Financial Questions for Bill Richardson Part 20
Good Morning. Here is the latest edition of 3 Questions for Bill Richardson. In this edition, we are going deeper on a single discussion.
How do you evaluate stocks to determine which are good growth candidates?
Choosing stocks is more a process of elimination than selection. There are simply way too many companies to choose from. In order to boil things down to a selection of ten to thirty companies for a portfolio, it is too difficult if you are fishing in too big a pond.
Think about it in a similar way to choosing a hockey team. Let’s say that you have 20 spots available on the team and 50 kids try out for the team. You start by eliminating players with poor skating skills or that don’t have the fitness level needed to play at your level. As a coach, that part is relatively easy. As you get the number into the mid 20s however, it become much more difficult.
The software that we use allows us to tap into a database of almost 22,000 stocks, so we have access to mega-sized companies, very small companies and everything in between. We generally focus on companies trading on North American exchanges. While most companies tend to be from Canada or the US, some are also from Europe or Asia. Although we will sometimes hold foreign stocks, we tend to outsource most International and Global positions to fund managers or ETFs. By choosing companies on the New York Stock Exchange, NASDAQ and Toronto Stock Exchange, we reduce the number of choices to 13,725, but this is still too many to choose from.
We further refine our search by looking at companies that are fundamentally sound by screening for companies who pass a 10-factor test by scoring 7, 8, 9 or 10 out of 10. This screen ranks companies on such things as earnings and revenue growth, Return on Equity and Gross Margins as well as standard ratios that help determine if a company can cover its liabilities with its current assets and whether the company over-extended itself with too much debt. By only selecting companies with Fundamental Scores of 7 or greater, we reduce the number of stocks to 1,385 or 6.2% of the database.
Next is to focus on the best longer-term performing sectors. Energy stocks have been on a constant slide for the past 10-years despite their recent strength. Even in good times, they tend to trade sideways. This is also similar with mining stocks. Both are fairly large components of the Canadian market. Real Estate gets eliminated as most stocks in this sector are income producing rather than growth and this also describes utility stocks. We also have an excellent Private Real Estate fund that covers this area well. By eliminating these sectors, we get the number of choices down to 1,138.
Our approach is to find large, mature companies with long-term track records of earnings growth, the key driver of stock performance, that are expected to continue into the future and buy them at reasonable prices. As we covered the growth aspects by using the Fundamental Score, we apply a filter to look for companies with $10B or greater market value (although we will also look at some companies in the $5B + range from time to time). Now we are down to a more manageable 345 companies. To put this into perspective, Canadian Tire has a market cap of $11B.
When we go shopping, we break this number down further by focusing on individual sectors, like technology or healthcare. Let’s use these sectors as examples. There are only 49 healthcare and 55 technology companies in North America that pass this test.
To make our final selections, we have created a scoring system made up of 9 factors. Things like earnings growth, profit margins, return on equity and identifying companies whose prices decline the least in bad markets. In the technology sector, Microsoft, Apple and Adobe are the top 3 and have returned 21% on average in 2021. In healthcare, Zoetis, Amgen and Johnson and Johnson are the top 3 and have returned almost 14%, on average, year-to-date (Jul 29/21). Source: Ycharts.com
Our scoring system is only one factor in our final selection. Our focus at this stage is earnings and being able to buy these companies at reasonable prices. We look for companies that are expected to grow their earnings at 10% or better over the next two years and where their PE ratio is lower than their 3 and 5-year averages. We then study news and research to get a feel for what is happening at the company and give other factors, such as demographics, some weight in our decisions.
Although we are confident in this system for stock selection, there are many things that can go wrong which is why we construct well-diversified portfolios with minimal duplication of industries (subsets of sectors). By focusing on the strongest sectors and selecting the final picks by choosing the strongest companies within these sectors, we can put together a strong set of stocks because we have eliminated companies that would potentially hurt performance.
We are equally concerned with avoiding the wrong companies as we are selecting the right companies. Our approach is to try and avoid major mistakes and position our portfolios for strong risk-adjusted growth over time.
Until next time, have a great day!