Choosing a Great Stock

April 18, 2016 |

In my earlier articles, I reviewed strategies for limiting your losses and for trading options safely. In this article, I want to dive deeper on strategies for choosing a great stock, and I can show you tools in Stock Rover to aid in the process.

Initial Selection Criteria

We want to look for companies that have a sustainable advantage in their industry. This is determined by understanding what the business does well relative to competitors, and understanding macro trends that could affect the industry in question. While these are qualitative factors, we can use quantitative metrics as a solid starting point by looking at a company’s profitability over time.

We should also look for companies that have good management (once again using profitability over time) and strong past price appreciation.

Additionally, I am most interested in finding stocks with the above criteria that also pay dividends that are sustainable overtime. When we identify these stocks, I will ensure that the payout ratio of the dividend is less than 50%.

A few other factors I consider before purchasing a stock are analysts’ growth estimates and valuation, which should be favorable compared with historical valuation.

Screening like Buffett

We can use Stock Rover to help us identify stocks that meet at least some of the above criteria by clicking on the screener Buffettology Inspired (a screener that is available in the Library).

This screener is based on criteria described in the bestselling Buffettology book, which specifies that a company should have a 10-year track record of generally increasing EPS with no negative earnings years, long-term debt not more than 5 times annual earnings, average ROE over the past ten years at least 15%, average ROIC over the last 10 years at least 12%, and earnings yield should be higher than the long term Treasury yield. I also updated my screener to include a minimum market cap of $10B because I prefer large cap companies.

At the time of writing, 69 stocks pass this screener. I can save these stocks as a watchlist using the Table’s Actions menu so that I can eliminate those that don’t pass further tests.

Benchmark Outperformance

We should now confirm that the stocks in the resulting list have been outperforming peers. One way to do this is by plugging the stocks into the Chart over a 1 year period and adding the sector and industry through the Benchmarks menu, and then setting the stock as a baseline, as I’ve done here with PAYX:

benchmarks

It’s clear that PAYX has outperformed both its industry and sector. I can simply tab through each of the stocks in the screener results to see how they each do in this test and remove any from the watchlist that haven’t outperformed their benchmarks.

Or, for even faster slashing, I could set up the 1-Year Return vs. Sector and 1-Year Return vs. Industry columns next to each other in the Table, like so:

table benchmark comparison

Then I can sort by one of those columns and simply multiselect (as I have in the screenshot above) and remove all rows that are showing red in both columns.

Sustainable Dividends

We’re now down to 52 stocks. Next I want to make sure that all these companies are paying dividends with a payout ratio of less than 50%. For this I can use the Dividends view tab in the Table, or look in the Summary tab of the Insight panel (where you’ll see the industry average as well):

table benchmark comparison

A high payout ratio can mean a stock could have trouble paying out its dividend in the future, whereas a lower payout ratio indicates that the dividend is sustainable and has room to grow. I like to couple dividends along with price appreciation to get the most out of my holdings.

Growth Expectations

After eliminating stocks who have not outperformed peers, don’t pay a dividend, or have an unsustainably high payout ratio, we are left with this list of 36 tickers (shown with dividend stats):

stocks with dividend info

That is still quite a few to sink my teeth into, but remember we got to this list in just a matter of minutes, and all of these companies meet my baseline quantitative criteria for growing earnings, good profitability, manageable debt, sustainable dividends, and industry and sector outperformance in the past year.

There are more factors to consider. One thing I like to look at for any company before I purchased stock would be the growth estimates for the next 5 years. I can add the 5-Year EPS Growth Estimate column to my table in Stock Rover, like in the image below. As an example, let’s take Texas Instruments (TXN).

5-year eps growth estimate

Ideally I’m seeing growth of 10% or greater (like in the list above). We can see above that TXN hits that right on the nose at 10.0%.

I also want to compare this expected growth with the earnings estimates for the industry as a whole. For the industry comparison, I can link to Yahoo’s Analyst Estimates, from the Research Links list at the bottom of the Insight panel:

link to industry estimate

(If you aren’t seeing the Yahoo Analyst Estimates link, add it using the gear icon, pointed out above.)

Find the following table near the bottom of the page and look in the second column for industry comparison. The specific number we’re looking for in this case is called out below.

industry 5-year eps growth estimate

We can see that the TXN’s expected growth of 10% for the next 5 years well exceeds its expected industry growth of 5.53%. It’s worth remembering that these are just estimates, but when they are strong like this they do increase my confidence about the company.

Valuation

In assessing a security, I make every attempt possible to purchase when it is trading at low P/E relative to its historical P/E. I will generally try to only purchase the stock in the event that the stock is trading in the bottom 50% of its high historical range. For example, if a stock’s P/E has historically traded between 10-50 over the past 5 years, I would look to purchase the stock when the P/E is at 25 or lower and would look to sell the stock when the P/E approaches 45-50.

If I want to take a hard line and only investigate stocks in the lower 50% of their valuation range, I can use the table filter. First I go to the Valuation tab in the Table, then filter for stocks in the lower 50% of their 5-year P/E range, like so:

filter the table

This knocks down my list to just the following handful:

filter the table

I could relax the filter criteria if I wanted to see more tickers left standing. By using a temporary filter like this, I can narrow the list down using any criteria I want without modifying the underlying watchlist.

After deciding on a manageable list of companies that pass my quantitative tests, I would then conduct additional qualitative research on each one to ensure that I understand what they do and what makes them strong within their industry.

Conclusion

Here I have presented criteria and concrete tactics for finding stocks that have the potential to be great from both an income perspective and a price appreciation perspective. These aren’t the only things I do before making a trade (I also look at technicals, for example), but if a stock passes all of these tests, then it could be well on its way to my portfolio.

I hope you found my process helpful. Happy stock picking!

 

Randall Bal is a professional swimmer and individual investor. Read our profile of him here.





Leave a Reply

Your email address will not be published. Required fields are marked *