Use this handy checklist to “stress test” your portfolio
Today I'm going to introduce you to a new way of thinking about companies.
As an avid reader of Money Morning, you've probably heard the terms: “Value investing” and “growth investing” before… And, if you haven't, don't worry, I will quickly recap what each strategy entails.
But, today we're going to go one step further. I'm going to show you a simple hybrid approach - what I call my “Stress Test”. You can use it to make sure you're including quality companies in your portfolio.
So let's get straight into it…
It all has to do with understanding the difference between Value Investing and Growth Investing
First let’s take a look at how “Value” investors differ from “Growth” investors:
Value investing, is a style of managing money in which the money-manager seeks out shares that have “fallen out of favour” with the market.
They’re generally beaten up companies that are considered bargain-priced when compared to their book value, replacement value or liquidation value.
Typically, value stocks are considered cheaper than shares of similar companies in the same industry. This lower price may reflect market reaction to recent company problems, such as disappointing earnings, negative publicity, or legal problems, all of which may raise doubts about the company’s long-term prospects.
Value investors may also look to invest in new listings when they believe the market has not fully understood how much these assets are worth.
Value investors tend to focus on stocks with relatively lower price-to-book (P/B) ratios and price-to-earnings (P/E) ratios and identify those as the best bargain stocks the market has to offer.
On the other hand, growth investors focus on industries with strong prospects. These investors seek out companies which should grow their earnings more quickly than the rest of the market.
A growth investor doesn’t mind ‘paying up’ for companies with higher P/E ratios and P/B ratios as these are simply indicative of the market's confidence in a company's ability to continue increasing earnings at an above-average pace.
Growth stocks usually have high price-to-earnings and price-to-book ratios. This means these stocks are relatively high-priced when compared with the company’s Net Asset Value (NAV).
Why has value investing struggled to generate returns in the last five years?
It’s been a torrid time for value managers over the last few years. Expensive stocks have generally become more expensive, helping growth managers to shine, while the “value plays” have mostly turned into“value traps”.
They look cheap for a reason. If the company suffers from high debt, lack of growth prospects or poor management chances are it’s doesn’t matter how long you wait, it will continue to be a bad investment.
It reminds me of the Warren Buffett quote:
“It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
You see, in the past the Oracle of Omaha, Mr Buffett, has also weighed in on the growth versus value debate:
Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. - Warren Buffett, Letter to shareholders 1992.
So how should you mix the two approaches?
At Rand Swiss, we like to call ourselves “momentum investors”.
Instead of focusing almost to exclusion on buying below Warren Buffet’s mysterious intrinsic value, our investment strategy aims to capitalise on the continuance of existing trends while understanding a securities value in the context of its trend.
Momentum strategies are not new, traders have successfully been taking advantage of price momentum for as long as there have been derivatives.
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A traditional momentum trader believes large increases in the price of a security will be followed by additional gains and vice versa for declining share price. This strategy looks at capturing gains by riding "hot" stocks and selling "cold" ones. A trader could take a long position in an asset, that has shown an upward trending price, or short sell a security that has been in a downtrend. The basic idea is that once a trend is established, it is more likely to continue in that direction than to move against the trend.
But trends are certainly not limited to share prices. Our own version of the old momentum strategy takes into account the underlying company fundamentals, global-macro trends as well as factors influencing the actual security price. When we begin to construct a portfolio, we use a variety of quantitative techniques to identify companies with the correct fundamental momentum.
We then place these companies in the context of their respective industry. We first compare them to local and offshore counterparts. We then decide on whether we’d like to be overweight or underweight the sector in the context of the macro-economic drivers. In this way we essentially come at a stock universe from both a “top down” and “bottom up” investment approach. Finally, we add a round of qualitative “stress testing” criteria to boot.
Now, that’s a lot to take in. But if I just break out some of the fundamental criteria we use to create our investment universe, we’re left with a very useful checklist for identifying whether or not you are holding a good company.
Let’s breakdown the strategy into eight simple criteria…
Remember, we’re trying to establish whether or not there is momentum in the fundamental metrics of the company while still keeping in mind the price you’re paying for the underlying assets. If you can tick 6 out of 8 criteria for your company below, the chances are you’re about to invest in something reasonable.
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Here’s the checklist:
While I’ve found this an exceptionally handy checklist, it’s important to look at how these metrics change over time and to view them in the context of the specific business.
3 year total return +20%: Look at the total return. This should include both capital growth as well as dividend pay-outs.
Increasing revenue over 5 years: Sales growth is a good indicator of demand for the product and the company’s ability to grow market share.
Increasing earnings over 5 years: A company’s bottom line is often one of the best indicators of overall company health.
Increasing dividends: A distribution of a portion of a company’s earnings, better earnings usually result in better dividends.
Increasing ROE: This reveals how much profit a company generates with the money shareholders have invested.
Outstanding shares stable or decreasing: There are many reasons for issuing new shares, but generally if a company is buying back shares it is supportive of the share price.
PE, P/B, P/S, PEG, in range: Only buy on a valuation that is acceptable to you. Also compare the valuation to other companies in the sector. Be aware of why you are paying a discount or a premium.
Current ratio, LT-Debt/Equity: Short and long term debt levels should not threaten the company`s financial health. Understand the companies gearing and its associated risks.
Of every measure above there can be good reasons for a company not fulfilling the criteria. For example, if the company has increased the number of shares in issue but has acquired a new asset at a fantastic price it wouldn’t fulfil the criteria but it would still indicate a reasonable investment. On the other hand if the company buying back shares well above the true value of the stock, this is not in the best interests of shareholders. These criteria are not “cast in stone” but can certainly help you identify a quality company.
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Breaking news: “My method has helped me multiply our portfolio more than EIGHT TIMES OVER between March 2011 and March 2016” – Analyst, Joshua Benton….
How is that possible?
So what to do next?
We find this sort of quantitative criteria particularly useful for clients with funds offshore.
In South Africa, we have less than 500 companies listed on the local market, so it’s fairly easy to identify the type of companies we’d like to invest in.
We use their products every day and as investment managers we generally have fairly easy access to company management as well.
The offshore markets are another animal entirely. When you’re suddenly looking at 85,000 investable securities across 20+ markets, using this type of screener becomes vital in separating the wheat from the chaff.
For The South African Investor
P.S. If you’re interested in finding out more about how we construct our portfolios or would like us to assist in stress testing your own current share portfolio, please feel free to get in contact here.