But how, and why, we choose makes a difference.

Finding An Edge — Or Finding An Interest?

A self-directed investor can begin to filter in one of two ways: where she believes she has an edge on the market, or where she simply is the most interested.

These two directions are not by any means mutually exclusive. To some degree, an investor has to go in both directions. For newer or younger investors with a smaller portfolio, the purely financial calculation is probably to simply buy index funds. Imagine a $100,000 equity portfolio (not necessarily a small portfolio by any means) where an investor believes she can create two points of excess returns (or alpha) above the market. That’s $2,000 a year.

To be sure, that $2,000 compounds, and the portfolio should grow larger over time; perhaps the excess returns too can grow as our hypothetical investor improves. Still, two points of alpha on a consistent, annual basis is a difficult target. Most investors capable of beating the market in that manner can probably find other, more certain, sources of income.

So there needs to be some kind of enjoyment in the process. Simply believing that there are untapped opportunities in, say, small- and micro-cap biotech stocks does little good if an investor has no interest in the sector. The research required to find the opportunities in the group is going to feel like work. And it’s difficult to put in that amount of work for such a nebulous, long-term target.

Still, there is a primary direction to choose — and there isn’t necessarily a correct answer. Investing behind one’s interests likely makes it more certain that the work will get done correctly: it’s easy to understand a business fully if that process is enjoyable. And the rise of Reddit and X in the last decade, has made investing in many stocks, a more shared and more enjoyable experience¹.

That said, investors still set out with the focus on profits first. Historically, the conventional wisdom for these individual investors was to focus on the micro- to mid-cap space (generally considered $10 billion and under, with some investors targeting only the low end of the range), because those were the stocks in which the individual investor actually might have an edge.

There are hundreds of millions of dollars a year spent on simply understanding the totality of the Microsoft MSFT 0.00%↑ business and forecasting the company’s earnings. The idea that a hobbyist can compete on its face might seem fanciful. Meanwhile, in micro-caps and small-caps in particular, many major funds (and successful investors) would never even consider taking a position, because a) the position wouldn’t be large enough to move the needle and/or b) the act of building the position itself would move the stock price higher². In micro- and small-caps, then, individual investors can compete and in some cases they actually have an edge over their institutional counterparts.

What’s Your Edge?

Whatever an investor’s strategy, it is helpful to have at least some idea of what the edge might be.

One possibility is simply to be smarter than everyone else. Not necessarily more intelligent or more researched, but more attuned to the psychology of the market. It sounds close to delusional, and for most of us it probably is. But the likes of George Soros and Stanley Druckenmiller³ have created billion-dollar fortunes without adhering to an obvious, consistent strategy, and that same sense likely applies to Warren Buffett and his partner Charlie Munger as well.

Soros has proposed a general “theory of reflexivity”, anchored in his philosophical studies as a young man. But he also famously said that “when I see a bubble forming, I rush to buy, adding fuel to the fire”, and claimed that backaches let him know when there was something wrong with his portfolio. His most famous bet, against the British pound in 1992, earned him $1 billion and didn’t rest on esoteric knowledge of trade flows; rather, he correctly bet he could outlast the Bank of England.

Druckenmiller made a mint on NVDA (he recently cut his position) on a simple thesis: his young partner told him to buy the stock, and then after the release of ChatGPT, he saw the stock as a winner and dramatically expanded his position. It’s not impossible to imagine a (very happy) patron in a bar buying drinks and telling the same story with the same returns (albeit on a percentage, not a dollar basis).

Source: Koyfin

Buffett and Munger, meanwhile, are known for decades-long investments in the likes of Coca-Cola KO 0.00%↑ and Wells Fargo WFC 0.00%↑, but both men have engaged in a variety of strategies over time. As the leaders of Berkshire Hathaway, the most consistent part of their investment process has been simplicity: not overreacting, not chasing, and keeping errors to the bare minimum.

There are other avenues to take. Sector concentration can help: if an investor is only going to cover 10% of the market, perhaps that 10% should be mostly in U.S. tech, or global software. There are learnings from each individual stock that provide a broader knowledge base across the group as a whole. Commodities — whether actual commodity trading, or a focus on oil and gas names — benefit investors who enjoy broader geopolitical analysis.

Buy What You Know

And then there is the advice from another well-known investor, Peter Lynch. This advice is worth covering, because it’s often shortened to “buy what you know” and therefore horribly misunderstood.

Lynch’s advice, a key part of his One Up on Wall Street, originally published in 1989, is better explained as “buy what you know better”. The advice is not to think, “hey, there’s a Starbucks SBUX 0.00%↑ on every corner, everybody knows Starbucks, I should buy the stock.” Rather, the point is that individual investors have areas of expertise that can be applied to the market. That may be from primary employment: a software developer might know which companies are hiring aggressively, or putting out a substandard product, or at risk from a rising startup.

It can be as a consumer, seeing a growing business (for instance, Starbucks in the 1990s, or the experience at Cava CAVA 0.00%↑ suggesting it indeed is the “next Chipotle CMG 0.00%↑”) or a broader trend (perhaps energy drinks, and the rise of Monster Beverage MNST 0.00%↑, in the 2000s). But the key idea is that an investor should invest on the basis of something that the market doesn’t know — or at least doesn’t fully appreciate.

Perhaps the greatest individual investor ever seems to have adopted that strategy — and a few others as well. Herbert Wertheim, a retired South Florida optometrist, built a multi-billion-dollar portfolio off earnings from a business he founded, invested in some of the best-compounding stocks of all time. Wertheim, with a background in engineering, focused not on financials but on patents, which as a 2019 profile in Forbes noted led him to IBM IBM 0.00%↑, 3M MMM 0.00%↑, and Intel INTC 0.00%↑. Those stocks have all hit tough times in recent years, but spent decades outperforming the market and creating a good chunk of Wertheim’s fortune. Meanwhile, he incredibly bought both Microsoft and Apple AAPL 0.00%↑ in their initial public offerings, and as of 2019 still owned those shares.

It’s unlikely any of us will reach those heights. But the story of Wertheim, and others like him, is of investors who find their niches, and find what they do well. The wonderful thing about having 55,000 stocks worldwide is that there’s no shortage of places to look.

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As of this writing, Vince Martin has no positions in any securities mentioned.

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1. Message boards do date to the 1990s, and individual stocks certainly wound up with small communities built around them after that. But Reddit and X clearly are on another level.

2. A fund can probably build a $50 million position in Microsoft in a week without being noticed: that kind of trading would have represented 0.1% of volume over the last five trading days, as we write this. In contrast, the initial buys of a $50 million position in a $500 million market cap stock, particularly one with lower liquidity, are going to move the price higher and likely catch attention from market insiders, who in turn may ‘front-run’ later buys.

3. Druckenmiller was once Soros’ right-hand man before leaving in 2000.