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One of the most important qualities leading to success is the ability to learn from ones mistakes. For an investor, the two most important qualities leading to capital appreciation from a portfolio of stocks are: win-rate and win percentage vs. loss percentage. An ideal portfolio should have: as many winning picks as possible while maximizing gains and minimizing losses. Successful stock picking is more of an art than a science, and the topic too broad to fully investigate here. However, while reviewing my wins and losses during the 2012 calendar year, I have come across some observations that I believe could be useful as general guidelines for future investments.

One thing that I have all too frequently ignored when deciding whether to buy a stock is whether macro fundamentals are likely to be a headwind or tailwind to the potential investment. Prices move upward when buyers outnumber sellers and downward when the reverse is true. Unfortunately, you may identify a stock that is cheap and yet sit on a loss for a very long time if fundamentals continue to weaken. A stock I purchased mid-year was Caterpillar (NYSE:CAT), where an alternative investment in Deere (NYSE:DE) would have led to greater capital appreciation.

During the May correction, I became tempted by the valuation of cyclical stocks, as they had plunged on growth fears that seemed likely to be temporary. I ended up settling on Caterpillar for the price of approximately 90 dollars per share. The TTM P/E was approximately 9, with a price to sales ratio of 1.1 (the low during the previous year's crash was about 1.3). Deere, on the other hand, had a TTM P/E of closer to 11 with price to sales at about 1 as well. So from my very cursory point of view, Caterpillar appeared to be a stronger buy. Figure 1 below shows the result; the trade was entered around the first rally in the mid-year downward correction (when both stocks had just about erased their YTD gains).

Figure 1: (click to enlarge)

While both stocks plunged, Deere recovered, and Caterpillar still trades 5% below my entry point. To understand why this is the case, consider the relative pricing of mining vs. agriculture (Figure 2). Mining is more cyclical than agriculture, and the relative price of metals and minerals has declined further than agricultural products. As a result, mining companies have retrenched more significantly on spending compared to farmers. Monitoring the price of agricultural vs. metallurgical commodities would have revealed that the lower price of Caterpillar was in fact discounting real weakness in the business model.

Figure 2: (click to enlarge)

The comparison is relevant, because it has caused me to rethink my stock selection methodology. I have become strongly biased that value is significant only during times of improving fundamental conditions. Until this is the case, valuations do not matter, because investors do not buy based on value. Incidentally, the reverse is often true; when a stock is overpriced, it tends to become more overpriced until a catalyst appears. Since I am a chemist, I think of this in terms of a reaction coordinate. Gasoline does not spontaneously burst into flames, there must be a spark. Thus, buying undervalued companies is no guarantee of success and neither is shorting overvalued companies.

So as an investment strategy, it is my belief that one is better off buying reasonably valued stocks with superior fundamentals, rather than cheap stocks with worsening fundamentals. I also believe that one of the most significant features of price action in the market over the past 12 months is the cheapening of cyclical companies and the appreciation of less cyclical companies. The value investor would look at this trend and say: "buy the cheaper companies." My interpretation is that investors should buy reasonably priced non-cyclical stocks with improving fundamentals. I expect that if the economy stays in its doldrums or takes a turn for the worse, non-cyclical stocks will outperform. It would take strong economic growth for the reverse to occur and non-cyclical stocks would only underperform in a relative sense if this were to happen. It is therefore very likely that non-cyclical stocks will have better returns and lower risk. You can have your cake and eat it too.

One such stock is Dollar General (NYSE:DG), which seems reasonably priced given its growth (TTM EV/EBITDA = 10.3; PEG = 1.0). It was recently added to the S&P 500 index, which should prompt buying from index funds to boost the price in the near term. The company has favorable tailwinds as the median disposable income in the United States has trailed the CPI index over the past 5 years (Figure 3), leading to increased cost consciousness among consumers as is evident from decreasing debt service as a proportion of disposable income.

Figure 3: (click to enlarge)

Dollar stores have been beneficiaries of this cost conscious behavior they tend toward smaller floor space compared to superstores like Walmart (NYSE:WMT) or Target (NYSE:TGT) with higher margins on smaller lower cost packaging. While the share price of Dollar General has greatly exceeded that of Walmart (Figure 3), TTM EV/EBITDA has expanded by only 10% and operating margins have expanded by 26% reflecting improved fundamental business conditions. The higher cost of gasoline and preponderance of consumers in more tightly spaced urban settings have further granted dollar stores competitive advantage against larger firms. An added bonus is investing in a fundamentally non-cyclical business provides ballast against an economic cycle, which is constantly on the edge of faltering. The stock may have run up too fast, however, after a period of consolidation, it appears to be showing strength, and the company has performed strongly and consistently exceeded analyst expectations.

Figure 4: (click to enlarge)

Conclusions:

Much of the thought process behind stock selection from strictly a valuation standpoint is woefully incomplete due to the unusual stress in the economy at the present time. This trend is likely to cause less cyclical 'safer' stocks to command an increasing premium over more cyclical 'riskier' stocks. In real estate, a common rule is to buy the most reasonably valued property in an up and coming neighborhood. Likewise, stock pickers should seek to avoid cyclical stocks trading at distressed valuations unless they can make a compelling case for why fundamentals will soon improve. At present, we are likely nearing a halfway point in our current debt-deleveraging cycle, thus I expect further multiple expansion of less cyclical stocks at the expense of more cyclical ones.

Some general screening tactics for finding attractive stocks are:

  1. Favor lower beta over higher beta (most companies with improving fundamentals are non-cyclical, thus I expect low-beta to outperform)
  2. Avoid sectors more sensitive to economic growth, unless you believe economic growth will soon improve, however, some subsectors (e.g. natural gas) may still be attractive
  3. Favor large cap stocks over small cap stocks (late in a bull market large cap stocks outperform with less risk, in a shaky economy this is doubly so)
  4. Favor moderate growth companies over high growth ones (when little growth is present investors vastly overpay for it, disappointment will end in a brutal sell-off)
  5. Favor US companies over International ones (nervous investors are willing to pay more for the "safety" of US companies)
  6. Favor strong business models and durable competitive advantage (a consequence of the low cost of capital is commoditization of many industries - avoid value traps like Dell (NASDAQ:DELL) and Hewlett Packard (NYSE:HPQ))
  7. Pick industries and companies with improving macroeconomic fundamentals - some examples are:
  • Discount stores (due to increased consumer cost consciousness) -Dollar General and Target
  • MLPs and REITs (due to low and decreasing interest rates) -Omega Healthcare (NYSE:OHI) and Kinder Morgan Energy Partners (NYSE:KMP)
  • Banks (due to mortgage refinancing resulting from lower interest rates) - Wells Fargo (NYSE:WFC)
  • Hospitals (the largest cost disadvantage for hospitals is acute care for the uninsured, the mandate for universal healthcare should be very bullish for the industry - the market is not sufficiently discounting this) - Universal Health Services (NYSE:UHS)

Many additional ideas could be listed, however, the purpose of this article is not to tout specific stocks, but instead, to give an investor a qualitative sense of an alternative way to pick stocks. Identify a sub-industry with bullish trends first, then identify attractive stocks within that sector. It is my opinion that this type of analysis will allow a thoughtful investor to better avoid value traps. At the very least, it is a method of stress testing stock picks.

Disclaimer: The above article should not be considered a solicitation to buy or sell any security. Please do your own due diligence before taking a long position in any stock.

Source: The Current State Of The Macro-Economy And Implications For Stock Picking