A More Refined Equity Selection Universe Breeds Superior Performance
How much financial bloodshed is necessary before we realize that there is no safe and easy shortcut to investment success? When do we learn that most of our mistakes involve our very own greed, fear, and unrealistic expectations?
Eventually, successful investors begin to allocate assets in a goal directed manner by adopting a realistic investment methodology --- an ongoing security selection and monitoring process that is guided by realistic expectations, selection rules, and management guidelines.
If you are thinking of trying a strategy for a year or so to see if it works, you're due for a smack up alongside the head. Viable strategies transcend cycles, not years, and viable equity strategies consider three or four disciplined activities, the first of which is selection.
How should an investor determine what stocks to buy, and when to buy them? Will Rogers summed it up: "Only buy stocks that go up. If they aren't going to go up, don't buy them." Many have misread this tongue-in-cheek observation and joined the "buy anything that is rising" club. I've found that the "buy investment grade value stocks lower" approach works better.
A Google search produces a variety of criteria that help to identify value stocks, the standards being low price to book value, low P/E ratios, and other fundamentals. But you would be surprised how the (self serving) definitions can vary, and how few include the word quality.
In the late 90's, it was rumored that a well-known value fund manager was asked why he wasn't buying dot-coms, IPOs, etc. When he said that they didn't qualify as value stocks, he was told to change his definition --- or else.
How do we create a confidence building stock selection universe? Operating on blind faith with one of the common definitions may be too simplistic, particularly since many of the numbers originate from the subject companies. Also, some of the figures may be difficult to obtain quickly, and it is essential not to get bogged down in endless research.
Here are five filters you can use to come up with a selection universe of high quality companies, and you can obtain all of the data inexpensively:
1. An S & P rating of B+ or better. S & P is a major financial data provider and its "Earnings and Dividend Rankings for Common Stocks" combine fundamental and qualitative factors into a letter ranking that speaks to the financial viability of a company.
Potential market performance (a guessing game anyway) is not a consideration. B+ and above ratings are considered investment grade. Anything rated lower adds an extra element of speculation to the portfolio. A staff of thousands does your research for you.
2. A history of profitability. Obviously, a company with a history of profits is a less risky investment than an unproven, start-up, or losing enterprise. Profitable operations adapt more readily to changes in markets, economies, and business opportunities, and are more likely to produce profit-taking opportunities for you.
3. A history of regular dividend payments. The payment of dividends, and periodic increases in the rate paid, are signs of economic viability. Companies will go to great lengths, and endure great hardships, before either cutting or omitting a dividend.
There is no need to focus on the size of the dividend itself; equities should not be purchased as income producers. On the other hand, companies who enrich officers and don't reward investors should be avoided.
Additionally, dividend cuts are a clear indication of financial stress within the company.
4. A reasonable price range. Most Investment Grade Value Stocks trade between $10 and $100 per share. If you have a seven-figure portfolio, price may not matter from a diversification standpoint, but in smaller portfolios, a round lot of a $40 stock may be too much to risk in one position, all at once.
An unusually high price may be caused by high sector or company speculation while a single digit price may be a warning signal. With no real structural size limitations, I feel most comfortable with a range between $10 and $90 per share.
5. A NYSE Listed Security. I'm not sure that the listing requirements for the NYSE are still more restrictive than elsewhere, but it is helpful to be able to focus on just one set of statistics. Market Stats, Issue Breadth, and New Highs vs. New Lows are reported separately by exchange.
Your IGVSI selection universe will become the conscience of your equity investment program --- allowing no room for creative adjustments to the rules and guidelines you've established. You will be able to focus on diversifying properly and on identifying stocks that are ready for purchase.
Always keep in mind that you want to sell each equity at your target profit ASAP. What, you say, what are targets? Well, security selection is just one part of the process.
You'll want to establish appropriate diversification, buying, and selling rules as well. For example, I never consider buying a stock until it has fallen at least 20% from its 52-week high. Your actual "buy list" should change every day in symbol, # of issues, and day-limit price.
You will need to apply consistent and disciplined judgment to your buying activity so you don't violate a formalized set of diversification rules as to sector, individual issue, global interest, etc. And then the absolute most important function of all --- profit targeting.
Never, ever, say "no thank you" to a net/net profit of 10%, or less under certain circumstances, and you'll be able to do it again, and again, and again.
One other observation, as IGVSI stocks gyrate above and below your purchase price (as they absolutely will), you can be confident that it is merely the nature of the stock market and not an imminent financial disaster --- and that should help you sleep nights.
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