3 Factors To Use When Selecting Individual Stocks

by: Brian Carney

As more and more investors migrate toward index funds, there is a greater opportunity for money managers to achieve outsized returns by investing in stocks that not everyone else is using to proxy the market. For example, General Electric (NYSE:GE), Wal-Mart (NYSE:WMT), Microsoft (NASDAQ:MSFT), and Procter & Gamble (NYSE:PG) are being purchased and sold inside Vanguard funds, exchange traded funds (ETFs), and other passive vehicles every day so that the returns inside a portfolio closely correlate or "mirror" the S&P 500. The good news is that an investor receives market returns, but the bad news is that an investor receives market returns.

Rather than simply accept market returns or as we term "closet indexing," we enjoy the challenge of trying to find "diamonds in the rough." But, how do you do that? What metrics or qualitative factors should an investor use to decide which stocks could potentially be good investments?

Three of the things we look toward include:

Firms with little or no competition - We have had a great deal of success investing in companies that have a particular niche. For example, we started buying Under Armour (NYSE:UA) around $55 per share. Though they compete with Nike (NYSE:NKE) in many areas, they have a unique product that seems to really appeal to kids, teenagers, and the 20 something's. UA is still working on expanding their international distribution and women's product line, but this story is in its infancy. Another name that has very little competition is Chipotle Mexican Grill (NYSE:CMG). We all have choices on where to eat, but Chipotle has carved out a space in casual dining that fits somewhere between Taco Bell and Abuelo's. In addition, the company's emphasis on organic health has helped set them apart from their competition. Though others such as Qdoba have tried to copy the model, it continues to post solid earnings.

Companies that are truly out-of-favor with brand recognition - During the meltdown, no one wanted to touch the leisure industry. Since we had quite a bit of cash during the downturn, we purchased senior secured debt of companies such as Royal Caribbean (NYSE:RCL), Hertz (NYSE:HTZ), and Hilton Hotels. These bonds were selling at 10-15% discounts to par, but have now returned to par and some have been called. Currently, the gaming industry is projected to have a major slowdown because of the lack of discretionary spending and many analysts are pessimistic about WYNN Resorts (NASDAQ:WYNN) because the new casino in Macau does not come on board until 2014 or 2015. These factors have caused WYNN to trade down near its 52-week low. With a 21 P/E and much less debt than its competition, WYNN looks cheap in our view.

Price-to-earnings growth multiple helps weed out overvalued stocks - We have always been a proponent of not overpaying for common equity. Often times, the psychology of investors causes stocks to run to much higher levels than warranted. This has sometimes caused us to miss out on stocks that have been great investments, such as Google (NASDAQ:GOOG) or Salesforce.com (NYSE:CRM). However, in the case of Facebook (NASDAQ:FB) and others, the majority of the time it has given us much needed discipline. If we can purchase names that have a PEG ratio in the 1-1.5 range that pays us some kind of dividend, we feel better about the long-term performance potential of the stock. Some names we like include Terra Nitrogen (NYSE:TNH), Penn West Energy (NYSE:PWE), Freeport-McMoRan (NYSE:FCX), Aruba Networks (NASDAQ:ARUN), and Helmerich & Payne (NYSE:HP).

Disclosure: I am long ARUN, HP, WYNN, FCX, PWE.