Blueprint to Make Money in Stocks
Today’s topic is process and why it’s so important. We’re going to use our equity portfolio process as an idea to communicate why we think the method is so vital.
By Louis B Llanes, CFA CMT
Founder, Wealthnet Investments, LLC
Today’s topic is process and why it’s so important. We’re going to use our equity portfolio process as an idea to communicate why we think the method is so vital. This information serves two types of investors – those that delegate their decisions to us and are interested in seeing what goes into creating their portfolio, and independent investors that like to roll up their sleeves and make these calls for themselves. Recently, we’ve been refining some of our processes and this is a high-level overview of what we do behind the scenes when building portfolios.
This is a broad-stroke overview of our equity portfolio process. We’re going to cover screening, assessing opportunities, and portfolio structure.
Looking at the left of the chart, you see the screening portion. We start with the equity universe, like the New York Stock Exchange and the Nasdaq. You want to begin with the exchanges you can get good investment opportunities in.
From those two markets, we go through a process of elimination because what we're trying to do is remove those companies that do not pass the basic tests that label them as good investments.
There are three main things that we look at when we're trying to go through that process: financial health, stock stewardship, and business uncertainty.
Financial health is something that can be nebulous to people and they’re not sure how to define it or look for the signs that a company has poor financial health. We have a process in which we look at the probability that a firm could face financial distress in the near future and also reference a predictive model that is designed to anticipate when a company may default on its financial obligations. This measure tends to favor companies with higher cash flow coverage, stronger cash positions on the balance sheet, and companies that have trends in these measures that are getting better.
If a company doesn’t meet these first requirements, we want to get rid of them.
The second thing that we look at when we're screening is stock stewardship. What we're talking about when we say stewardship is more related to the management team. Is the structure of management in the favor of investors or is there a conflict of interest that could mitigate excess returns in the future? We don't want to own companies that have poor structures where management has shown a track record or has structures in place with a lot of conflict. We want to make sure that we have an opportunity to put all the odds in our favor that we possibly can, so we get rid of those poorly structured companies.
Lastly, what we're looking for when we're eliminating stocks is business uncertainty. What exactly does that mean? This essentially comes down to predictability. What is a sale’s predictability? What is the operating leverage? In other words, how much of their total expenses are fixed? If a company has a lot of fixed expenses, they can have a very small change in revenue and that can lead to wild swings in earnings. We want to know how much of that we're dealing with and we also want to know how much financial leverage there is. Another thing to look at is how much debt there is because that's just like operating leverage, but it's more from financing from debt. Finally, what exposure they have to a contingent event that is going to lower the predictability that company.
This is akin to a pass or fail test - if they have the minimum financial health, the minimum stock stewardship, and the minimum business uncertainty, they pass. Otherwise it's a fail and they're removed from the list.
Now we move onto assessing the opportunity. Now we have this universe that has been narrowed down from our original amount. The first round of qualifications cuts a lot of companies out of the picture. Once we get these companies entered, it’s a case of grading them similar to grading a test. We look at three main dimensions, and there are subcategories within them, so this is going to be a simple overview.
The first category is quality – what we mean by quality is the financial health. We’ve already talked about what financial health is, but now we're going to take our leftover opportunity set and compare them to each other who has more financial health versus a competing company. Return on capital is one of those factors; companies that have higher return on capital tend to earn more money if you don't overpay for them.
We're looking for those companies with consistent profitability. That's another kind of indicator that a company has a moat around their business and generally higher quality. Predictability is another factor. The more predictable a stock is, the higher the quality.
Next up is the value scorecard. How much are we paying for this company? What are the cash flows, earnings, and book values? What kind of dividends and expected growth are we getting? When we put those together it gives us a sense of what we’re getting for each dollar we invest.
We combine those quality and value characteristics together into an opportunity set, which we then whittle down to a smaller number.
On the other side, the last category is the technical scorecard. What we're looking for there is oriented more towards trend in price, volatility, and short-term sentiment. If there are technical factors that have shown to add value to stock returns, they're known as anomalies. In fact, all of the items we look at on this chart are generally considered anomalies.
Let’s dive into the technical side for a minute, specifically momentum. It's very interesting when you have rates of change in prices moving better than other companies. Over intermediate timeframes, they tend to outperform in future periods. It almost goes against common thought but it is, in fact, an anomaly that we see in the market. That being said, there is a caveat.
We look at the short-term sentiment because in the very short term, there tends to be what's called “mean reversion”. This means that the market tends to move in the opposite direction.
In terms of volatility, theoretically, the higher the beta of a company, the more return you should get.
In actuality, lower volatility tends to outperform. We sort of handicap companies that have higher volatility characteristics and give more weight to those that have lower volatility.
At this point our technical opportunities are ranked. We now have these two opportunity sets - quality/value and technical opportunity set.
We ranked them from those with the highest potential to those that have the lowest potential because we want to focus our attention on the most attractive ones.
We know that there are competing factors of quality, value, and technical that don't always match, so we separate them and then blend them back together. Essentially, we pick the best ones and we get rid of overlap.
Once we've done that, we've got our final ranked opportunity set. We then go through an algorithm where we're looking at each stock and asking, what are the constraint tests? And do they pass them all?
We want to make sure that we have a wide range of stocks that we can put in sectors so we can overweight a sector if it's more attractive, but we don't want to have too much room in there because you can have big dislocations and what's called a tracking error.
We’re trying to optimize tracking error versus the ability to make excess returns. We do guardrails in terms of how much we'll put it into a sector and an industry. Once we’ve done that, we now have this portfolio, and there can be 50 or 100 stocks in it.
The next step is hedging. One of the biggest and most obvious risks with stocks is that if the general market starts falling, they all go down. We have a process in which we analyze the risks of the overall stock market and when our research shows that there's more risk in the market, we will hedge some of that market risk out.
We go through and every month we run this routine again. As you can see, it cycles back - who's in the universe, who do we need to pull out, who's passing? It’s really recycling through the process and always looking at where we can focus our capital in a consistent way.
In summary, what this boils down to is getting yourself into a routine where you have that discipline. It’s important to make a habit of having guidelines that are going to help you go through your checklist to make sure you’re focusing capital in the areas that are likely to give you excess returns.
Do your research on stocks that look attractive. Keep in mind all the facets that make companies valuable. Have guidelines of how much you’ll put into a specific sector or industry.
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Are you tired of not knowing whether you are in the right investments? In the Financial Freedom Blueprint, written by veteran wealth manager Louis Llanes, discover how to exponentially improve your ability to make smart financial choices.