It is exciting to innovate and try a new investment strategy. But expectations meet reality when stock purchases begin. 2023 will indicate the initial soundness of the strategy. My December 28th memo (Designing an Active Stock Picking Strategy) established investment risk and return objectives. Now to turn to the design criteria for stock selection:
Stocks must have the following attributes.
Profitability. To be consistently profitable. No over-reliance on new products, betting on commodity prices or trending consumer fads.
Fundamentals. To have a strong balance sheet, with plentiful cash flow. I am not looking for startups, poorly financed or speculative companies.
Valuation. Trade at a price/earnings multiple that is generally at the midpoint of its historical range (i.e., if the home builder Toll Brothers has historically traded in a P/E range of 5x to 20X earnings, look to purchase at less than 10X earnings). If I can purchase shares at the lower end of their historic valuation I should increase my odds of not overpaying.
Market capitalization. Select companies valued between $1b -$20b, (while targeting an average of $10b across the portfolio- a similar capitalization to stocks in the S&P 400 Index). This will allow me to compare the strategy performance to the S&P 400 Index. Will I be able to add value by active stock selection rather than owning the passive S&P 400 index?
Volume. Ensure ample trading volume for each selected stock, so that liquidity is never an issue.
Coverage. Ensure that there are multiple Wall Street analysts covering each stock, I am not looking to find hidden jewels, stocks that might never see investor interest.
Return on equity. Companies should have a track record of generating a 20% return on their equity. Indicating that historically corporate margins are attractive, the company is well managed and exists in a profitable industry.
Earnings stability. The rating service, IBD, has a measure of earnings stability (are corporate profits consistent or irregular). IBD ranks #1 as being most stable, and #99 as being least stable). The preference is to hold stocks with a stability rating of 20 or less. This could decrease the risk of a disappointing earnings release that causes shares to drop unexpectedly.
Due diligence. External stock research that is positive in regard to company valuation and outlook. Perhaps this research is not of great importance, but it might prevent the purchase of a stock where I have failed to identify a non-obvious risk.
So what might a typical stock holding look like? One stock that jumps out is AGCO Corp (AGCO). Those of us lucky enough to own tractors know the company for their manufacturer of agricultural tractors and combines.
Profitability / Fundamentals. AGCO is a very successful company with long-term earnings growing by 32% annually. Moderate debt levels. Cash flow of $14.00 per share to fund R&D and growth.
Valuation. Currently trading at 13X earnings. Over the past 5 years, the stock has traded at 8-22X earnings, so a purchase could be made at the lower end of AGCO's valuation range.
Market Capitalization is $10.35 billion, nicely within the parameters of the strategy.
Volume is generally over 2 million shares per day, so no issues with liquidity.
Coverage. There are 19 Wall Street analysts covering the stock, so ample visibility to highlight the company's success.
Return on Equity. AGCO is a good steward of capital, generating a 25% return on equity.
Earnings Stability. The company is ranked extremely well, at 15 out of a possible 99 by IBD.
Due Diligence, Wall Street analysts are favourable, and hidden dangers to the corporation have not been identified. Thomson / Reuters ranks the outlook for AGCO at 10 (their top rating).
Now to find 19 more candidates that qualify for inclusion in the strategy......
best regards, Tim
Thoughts, agreement/disagreement? email me at tim@mortonir.com
Tim Morton, CFA is a retired portfolio manager with 45 years of experience working with private clients and is the editor of mortonir.com and a contributor to Barron's. My comments are not to be taken as investment recommendations. They are purely for discussion purposes. Please see your registered advisor for investment advice.