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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 greed, fear, or unrealistic expectations about what we
own? Eventually, successful investors begin to allocate assets in
a goal directed manner by adopting a realistic Investment
Strategy... 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 to see if it works, you're due for another smack up
alongside the head! Viable Investment Strategies transcend cycles,
not years, and viable Equity Investment Strategies consider three
disciplined activities, the first of which is Selection. Most
familiar strategies ignore one of the others.
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) High" club. I've found that the "Buy
Value Stocks Low (er)" 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
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? Simply 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 higher quality companies, and you can obtain all of the data
inexpensively from the same source:
1. An S & P Rating of B+ or Better.
Standard & Poor's is a major financial data provider to the
investment community, and its "Earnings and Dividend Rankings for
Common Stocks" combine many fundamental and qualitative factors
into a letter ranking that speaks only to the financial viability
of the rated companies. Potential market performance (a guessing
game anyway) is not a consideration. B+ and above ratings are
considered Investment Grade. Anything rated lower adds an element
of unnecessary speculation to your portfolio. A staff of thousands
does your research for you.
2. A History of Profitability. Although it
should seem obvious, buying stock in a company that has a history
of profitable operations is less risky than acquiring shares in an
unproven, or start-up entity. Profitable operations adapt more
readily to changes in markets, economies, and business growth
opportunities. They are more likely to produce profit
opportunities for you quickly.
3. A History of Regular Dividend Payments.
The payment of regular dividends, and periodic increases in rate
paid, are sure signs of economic viability. Companies will go to
great lengths, and endure great hardships, before electing either
to cut or to omit a dividend. There is no need to focus on the
size of the dividend itself; Equities should not be purchased as
income producers. A further benefit of using dividend payment as
one of your selection criteria is the clear indication of
financial stress that a cut communicates.
4. A Reasonable Price Range. You will find
that most Investment Grade stocks are priced above $10 per share
and that only a few trade at levels above $100. If you have a
seven-figure portfolio, price may not matter from a
diversification standpoint, but in smaller portfolios, a round lot
of a $50 stock may be too much to risk in one position. An
unusually high price may be caused by an unusually high degree of
sector or company specific speculation while an inordinately low
price may be a good warning signal. With no real structural size
limitations, I feel comfortable with a range between $10 and $90
per share... but I would avoid most issues even at that level.
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. Most of the information you need
regularly is reported by Exchange (Market Stats, Issue Breadth,
and New Highs vs. New Lows).
Your Selection Universe will become the
backbone of your Equity Investment Program, so there is no room
for creative adjustments to the rules and guidelines you've
established... no matter how strongly you feel about recent news
or rumor. Now you can focus on operating procedures that will help
you diversify properly by position size, industry, etc., and on
guidelines that will help you identify which stocks should be
watched closely for purchase when the price is right. Keeping in
mind that you want to sell the Equity Position at a target profit
ASAP, you'll want to establish appropriate buying (and selling)
rules. For example, I never consider buying a stock until it has
fallen at least 20% from its highest level of the past 52 weeks,
so I include those that are close or at this price level on a
"Daily Watch List". Then, I select those that I would be willing
to add to equity portfolios if they fall a bit more during the
trading day. My actual "Buy List" changes every day in both symbol
and limit price.
You will need to apply consistent and
disciplined judgment to your final selection process, but you can
be confidant that you are choosing from a select group of higher
quality, well-established companies, with a proven track record of
profitability and owner awareness. Additionally, as these
companies gyrate above and below your purchase price (as they
absolutely will), you can be more confident that it is merely the
nature of the stock market and not an imminent financial
disaster... and that should help you sleep nights.
By the way, never say no to a profit when
the upward movement equals 10%, and you'll be able to do it again,
and again, and again.
Steve Selengut
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