In 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.
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 since 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 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.