It has been a year since we first introduced our factor-based quality ranking model (see "13 Stocks That Top My Factor-Based Value Investing Ranking Model"). The purpose of the model has always been to find wonderful businesses at fair prices, although the valuation consideration is not reflected by any factor in the model. Our investment approach is to follow businesses only with strong fundamental qualities (e.g., high returns on capitals, healthy balance sheet, sustainable cash flow, low capital requirement) and wait for the right entry points. Select factors with high weights are listed below, and a weighted sum of all factors is calculated for us to assign the score to each stock:
- Cash/earnings return on invested capital/equity/asset and their historical stabilities
- Historical earning and FCF
- Financial health
- Margins and their historical stabilities
- Growth track record and momentum
- Dividend track record
- Generations of free cash flow and operating cash flow
- Capital intensity
- Compared to peers (in terms of profitability, capital efficiency, growth track record and financial health)
- Qualitative factors (including moat, competitive landscape, market leadership, and industry stability)
Even without valuation considerations, a hypothetical portfolio of top-ranked stocks picked by the model last year proved to have outperformed the benchmark by a wide margin (see "Performance Review: Stocks That Topped My Factor-Based Quality Ranking Model").
No model is perfect. During the past year, a couple of improvements and adjustments have been applied to our ranking model. Many of them, as described below, echo changes to our investment thinking.
- Volatility and trend in terms of returns on capitals: We would like to gauge not only the absolute number but also the relative level and stability to the historical; it should be theoretically easier for a business to maintain high ROICs than high growth rates (see "The Importance Of ROIC And My Strategy"), but we still hope for the business to have already proven their durable competitive advantage at least quantitatively; adding such factors, investors could avoid pitfalls like NetEase (NTES), IBM Corp. (IBM) and Walmart (WMT), all of whose moats have been deteriorating in recent years.
- Weights in growth and momentum factors: We reduced the weights in most growth and momentum factors in our model, as we believe that previous growth track records would not do a great job in telling us about management's capital allocation skills or predicting the business prospects (see "Growth Trap: Why Is Earnings Growth Not Always A Good Thing?"). We do, however, trust dividend increase records relatively to other growth/momentum metrics, as they reflect management's confidence level in future growth (see "The Importance Of Dividends And My Strategy"). As a result, high-growth stocks, such as Tencent (OTCPK:TCEHY, OTCPK:TCTZF), Intuitive Surgical (ISRG), would score lower this year.
- Return on reinvested/retained capital: This is the most important new factor we introduced to the model, as we believe RORC is the best measurement of how well the management team leverages freshly generated capital to compound business growth (see "Uncover Managements' Capital Allocation Skills"). Some examples of stocks with high RORC are Intuit (INTU) and Domino's Pizza (DPZ), both of which top the list this year.
- Estimates/projections: We removed all factors relying on estimates from Wall Street analysts on individual companies. Previously, we were already a bit suspicious of their usefulness in terms of stock picking, and now we have our solid conclusion. Removing such factors would prevent investors from chasing hot tech stocks, such as Facebook (FB), Booking Holdings (BKNG), usually with too optimistic views from analysts. We may, however, have our own projections regarding future growth, which we prefer to take into consideration at the valuation level (e.g., PEG), not the fundamental level.
One year since disclosing our top-ranked picks from the model, there are certainly some adjustments to their rankings due to respective businesses developments as well as improvements to our model. As promised to the Seeking Alpha community previously, we are now listing our top-ranked stocks below. Since the beginning of 2018, we have been advocating that there are relatively fewer opportunities now within the States considering the overall valuations (see "The Warren Buffett Indicator Is Now Telling You Not To Bet On America"). Consequently, this year, we would like to provide two separate lists: one for US equities and the other for foreign ones. We also hope to compare performances to different benchmarks (e.g., the S&P 500 Index (SPY) for the US, the MSCI EAFE Index (EFA) for the overseas). Again, these are the picks which we (and our model) think possess great fundamental qualities in their operating businesses, certainly without the price tag taken into account.
We have six stocks that made it to our Top 13 list last year but did not this year: Credit Acceptance Corp. (CACC), Intuitive Surgical, Waters Corp. (WAT), Tencent, NetEase, and Amgen (AMGN). Most of them "suffer" from our reduced weights in growth/momentum, as well as more emphasis regarding returns on capital.
Below are our Top 13 lists for 2019.
Top 13 US Stocks
- Rollins (ROL): ROL shareholders should be fortunate, as the world's largest pest/termite control company has a stellar financial track record of increasing its both top line and bottom line every year for 20 years, spanning several economic slowdowns.
- Ross Stores (ROST): The company is one of the very efficiently run off-price retailers which are both relatively recession-proof and Amazon (AMZN)-proof - great ROE with a strong balance sheet.
- SEI Investments Company (SEIC): As a global provider of investment processing, investment management, and investment operations solutions, the company has consistently high ROIC and FCF margin with a decent balance sheet;
- Accenture (ACN): Partnering with more than three-quarters of the Fortune Global 500 and with a high customer retention rate, Accenture is a global leader in management consulting and professional services with consistently high returns on capital.
- Intuit (INTU): Intuit is a business and financial software company that develops and sells financial, accounting, and tax preparation software and related services for small businesses, accountants, and individuals. The business has consistently improved its returns on capital and cash generation for the past decade.
- Paychex (PAYX): Paychex is the "ADP" (i.e., provider of payroll, human resource, and benefits outsourcing services) for small- to medium-sized businesses in the US. It operates with even higher capital efficiencies compared to ADP in terms of returns on capital.
- Gilead Sciences (GILD): As a global leading player, Gilead Sciences is grabbing a big share of the expanding market for HIV/AIDS drugs and would continue doing so no matter what the economic condition is. The company has also been working to widen its focus to cover other critical illnesses, such as liver diseases, hematology/oncology, cardiovascular, and inflammation/respiratory diseases.
- Domino's Pizza (DPZ): Delivering more than 2 million pizzas a day worldwide, Domino's is the recognized world leader in pizza delivery, operating a network of 15,000 company-owned and franchise-owned stores in more than 85 countries around the world. Its franchise model is capital-light and gives the opportunity to generate high returns on reinvested capital.
- NIC Inc. (EGOV): NIC is the leading provider of digital government services. We appreciate its transaction-based model saves taxpayers' money on upfront development cost and generates recurring revenue whenever users enjoy the efficiency through digital/online services provided by NIC. It is a win-win solution for all parties (i.e., governments, taxpayers, and NIC itself), benefiting from user population growth, government promotion, and service monopoly.
- Texas Instruments (TXN): We like Texas Instruments' positioning offering the full breadth of analog and embedded processing products and providing the industry's largest sales and support staff. Again, this is a business with consistently strong cash flow and decent capital allocation skills from management.
- Nike (NKE): Nike is the world's largest supplier of athletic shoes and apparel and a major manufacturer of sports equipment. The company's continuous expansion in Asia-Pacific (especially China), along with a great brand, unlocks further growth of its relatively high-margin businesses.
- Apple (AAPL): Apple is the example of another well-recognized global brand; the company has been continuously developing consumer loyalty towards its products/services and possesses the potential to capture the high growth in Asia-Pacific (particularly China).
- Atrion Corp. (ATRI): While it is a comparatively small company in the sector, Atrion is the leading U.S. manufacturer of products in several market niches. The company has been and will be benefiting from the industry tailwind, as the growth of health care spending is consistently exceeding the overall GDP growth (see below) due to the aging population.
Top 13 Foreign Stocks
- Rightmove (OTCPK:RTMVY, OTCPK:RTMVF): Rightmove is the UK’s largest property portal with extremely high margins and returns on capital (see "Rightmove: Recent Finding That Tops My Stock Quality Rankings").
- Hargreaves Lansdown (OTCPK:HRGLY, OTCPK:HRGLF): Hargreaves Lansdown claims to be the UK's No. 1 investment platform for private investors. The management has done an excellent job delivering astonishingly high ROIC/ROE (60%+) for its owners over the past 10 years.
- Kakaku.com (OTC:KKMMY, OTCPK:KKKUF): Kakaku.com owns and operates a range of businesses, mainly including Japan's largest price comparison website kakaku.com and Japan's largest restaurant review website Tabelog. When it comes to the Internet sector in Japan, we think differently about the competitive landscape for already leading online businesses, as the tech startup mindset is not that popular (i.e., low user acquisition cost), and online users are relatively easy to accommodate (i.e., high customer lifetime value).
- Hermes International (OTCPK:HESAY, OTCPK:HESAF): Hermes positions itself as a great recession play (due to its ultra-high end branding), as well as a potential China market play (see "This Is How Hermes Excites A Guy Like Me").
- Novo Nordisk (NVO, OTCPK:NONOF): Being the industry leader to tackle diabetes globally, Novo Nordisk owns patents on multiple medicines which control almost one-third of the total diabetes care market. According to Statista, around 326.5 million people aged 20-64 years had diabetes in 2017, and it is projected that this number will increase up to 438 million by 2045.
- Evolution Gaming (OTCPK:EVVTY, OTCPK:EVGGF): Evolution Gaming is a leading B2B provider of live casino systems in Europe. The business has earned extraordinary returns on capital every year since it went public.
- SimCorp (OTC:SICRY, OTC:SICRF): Simcorp is the leading provider of investment management software solutions for the world's leading financial organizations, such as banks, national banks, pension funds, and insurance companies. The Danish company owns roughly the global market share of 15% in the small but highly profitable market, and management has great capital allocation skills and improved the already high returns on capital over the past decade with almost no debt employed.
- Craneware (OTCPK:CRWRY, OTC:CRWRF): Craneware is the leader in automated value cycle solutions for US health care providers. Management has not only demonstrated highly efficient capital allocation capabilities (i.e., 15% ROA, 25% ROE, 25% ROIC) but also generated tons of free cash flow for shareholders (i.e., 23% free cash flow margin). Continued sales success, combined with renewals remaining above 100% (by dollar value), has demonstrated the company's competitive advantage;
- City of London Investment Group (OTCPK:CLIUF): City of London Investment Group is a UK-based institutional asset manager focused on closed-end fund investments. The company generates superior free cash flow returns on fixed assets even among the asset management industry.
- Check Point Software Technologies (CHKP): Check Point is a multinational provider of software and combined hardware and software products for IT security. According to a report by MarketsandMarkets, the cybersecurity market is estimated to grow to US$232 billion by 2022, at a Compound Annual Growth Rate (CAGR) of around 10% from 2017 to 2022. CHKP maintained its EBT margin steadily above 50% over the past couple of years, while improving its asset turnover ratio from 0.33 to 0.35.
- NetEnt (OTCPK:NTNTY): Sweden-based NetEnt has been a pioneer in digital entertainment, offering around 200 game titles in 24 languages and a powerful technology platform with a server solution and 24/7 support 365 days a year. We like its partnership model, where NetEnt is responsible for operation and monitoring of gaming transactions through hosting and gaming operators pay royalties to the company based on a percentage of the game win (i.e., player bets minus player wins) generated.
- M3, Inc. (OTCPK:MTHRF): M3 Inc. engages in the provision of medical-related services through the Internet mainly in Japan. We appreciate the stability of its high returns on invested capital along with a debt-free balance sheet. In the meantime, we believe that a bright future of growths lies ahead, especially in light of Japan's aging population and expanding health care industry.
- Domino's Pizza Group UK (OTCPK:DPUKY, OTC:DPUKF): Domino's UK master franchise has achieved consistently high ROIC, uninterrupted strong growth, and a track record of paying back its owners. Meanwhile, we appreciate the business model of the pizza franchise, which is simple, capital-light, and recession-proof in nature (see "Domino's Pizza U.K. Is Quietly Shaping Into The Next McDonald's").
We strongly agree with Warren Buffett's approach to investing in wonderful businesses at a fair price rather than fair businesses at a wonderful price. Our investment time horizon is long term, and time is the sure friend of wonderful businesses (think about compounding and exponential growth, for example).
The ranking model based on a number of quality factors would be useful in terms of stock picking. Business wonderfulness is a must and exceeds price fairness in importance. Sometimes, we do not even think investors should mind paying a bit premium for some of the wonderful businesses.
The above lists (of 26 stocks) should give you a general idea of what companies our ranking model value most. However, no pricing is taken into account. Hence, those truly long-term investors who aim at buying and holding wonderful businesses could follow the names and wait for individual favorable entry points. In terms of valuation, we would recommend investors consider accumulating share at price multiples (e.g., P/E, P/CF, P/S, EV/EBIT) at least below their 5- to 10-year historical averages (or starting with small positions at around historical levels).
Let us know if you think any of the above names should not be on the quality stock list or any stock is missing on the list.
Disclosure: I am/we are long MOST OF THE STOCKS MENTIONED. 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.