Should investors be thinking “old school” for their portfolio selections?
It’s the time of year when notebooks and pencils (OK, iPads and styluses) are replacing flip-flops and swimsuits. Go into any store and you’ll see all of the back-to-school trappings: every food item imaginable in snack-size packaging; backpacks; dorm-room accoutrements; and a sea of organizational shelves, bags, and boxes.
It might also be a good time for investors to evaluate how organized they are with respect to their investment portfolio. Do they have a solid, go-to approach that is aligned with their risk profile and future goals? Are they sticking to that approach no matter what is heard on television or from friends and family? If not, these are questions that deserve their attention.
At Validea, our investment strategies are built on the philosophies and investment criteria of some of the most successful investors of all time, including Benjamin Graham, Warren Buffett, and Peter Lynch. These market gurus are not Wall Street superheroes that were blessed with the ability to enter the market at just the right time and cash out just before things went south. Savvy and disciplined, they succeeded over the long term not by playing the game better than the average investor, but by finding a way to assess a stock’s long-term value other than by looking at recent shifts in market price.
A stock’s price can shift in the short term because of a variety of factors that have nothing whatsoever to do with the company’s quality. But the previously mentioned stock market greats valued stocks by focusing on the underlying fundamentals—true indicators of how well a business is performing. They understood that companies with strong earnings, sales, cash flow, etc., tended to boast more successful businesses, and that their long-term success typically correlated with long-term gains in their share prices.
The late Benjamin Graham, who earned the nickname “Father of Value Investing,” argued that an “investor” wasn’t someone who bought and traded stocks in the hopes that they were about to go up. He viewed such people as speculators, and the investment style a recipe for disaster.
Warren Buffett, known and revered the world over for his investing prowess and home-grown demeanor, shies away from “hot” stocks and market noise. Instead, he spends his time educating himself on what makes businesses tick and where he can find value.
Peter Lynch, the renowned Magellan Fund manager (from 1977 to 1990) and best-selling author of “One Up on Wall Street” (1989), offered down-to-earth advice that resonated with the investment community as well as to the “everyday” investor with little to no finance know-how.
The stock screening models I created are built on a solid foundation of financial data that allows me to simulate the approaches of these market gurus and identify stocks that pass muster under the various methodologies. Of the many criteria we use, here are four that play a significant role:
Debt: Most of my guru strategies include a metric related to a company’s debt, since high leverage can put a strain on cash flow and make earnings figures misleading. Warren Buffett delves deeper than the traditional debt-to-equity ratio to ensure that a company’s long-term debt can be paid off from income in two years or less. Professional services company Accenture PLC (ACN) fits the bill.
Price-to-book ratio: By comparing share price to a company’s book value you can get an idea of whether a stock is undervalued. While my various guru models might define book value slightly differently from each other, the basic idea is always to determine the true value of a business. My David Dreman-based model, for example, defines book value as common stock less all liabilities and preferred shares, and gives a high sign to companies such as Verizon Communications (VZ). My Graham-based model uses total assets less both intangible assets and liabilities, and favors companies such as Bridgestone (BRDCY).
Return on equity (ROE): While there is no single, sure-fire way to ascertain whether a company has what Warren Buffett calls “durable competitive advantage,” companies that have this distinction share a fundamental strength in return on equity. For Buffett, an ROE of greater than 15% indicates that management is doing a good job allocating retained earnings and is providing a solid, above-average return for investors. My Buffett-based model gives a thumbs-up to Apple (AAPL) on this basis. David Dreman viewed ROE as an important measure of a firm’s profitability and a way to uncover structural flaws in the business. My Dreman-inspired model favors AT&T (T).
Relative strength: This measures the price performance of a stock against the market as a whole. The higher the relative strength, the better the stock price is tracking the market. My James O’Shaughnessy investment model, for example, looks for a stock’s relative strength to be among the top 50 stocks that pass the model’s benchmarks, and gives high marks to truck manufacturer Navistar International (NV).
John P. Reese is co-founder of Validea Capital Management. He is the manager of Validea Capital’s active equity ETF and separate accounts. Mr. Reese is the author of “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies.” He is a graduate of MIT and Harvard Business School and holds two patents in the area of automated stock investing. Follow John’s thoughts and ideas at www.validea.com/blog or on Twitter at @guruinvestor.