It's A Stock Picker's Market. Here's How We Are Picking Them

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Includes: QQQ, SPY
by: WMA, LLC
Summary

The high-flying index stocks have finally broken down.

Index investing on the back side of an equity bubble is a recipe for disaster.

It's time to get back to focusing only on companies with the strongest fundamentals.

Passive Index Investing Is So “Has Been”!

How are those trillion-dollar market caps working out for your U.S. Growth Fund? Apple’s (NASDAQ:AAPL) market cap is down to $689 billion and Amazon (NASDAQ:AMZN) is down to $749 billion. These two stocks alone had shaved almost -4% off the S&P 500 since the October top! Easy come, easy go for index investors, we suppose. We will not be investing in S&P (NYSEARCA:SPY) or Nasdaq (NASDAQ:QQQ) index funds in 2019. The reasons are simple. First, most of the gains in these stocks over the past years are due to the passive investment craze. You many not like Amazon’s valuation, but if you buy an S&P 500 Index fund, you’re buying about 4% in Amazon. Second, if we get more signs of impending recession, all the money that went into passive index funds will come out. That means if an investor sells $100,000 in an S&P 500 index fund, a $4,200 sell order goes in for Apple, a $3,500 sell order goes in for Microsoft, a $3,300 sell order goes in for Amazon, and so forth. In other word, all index component stocks will see forced selling. A final reason we don’t like passive U.S. index funds going forward is that an investor is buying the good with the bad. As Bill Cara likes to say, when you buy apples at the supermarket, you don’t just take the apples on top or buy the bulk bag. Rather, you take the time to hand pick the apples that look the best and are not bruised. Same with picking companies. Some index component stocks may be worth holding. Others not. For investors who have the time and interest, we propose an investment methodology of selecting the fundamentally-strongest companies. Overtime, holding and rebalancing into portfolio containing the best companies, will produce significant alpha versus an index fund.

Choose Your Investment Theme: Growth, Value, Yield

The stock market is characterized by different themes that vary over the investment cycle. When the economy is booming and profits are growing rapidly, it is usually Growth companies that out-perform. Growth companies leverage up the economy’s growth and offer above-average profit/revenue growth (at generally higher valuations). We have seen extreme out-performance of Growth over the past year. In contrast, Value companies tend to do better as economic growth tapers off. Value stocks offer relatively steady and predictable sales/profit growth (at generally lower Price-to-earnings and Enterprise Value-to-Earnings ratios). Finally, Yield stocks offer current income and tend to do well in all market conditions, notably out-performing as the economy dips into recession. Typically sporting a lower beta, Yield stocks are the proverbial "last baby investors throw out with the bath water" in a recession (with Growth stocks getting dumped first) as investors appreciate the regular dividend income as other stocks swing wildly.

A good portfolio should contain a mix of Growth, Value, and Yield stocks (unless you have a crystal ball and can predict swings in economic growth). We tend to place greater emphasis on Growth in mid to late economic expansions, and Value as economic growth troughs and the economy enters the early expansion phase. But we generally try to keep exposure to some stocks matching each theme throughout the stock market cycle.

At WMA, our methodology for selecting the best stocks based on company fundamentals involves an analysis of key balance sheet, income statement, and statement of cash flow items, as well as forward-looking consensus forecasts for Earnings per share (EPS) and Revenue growth (including regular EPS and revenue revisions offered by company analysts). We created thirteen aggregate scores (each containing several measures of the broad fundamental quality), which we call our “F-scores”:

  • Growth
  • EPS Revisions
  • Revenue Revisions
  • Price/Earning/Growth (PEG)
  • Valuations
  • P/E
  • P/E spreads vs. historical mean P/E
  • P/Book Value spreads vs. historical mean P/BV
  • Market Value / EBITDA
  • Yield
  • Profitability
  • Financial Situation
  • Consensus Analyst Recommendation

To deem a company’s stock a “Growth” stock, we focus on the first four scores (although all F-scores enter into the calculation). High growth is important, but so is growth at a reasonable price (NYSE:PEG). For a company to be qualified as “Value”, we focus on the next five scores (not disregarding things like EPS and Revenue revisions). Just comparing forward consensus P/Es is not a very robust approach. Finally, a Yield stock will have high Yield, Profitability, and Financial scores. For a company to maintain the high yield, it must have profits. Similarly, investors buying a stock for the current income want a stable cash cow, hence the attention to Financials.

We bring in data from the most reliable financial data providers (Bloomberg, Thomson Reuters), including the valuable consensus forecast data, to create a 0 to 100 ranking for all companies in each of our thirteen categories (100 being top-of-class). A score of 50 represents either the median of all companies, or the break-even point for some measures (for example, 0% growth, 0% profitability). Our database contains over 5,000 listed companies (both U.S. and foreign companies accessible on U.S. exchanges via dollar-denominated ADRs). In addition, we calculate the percentile ranking so that investors can see the ordinal ranks for companies under consideration.

We use our fundamental ranking methodology to create the basket of stocks in our Top Picks Strategy. Readers can access our powerful Stock Screener to analyze companies being considered for their portfolio as well as generate ideas for new holdings that corresponding to desired investment criteria (contact us for a free discount code).

Among the company characteristics an investor can chose from, we have included the following in our search engine:

  • Company ticker (on New York)
  • Company name
  • Region of domicile (U.S., Developed Market, or Emerging Market)
  • Country of domicile
  • Market Capitalization Sector

We also allowed for searching among our in-house calculated Composite Growth, Composite Yield, and Composite Valuation scores. Each Composite Ranking score is based on an algorithm that incorporates several of the above thirteen F-scores.

Finally, we offer searches via each of our thirteen F-scores. The scores and rankings are based on Sector-level comparisons (comparing apples to apples). For example, Exxon’s scores are determined by comparing Exxon’s fundamentals to all other Energy company fundamentals. Note that in the search engine output for each company, we include both the Global scores (the company versus all 5,000+ other companies in the database) and the Sector scores (the company versus sector peers).

Let’s Find Some Companies!

Suppose that an investor likes Energy stocks in today’s market. He/she wants a big cap, U.S. company. The investor is interested in finding a company offering attractive firm valuations in this market. Using the WMA Stock Screener, we set the screener to Country U.S. ; Sector Energy ; Market Cap Large ; Valuation Top Quartile.

We find the following four stocks with this search.

Suppose that we are now concerned about the market volatility and would like any companies with strong balance sheets, high profitability, and a good valuation cushion. We leave the company characteristics unselected and choose Profitability Top Quartile ; Financials Top Quartile; P/E Top Quartile ; P/E_Spread Top Quartile. Note that our “P/E metric” ranks each company’s aggregate Next Twelve Month P/E + the Next Year P/E versus sector peers while our “P/E spread” ranks the company Price/Earnings against their average historic level (companies trading at a bigger discount relative to their past have higher F-scores).

With these four F-score criteria, we narrow our choice down to the following six companies.

With the search results, we present the full battery of F-scores for each company so that users can compare companies on a head-to-head basis. We will also be adding “Top Decile” and “Top Half” to the F-score dropdown selections in the Stock Screener to allow investors to refine searches across the different fundamental criteria. In practice, we apply a Daily Trading Model to positions in our strategy portfolios to guard again stock prices breaking down before we see a downturn in fundamentals.

Conclusion

One investment strategy will never out-perform forever. Passive index investing has likely run its course – it’s time to get back to company fundamentals. Building a portfolio of companies offering attractive valuations, positive earnings/sales revisions, strong balance sheets, and good profitability will allow investors to hold out-performing portfolios, whichever way the indexes zig-zag in the coming years. Use the WMA Stock Screener to help screen your companies and generate thematic investment ideas.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.