Over the years I have been asked several times how we pick our stocks. The process for picking stocks really begins with our overall investment philosophy. All decisions are made in the context of achieving the best risk adjusted returns for the entire portfolio over a medium to longer term. Returns can be achieved through both distributions to shareholders (i.e. dividends) and share price appreciation. Here are a few principles we consistently have used over the years:
1) Zero speculation
Nearly all of our clients have one primary investments objective — capital preservation. Our clients have worked really hard for their money and they don’t want to lose it.
One of the guiding principles we believe in when picking stocks is investing for long term rather than speculating on any short term volatility. Sometimes people have asked me what the difference is.
One of the ways that I have described it is the mind set of thinking longer term (investing) and avoiding the temptation of shorter-term (speculating). It can be tempting to jump on the latest craze or hot stock pick suggested by a friend or neighbor in the hope of a significant gain in a shorter period of time.
One client told me years ago that he likes to grow wealthy slowly. He was willing to forgo all short term significant gain opportunities to ensure his capital was prudently invested in solid well-known companies. Avoiding the mistakes was more important than trying to hit home runs.
Although we steer away from giving advice for clients wishing to purchase speculative names, our general comment is to keep the position size small, hold it in a non-registered account (to claim the loss if it does not work out) , as future performance data will be impacted if our model portfolio recommendations are not adhered to.
2) Large capitalized companies only
Another guiding principal is avoiding smaller and medium capitalized companies. From our experience, the smaller and medium sized companies often have greater levels of volatility and greater risk.
Our equity selection process focuses 100 per cent on the largest capitalized companies within Canada, United States, and outside of North America. Our screening process first begins with approximately 1,200 constituents companies as follows the 500 largest companies in the U.S., the 350 largest companies in Europe, the 250 largest companies in Canada, and the 100 largest companies in the Asia/Pacific region.
We feel that a portfolio biased only to Canada has, and will continue, to underperform other markets over time. Although 1,200 individual companies may still seem like a lot, once the other principles below are applied the subset of companies narrows and becomes reasonable.
3) Corporate profitability
We will never purchase a company that is not profitable. The most simple of ratios to look at when assessing profitability is Earnings Per Share (EPS). If a company is not making money, it is automatically excluded. Projected growth in earnings or future outlooks provided by analysts can provide a good rationale for what will drive growth in earnings for the company.
We spend a significant amount of time reviewing internal and external research reports from analysts — with both positive and negative comments. Past profitability normally gets a company on the initial subset of companies to be considered, though future and current profitability are even more important.
4) High capital efficient companies
What does “high capital efficiency” mean? Let’s break it down to two terms we use returns on invested capital (ROIC), and free cash flow (FRF). All companies finance operations either through the issuance of debt or equity. The cost is the interest rates on the debt and dividend expectations on the equity.
Leverage is perhaps the one component we will focus on. A company that has internally sourced capital is always in a better situation then one that relies on external capital. A company that has low financial borrowing costs and leverage will have less dependence on external financing and external events. The more predictable a company’s ROIC and FRF are the better.
5) Lower leverage
If a company is profitable it can naturally expand its operations organically (with its own profits). If a company wishes to grow faster than the current profits allow, then it must choose to issue additional equity or debt to finance assets purchases or acquisitions.
Many advisers will look at various ratios to screen for good stocks. The financial leverage ratio is definitely worth looking at. It is relatively easy to calculate. From the financial statements you must determine the total debt of the company and the total equity held by shareholders. You simply divide the total debt by total equity. The normal rule of thumb is that this should not be above a level of 2.0, though some exceptions exist.
Leverage is essentially when a company borrows money with the expectation that the profits made from borrowing the money will be greater than the cost of the amount borrowed (i.e. the interest costs) . If a company is financing its operations by continually taking on debt and other liabilities then naturally it is riskier than a company with less leverage. This is especially the case in periods when interest rates are rising.
6) Prudently managed
Investing in companies that are prudently managed is a key component to any quality stock. This is particularly important as the landscape is constantly changing and we have to feel confident that management will make prudent changes to stand the test of time. Understanding what the company does is fundamental to selecting the stock. Management of the company should be able to provide information that makes sense.
A simple starting point is the company’s annual reports which are all available on each company’s website. My favourite section to read in financial statements is the “Management Discussion and Analysis”, also referred to as the MD&A.
An independent auditor must prepare and audit the company’s financial statements. The information is historical which immediately discounts its use from a planning standpoint.
The one exception is the MD&A statement. Although this statement is not audited it does give the management’s opinion on the current results (compared with previous results) and provides a forecast of future operations. Thoughts and opinions can be expressed that should include both positive and negative information. After reading the information you still don’t understand what the company does, or you do not agree with the future direction, then it’s best to avoid.
7) High cash in-flow
High net cash in-flow, consistent cash flows, and predictable cash flows are all attractive features to equities we add to the portfolio. If a company has a “burn rate” (term used to describe a company losing money and how quickly the company’s shareholder equity will be used up) it is automatically excluded on several grounds. A company must have high net cash-in flows to be considered in the model portfolios.
If companies have consistent earnings that are also predictable, we often refer to this as having an annuitized income stream. Royalty rights, contract obligations, licensing, subscription revenue, locked in contracts, membership fees, renting/leasing can all be sources of annuitized cash flow.
8) Competitive advantages
Within Canada, our favourite companies to invest in are those with a competitive advantage. We love companies that have a natural monopoly. Any business or industry that is capital intensive and has a high cost to entry is worth considering. In Canada we have some examples, such as banks, telecommunication, railways, and utilities.
We feel that well established companies that have competitive advantages are generally lower risk and have more predictable cash flows. They are lower risk in the sense that they do not have the immediate threats of new entrants to replace the product or service.
9) Corporate governance
One of the components we review is overall transparency and how that may impact shareholder returns. Transparency begins with the company policies, controls, compensation for executives, and communications to shareholders. We ask ourselves, is management providing clear information on the direction of the company that is understandable?
We always use caution if activities are overly complex and are not transparent. The more complex the accounting policies, the more scrutiny that needs to be put on a company. Are the executives and managements objectives also aligned with shareholder interests? Do we understand the direction the company is taking with any mergers, acquisitions or spinoffs?
10) Complimentary to other holdings
Our model portfolios typically have 30 to 35 holdings when fully invested. When we add or remove a stock from the model portfolio we must assess the impact of diversification and correlation. Typically when a stock is removed from a particular sector, we would replace it with a better holding option within the same sector.
Strategically we may change the weighting of sectors depending on our outlook for the economy and the stock market cycle. When adding stocks to a portfolio it is important to also look at how they are correlated to each other.
It’s important to have a disciplined approach to your criteria by which you pick stocks. If those criteria’s are stuck to consistently we feel that you’ll have fewer losses and more successes.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the Times Colonist. Call 250-389-2138. greenardgroup.com