With thousands of stocks to choose from, how does one go about selecting the next stock to purchase for one's portfolio? I'm sure most veteran investors have their method down pretty well, but I've been asked several times recently to describe my own method, and so I've decided to write this article in the hope that it will help other new investors (and maybe even some veterans) to come up with their own approach.
In Part 1, I'll introduce you to the philosophy behind what kind of stocks I like in my portfolio, and therefore what kinds of stocks that I'm currently tracking, as well as an overview of "My Mad Method" for deciding which of the stocks I'm actively tracking that I might want to add to my portfolio once I've got enough funds to justify a purchase. I'll cover some of the metrics that I use to evaluate stocks on my watchlist against each other, and in Part 2 I'll finish up with the remaining metrics that I use, and how I use all of those metrics to help me make my buying decisions.
In the Beginning...
My overall goal for my portfolio is to collect the best stocks that will provide solid, stable, growing dividends for the remaining years before I retire (currently ~17 years), and hopefully beyond that. Of course, I'd like some good growth to go along with those dividends, and as it turns out several studies have found that dividend paying stocks generally and measurably outperform non-dividend paying stocks over time. So by picking solid, stable dividend payers with a history of increasing dividends on a regular basis, and reinvesting those dividends into these or other positions with the same characteristics, I figure I've got some pretty good growth baked into my plan. That doesn't mean that there's no room for some purely speculative growth plays; there is, but these are generally outnumbered by the dividend payers.
Of course, I want diversity in my portfolio, as that has been shown historically to provide a degree of protection from bear market swings and the general erratic behavior of Mr. Market over time. For the purposes of this article, I'm going to concentrate on my equity positions; I have some of my overall portfolio invested in things like bond funds and the like, but here I'm going to focus on stocks.
Diversity comes in many forms, but for my taste I've chosen a mix of stocks from different industries as well as different market capitalization categories, and included a blend of domestic and international selections. The industry mix I currently have includes Technology, Mining (Gold and Silver), Healthcare/Medical Devices, Utilities, Energy, Consumer Goods & Services, mREITs and Telecom. Within these broad categories there is a variety of mega-, large-, mid- and small-cap positions, depending on how many stocks I have in each industry category, some of which are domestic stocks and some of which are international stocks within those other two categorizations. Since I'll be adding to this brew, my watchlist of potential future stocks has the same basic characteristics, plus a few industries that I don't yet hold a position in.
In order to make good choices to add to my growing portfolio, I first need a good watchlist. For me, having about 30 stocks on my active watchlist is a good number; not too few, so I've got some variety and range to work with, and not so many that it becomes unwieldy and difficult to zero in on the next great thing. But which stocks to include? Well, I've already described the diversity I like, but from there it starts to become more personal.
Watching companies that you know something about takes a bit of the mystery out of whether or not they'd make good additions to your portfolio, but I'm also open to new ideas from the various websites that I frequent, adding new potentials to my watchlist as I read and learn about these companies that I may not have heard about previously, or maybe I had heard of them but didn't really know that much about them. This is the point where I start my due diligence in earnest, learning about each company and deciding at a high level whether I want to include it in my watchlist or not. Here's my current watchlist of 30 stocks, sorted by company name:
Alliance Resource Partners, L.P.
Annaly Capital Mgmt
Compass Minerals Int'l, Inc
Cheniere Energy Partners, L.P.
General Electric Company
Johnson & Johnson
Lockheed Martin Corp
MV Oil Trust
National Grid, plc
National Presto Industries
Philip Morris International
Procter & Gamble
Wells Fargo & Co
So now I've got a baseline of 30 stocks to work with, companies that I think I might like to add to my portfolio as I accumulate enough dividends to make a purchase, or if something I currently hold falls out of favor with me for whatever reason and I decide to sell it (that's another article altogether). Where do I go from here? For example, both Johnson & Johnson and Philip Morris International are dividend stalwarts with almost identical yields and P/E ratios, but 2 metrics aren't enough for me to be able to make a choice between them.
Or, what about JNJ, Medtronic and MAKO Surgical, all medical device manufacturers? There are compelling but different reasons to pick any of these three, and if I just looked at their yield and P/E, I might not get the complete picture; I have limited funds with which to work, so I want to make an informed decision. Or, now that they're paying a dividend and their stock price has pulled back a wee bit (as of time of writing), what about Apple? Would it be worthwhile to add more shares of AAPL to my current position, based on the numbers?
In order to narrow down my watchlist of 30 stocks to a few that I'll be willing to pull the trigger on when I've got enough dry powder, I employ a rating and ranking method that takes 15 different metrics (i.e., characteristics that can be expressed as a number) about each member of my watchlist, ranks each stock against all the others on each metric individually, and then aggregates those 15 metric ranks together in a final score, which itself is then ranked, resulting in a value between 1 and 30 being assigned to each stock, where lower is more desirable than higher. In other words, I'm going for #1.
To accomplish this task, I take advantage of the formulas and calculation power available in any basic spreadsheet program. My tool of choice is Microsoft Excel, but any spreadsheet program worth its salt should be able to accomplish the same goals. When using the "rank" function in Excel, you have the option of ranking the group of cells in a column in either ascending order or descending order; I will indicate which to use with each metric that I describe below.
The following is a list of the 15 metrics that I use in My Mad Method of picking stocks to buy. Most of these metrics and/or their components are fairly straightforward and should be familiar to most readers and can be easily found on most popular financial websites, although some of them are a bit trickier than others to track down:
- Dividend Yield
- Payout Ratio
- Five Year Dividend Growth Rate
- Current P/E
- Price to Book Ratio
- Return on Equity (ROE)
- Gross Margin
- Net Profit Margin
- Current Ratio
- Five Year Revenue (Sales) Growth Rate
- Trailing Twelve Month (TTM) Cash Margin
- PEG Ratio
- Graham Number Ratio
- The BMW Method Root Mean Square (RMS)
- The BMW Method Return Factor
These 15 metrics represent the way that I've come to do a technical evaluation of the stocks I'm interested in and actively tracking, but they're not a be-all-end-all list of metrics. You can pick and chose whichever ones you fancy, but in general I would keep the ratio of stocks you're evaluating to the number of metrics you're ranking them by to be roughly 2:1.
In my case, I keep about 28 to 30 stocks in my watchlist, and use these 15 metrics to rank them. Using more metrics than this will narrow the difference in the average values of all of them when compared to each other, which can make the resulting rankings somewhat "fuzzy," while fewer metrics may not give you the right indication of which stocks really are more worth your consideration than the others.
In today's article, I'll cover the first 11 metrics and how I find and/or calculate them, and how I rank each one on its own; I'm also assuming that you'll be entering the data into a spreadsheet. In Part 2, I'll present you with the remaining 4 metrics and wrap up how to aggregate all 15 of them to come up with a single value that can then be ranked to give your watchlist an overall, visual view into how those stocks you're interested in stack up against each other:
1 - Dividend Yield - Enter the percentage Dividend Yield. Rank this metric in ascending order.
2 - Payout Ratio - Enter the payout ratio as a percentage, but rank this in descending order. If a given stock doesn't have a divided yield, I use 2,000% for this metric so that it ranks at the bottom.
3 - Five Year Dividend Growth Rate - Also a percentage and relatively easy to find, rank this in ascending order. If a given company doesn't have 5 years of growth history to work with, just enter a zero here, and keep in mind that this number could be negative.
4 - Current P/E - Enter the current P/E ratio, not the forward P/E. Rank in descending order. This number could be negative, which is OK, or you can simply enter zero for a negative P/E.
5 - Price to Book Ratio - Enter the Price to Book ratio and rank it in descending order.
6 - Return on Equity (ROE) - Enter the ROE and rank it in ascending order. If a given company doesn't have an ROE figure, enter zero here.
7 - Gross Margin - Enter the current Gross Margin, or enter a zero if this number is not reported or is "N/A" in your source. Rank in ascending order.
8 - Net Profit Margin - This could be negative, too. Rank in ascending order.
9 - Current Ratio - Higher is better here, so enter this and rank it in ascending order.
10 - Five Year Revenue (Sales) Growth Rate - This is a percentage. Some companies don't have 5 years of numbers, in which case use 3 years if available, or just the prior year's figure if that's all there is. Don't be tempted to use a better number from a more recent range here; stick to the 5 year growth number if it's available. Rank this in ascending order.
11 - Trailing Twelve Months Cash Margin - Here's where it starts to get a little tricky. What we're looking for here is an indication of how the company manages its free cash, since we want a lot of free cash to cover its dividend distributions. To calculate this, I use the cash flow and income statements for the company for the last 4 fiscal quarters, whatever is currently available from my source.
This calculation is made up of the sum of the Operating Cash Flow, or OCF, for each quarter (from the cash flow statement), minus the sum of the Property, Plant and Equipment, or PP&E, dollars spent in each quarter (also from the cash flow statement, but expressed as a positive number so that it subtracts from the sum (Operating Cash Flow) properly), and then that result is divided by the sum of the Sales for the trailing four quarters (from the income statement). The higher the better, so rank in ascending order. Here's the formula:
(SUM(4 quarters' OCF) - ((SUM(4 qtrs' PP&E)*(-1))))
/ (SUM(4 qtrs' Sales))
That's it for Part 1. Check out Part 2 for the details of how I calculate and rank the remaining 4 metrics, how to come up with a single value to use to rank all of your watchlist, as well as a look at how well this method has worked for me so far.