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Value Stock Investing, Quality is Job One
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 at the higher level.
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 each
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. Your 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.
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