Book Review: The Little Book of Picking the Best Stocks

The Little Book of Picking the Best Stocks: How to Discover Hidden Gems. 2023. Martin S. Fridson, CFA. John Wiley & Sons, Inc.

Editor’s Note: In order to keep our book review selection process neutral and free of bias, Martin Fridson, CFA, was not involved in the decision to review the book or write and edit this review.

When I first saw the title of Martin Fridson, CFA’s latest artwork, I wondered what the focus might be on other than hitting his paycheck or picking the winning horse, which was a long way off. Given Fredson’s deep background in fixed income analysis, I initially thought a secret advantage could be found by using extensive credit analysis or tracking the ups and downs of a company’s credit ratings. But what happens when a company does not have very low credit ratings? This “small” book of big ideas offers a fresh approach not yet organized in an evidence-based style as presented here.

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Do you want to get involved in identification the Best performing stock? One might think of this as instant gratification, and it sure is! However, there is an obvious way for it to lie outside the realm of Wall Street analysts who are fed essentially the same information by companies – especially when it comes to forecasting EPS for a quarter or a year – and then set a price target and place a buy or sell call. The author states that the bulk of stock ratings are in the buy/hold category, and a sell recommendation is rarely seen. Is there really a rating like Hold, which can be a “wink-wink” sale? Analysts deserve recognition for what they do best: fundamental analysis of a group of companies in an industry and tracking their fortunes. But can such analysis be relied upon to achieve the best stock performance?

Friedson breaks down the basic and industry-specific stories for the top S&P 500 stocks in each of the years from 2017 to 2021. He also delves into the importance of determining free cash flow and estimating its direction in contrast to net income, or EPS, and even GAAP (Generally Accepted Accounting Principles) earnings. Another questionable item to consider is “dividend management,” which many companies use to “soften” reported earnings. A unique and detailed analysis is given for each stock, with the “worst case” yielding 80% in 2018, when the S&P 500 stocks returned -6.24%. Readers will recognize each of the names but may be surprised to learn about the performance drivers Fridson identifies. The items I stand out the most for are an increase in free cash flow generation, credit improvement (generally from bad to less bad), restructuring, choosing a special dividend vs. constantly increasing dividend, and unique market conditions. Identifying past winners and understanding the pulse points of exceptional price performance provides clues to what follows later in the book.

Keep in mind that non– S&P 500 stocks that delivered an impressive performance for the same period. Fredson explains their conditions for the years 2017-2019. Catalysts are similar to the big stock names. Here, though, one is dealing with smaller capitalizations (but not necessarily so), a lack of positive earnings streak, and perhaps fewer publicly traded shares. If one reviews top stock records for years that are not included in The little book of picking the best stocksIn 2020 and 2021, one will find unusual triggers that could not have been identified before exposure to the sun. In 2020, Nio Inc. acquired (NIO) 1,103%, making it the only large-cap issue in the top 10 non-S&P 500 stocks that year. And in 2021, the highest stock was GameStop (GME), up 815%.

The book mounts to its detailed quantitative and qualitative presentation in its back half. The quantitative characteristics presented are strikingly evidence-based and give readers a green light of sorts to begin their own analysis. They are based on stock price volatility (the lower the better), EPS forecast dispersion (the lower the better), bond ratings, and market capitalization. The reader may be surprised to find “EPS dispersion” in the list since EPS typically runs very narrowly on Wall Street research, as discussed at some length. Friedson and researcher John Lee created a very simple statistic, the Fredson-Lee statistic. Significantly greater dispersion of EPS appreciation is observed in the top stock than in the “mid” S&P 500 stock (ie, stock #250). Readers will also enjoy the “plausible hypothesis blown” discussed and the explanations for why it didn’t work.

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The qualitative characteristics Fridson addresses focus on external pressure for change, dynamic technology, signs of potential credit improvement, and competitive dominance. Do I hear the name Tesla? Readers will remember 2020 fondly — even though that particular year started with more sell ratings than buy ratings on the stock.

Fredson The little book of picking the best stocks It will encourage analysts and investors to do something they may not be aware of: go for the first position systematically. The goal need not be to peak stock price performance in one year, but investors can get satisfactorily close. He states that this process does not have to be added to an overall portfolio but can be performed on a portion of a portfolio that one can dedicate to higher risk and possibly higher rewards. And one can have a lot of fun in the process.

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All posts are the opinion of the author. As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.

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Janet J Mangano

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