How To Choose Better Stocks

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Includes: ENB, FB, GD, LMT, RTN, TRP
by: Canadian Dividend Growth Investor
Summary

Should you choose stock A or stock B from the same industry?

Which stock is lower risk? Does lower risk lead to lower returns?

Choose better stocks by reviewing a number of things:

Credit ratings, interest rate, dilution, percentage of shares shorted.

It's a given that buying stocks at reasonable valuations reduces the risks you're taking.

Stocks from the same industries are subject to the same operating environments/challenges and risks. So, it makes sense to compare stocks from the same industries. Additionally, you'd generally want to compare with peers of similar size (i.e., large cap to large cap and small cap to small cap).

In general, you don't want to hold too many stocks in the same industry because such stocks tend to move in tandem, and you want to reduce risk through diversification. Besides, why not choose the best stock from an industry you're interested in? The aim is to lower your risk for satisfactory returns.

stamped words of "best quality" in red Are you having trouble choosing one stock over another in a given industry? If so, here are some things to look at to give you an idea which stock is lower risk.

It goes without saying (whoops, it turns out I'm saying it again) that the first thing to look at to identify defensive stocks is to look for businesses that generate stable earnings or cash flow through economic cycles, as I discussed with examples in my previous article, How To Choose Stocks For Your Defensive Dividend Portfolio.

Without further ado, here are 3 simple things to review to help you identify lower-risk stocks in comparison to peers.

Credit Ratings

You can easily look up credit ratings of a stock. For example, to find out the S&P credit rating of a stock, you can search for it on the Standard & Poor's website.

When a company has an A-grade credit rating, it has a strong capacity to meet its financial commitments. So, if company A has an A-grade credit rating and company B of similar size in the same industry has a B-grade credit rating, company A will be of higher quality as it is more financially sound.

We need to do more work if company A and company B have the same credit rating. For example, S&P gives Enbridge (ENB, TSX:ENB) and its peer, TransCanada (TRP, TSX:TRP) credit ratings of "BBB+". Since they have the same credit rating, we cannot conclude from just looking at the S&P credit ratings of Enbridge and TransCanada, which stock is riskier right now.

No big deal, though. There are more things we can check.

Weighted Average Interest Rates

Typically, the higher the weighted average interest rate of a stock, the riskier you can assume the stock to be. The logic is that the more costly it is for a company to borrow, the riskier its stock is.

It's a similar logic for why we don't chase high-yield stocks, which are viewed as risky -- either the investment itself is risky or the stock is risky in having low growth, which could result in low total returns for investors.

At the end of 2018, Enbridge had CAD$64.1 billion of total debt outstanding, while its interest expense was CAD$661 million for Q4 2018. This implies a weighted average interest rate of roughly 4.1%. Doing a similar calculation for TransCanada, we came to a weighted average interest rate of 5.1%.

This implies that TransCanada maybe a riskier investment than Enbridge right now.

Is There Dilution?

Other than debt, another way for the company to raise funds needed to grow the company is by issuing equity. If a company issues more shares, it must show that it put the capital to good use by generating earnings or cash flow growth that leads to good returns.

Over the last 10 years, Enbridge has increased its share count much more than TransCanada. In the period, Enbridge increased earnings per share by about 111% and delivered annual total returns of 13.7%. Enbridge began with a P/E of 18.2 and ended at a P/E of 19.

Chart Data by YCharts

Over the same period, TransCanada increased earnings per share by about 93% and delivered annual total returns of 10.6%. TransCanada began with a P/E of 13.6 and ended at a P/E of 15.9.

What investors need to watch out for are companies that dilute shareholders. That is, these companies issue more shares over time but end up with lower earnings or cash flow per share generation. The lower profitability, in turn, leads to underperforming stock returns.

Ultimately, choose stocks that tend to appreciate in the long haul backed by earnings or cash flow growth.

What's the Percentage of Shares That Are Shorted?

Investors or hedge funds that short stocks must be very smart to make money because the stock market goes up most of the time. So, if a stock has a high percentage of shares that are being shorted, there must be something especially risky about the stock.

Yahoo Finance indicates that the "Short % of Shares Outstanding" for Enbridge and TransCanada were 2.29% and 3.53%, respectively, as of March 14. TransCanada's higher short interest indicates it's a riskier stock compared to Enbridge. This conclusion confirms with its higher weighted average interest rate compared to Enbridge.

More Examples Going Through the Same Process

Popular Aerospace & Defense stocks, such as Lockheed Martin (LMT), Raytheon (RTN), and General Dynamics (GD), have done well in the last five years.

S&P Credit Rating Weighted Average Interest Rate % of Shares Shorted Annualized Returns since 2014 EPS Growth since 2014
LMT BBB+ 5.07% 1.11% 16.6% 75%
RTN A+ 3.87% 1.25% 15.5% 66%
GD A+ 3.6% 1.18% 13.3% 49%
  • S&P credit rating, Annualized returns, and Earnings Per share Growth are derived from F.A.S.T. Graphs
  • Weighted Average Interest Rate and % of Shares Shorted originated from data obtained from Yahoo Finance

In the last five years, the Aerospace & Defense stocks have taken the chance to reduce their share count thanks to their strong profitability.

Chart Data by YCharts

Which is the riskiest? From the S&P credit rating and weighted average interest rate, LMT is a tad riskier than the other two, but in this case, the higher risk led to higher growth in profitability and ultimately, total returns.

One of the largest risks comes from buying expensive stocks, but all of these Aerospace & Defense stocks look reasonably valued with RTN and GD, in fact, seemingly undervalued.

There are lots of SA articles that talk about valuation, such as here, so I decided not to discuss it in this article to keep it concise.

In the case above, GD seems to be the lower-risk investment that delivers lower (but still very good) returns. However, lower-risk investments don't necessarily lead to lower returns. For example, it also depends on if you bought the stock at a reasonable to cheap valuation.

Investor Takeaway

Consider investing in the best stocks from an industry you're interested in, instead of buying more than two from the same industry, as there usually aren't that many great investing ideas.

If you're a low-risk, conservative investor, you should consider focusing your investing dollars on stocks that:

  • have stable earnings or cash flow generation,
  • have an investment-grade credit rating or stocks that have little to no debt and are not rated, like Facebook (FB),
  • have weighted average interest rates of about 4% or lower,
  • don't dilute shareholders,
  • have little short interests, and
  • are trading reasonable valuations.

Share your thoughts below!

  • How do you decide which top stocks to buy in a given industry?

Disclosure: I am/we are long FB. 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.

Additional disclosure: We're long on the TSX: ENB.

Disclaimer: This article consists of my opinions and is for educational purposes only. Please do your own research and due diligence and consult a financial advisor and or tax professional if necessary before making any investment decisions.