In the book 'Four and Twenty Rules for Buying and Selling Shares', New Zealand investor, Nigel McCarter, details an investment strategy that returned an average of 23% annually in the Australasian share market between 1996-2012.
Since 2008, the same strategy has captured gains of 40% annually.
The good news is that McCarter's rules do not just apply to the Australian Stock Exchange. The strategy, which relies on finding stocks using compelling investment criteria, can be applied to any share market and will likely work well for American, Canadian and UK shares too.
In this article, I describe some of McCarter's rules and present 3 stocks that satisfy nearly all of them; making them extremely compelling investment ideas.
Based on years of stock investing, data-modeling and financial wisdom, McCarter has come up with a number of rules that have served him well in picking successful stock investments:
Rule 1 - You should understand how a company makes a profit
Rule 2 - The company is in a different sector to other investments
Rule 3 - You consider that the sector is likely to grow over the next 5 years
Rule 4 - Revenue is greater than $100m
Rule 5 - The company is growing by itself or taking over/merging with similar companies in the same sector
Rule 6 - EPS has been growing 10% or more for the last 3 years
Rule 7 - Share price has been growing 10% or more for the last 3 years
Rule 8 - The company has paid dividends every year for the last 5 years
Rule 9 - Dividend yield is between 2% and 7%.
Rule 10 - Profit margin is > 5%
Rule 11 - ROE is > 5%
Rule 12 - PE is > 5 and < 25
Rule 13 - PS is > 0.1 and < 4
Rule 14 - PEG is < 1
Rule 15 - Options outstanding < 3% of total shares issued
Rule 16 - Current ratio > 1
Rule 17 - Equity/ Capital employed > 60%
Rule 18 - No adverse qualifications in the auditor's report
Rule 19 - No substantial unexplained changes between annual reports
Rule 20 - Directors and managers hold shares in the company
When a stock satisfies one of these rules it is given one point with a higher score indicating a stronger investment. McCarter states a stock with a score lower than 10 should not be considered.
I was able to run a stock screener to return a full list of stocks that satisfy some of these rules. I then used annual reports and financial statements to fill in the remaining investment criteria.
Doing so, I was able to whittle a list of over 100 stocks down to just 3 high quality stocks; Select Medical Holdings Corp (NYSE:SEM), Schweitzer-Mauduit International Inc (NYSE:SWM) and American Railroad Industries Inc (NASDAQ:ARII).
|Rule 4||> $100 M||2.94bn||780m||761|
|Rule 6||> 10% per year||43.90%||88.80%||11.40%|
|Rule 7||>10% per year||15.23%||14.70%||28.00%|
|Rule 9||2% - 7%||3.65%||2.91%||2.15%|
|Rule 10||> 5%||5.30%||13.30%||11.40%|
|Rule 11||> 5%||20.90%||19.00%||22.20%|
|Rule 13||0.1 - 4||0.5||2.02||1.3|
|Rule 14||< 1||0.82||0.94||0.76|
|Rule 15||< 3%||NA||0.11%||NA|
|Rule 16||> 1.0||1.3||3.7||2.5|
|Rule 17||> 60%||30.2||69||58.9|
NB: Some of this data was pulled from Finviz.com, which I consider to be one of the best stock screeners and some was pulled from financial reports. Please verify this data before making any investment decision.
Select Medical Holdings Corp
Select Medical operates specialty hospitals and outpatient rehab clinics. With a high score of 16, SEM looks to be an interesting investment in a sector that should experience plenty of growth given aging demographics trends in the United States.
The company failed rule 8 as it has not filed a dividend for the past 5 years. This year's dividend was a special case and there are no plans to issue further dividends in the future. SEM plan to use the funds to invest within the company.
Another risk with SEM is that 47% of its operating income comes from Medicare policies, a change in legislation would prove problematic for Select. Nevertheless, the fundamentals show this is a high quality company at a good price.
Schweitzer-Mauduit International Inc
Schweitzer is a provider of paper to the tobacco industry, in fact 97% of its paper goes towards tobacco products. I failed SWM on rule 3 because the tobacco industry has some uncertainty owing to legislation changes. Having said that, tobacco stocks have been a solid, defensive play for years and there could be plenty of demand in less developed nations to tap into.
As well as this, SWM is a pioneer in LIP (lower ignition propensity) cigarette papers which are favored as they contribute to reduced fire risk. SWM dropped heavily last November after missing on earnings and looks very cheap.
Could it be that less ethical companies are more overlooked by investors?
American Railroad Industries Inc
There will always be a need to transport goods by rail and with the economic recovery gathering momentum, commodity prices are set for a better couple of years. This will cause more demand for American Railroad's Hopper and tank railcar products and their ability to transport commodities across long distances.
The company sees plenty of growth opportunities ahead and is positioning itself in Russia, Saudi Arabia, India and Australia according to its recent filings.
It's also worth mentioning that notable hedge fund investor Carl Icahn owns a substantial stake in the company and is on the board of directors.
ARII failed rule 19 and also rule 8, since it suspended dividends in 2009-2011. Apart from that, the fundamentals suggest ARII would be a solid investment at current prices.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SWM, ARII, SEM, over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.