Diamonds in the Rough — Finding Good Investments

This is the second post in our guest author Paul Maplesden’s series. Find part one here and part three here.

Paul is a freelance writer, specializing in business, finance, entrepreneurship, and marketing.

We’ve got to talk about investing; if you can stay awake, it could make you money…

Investing is all about making the right decisions — decisions that ultimately should make you money. The question is, how do we make that decision when we have a choice of thousands of companies that we could invest in?

The New York Stock Exchange and the Nasdaq alone list over 4,000 companies between them; add in the various international exchanges and ‘over the counter’ markets and there’s a bewildering amount of choice. It’s against this background of results, reports and rhetoric that we need a balanced, calm and objective way to find worthwhile investments.

Jurag Uher via Flickr

You’ll know from my previous post that I’m planning to make an investment of $30,000 as an experiment across various different stocks, based on information from the Simply Wall Street (SWS) app. In this post, I’ll explain the methods and approach that I am using to find the signal among the noise.


The importance of having an investing strategy

Discussing investing strategy may not be the most… fascinating of conversation topics, but having an effective one will reduce your risks and increase your likelihood of making money. That’s why it’s worth spending time thinking about how and why you want to invest. Ultimately, an investment strategy is simply a set of guidelines that you will use to decide when, how, why and what you are going to invest in. A good investment strategy:

  • Creates a consistent way of looking at your investment choices
  • Relies on a repeatable, objective approach
  • Uses facts and figures, rather than emotions and feelings
  • Varies from person to person; and a person may change their investing strategy over their lives
  • Is tailored to your risk appetite and personal circumstances
  • Can be flexible when it needs to be
  • Should be tested over time to make sure that it is performing

Foundations of an investing strategy

There are dozens of factors that you can use when deciding on your own investment strategy and approach. You might base your own rules around:

  • Sectors and industries
  • Market capitalization
  • Dividend yield
  • Financial health
  • Ratios (P/E, PEG, Assets etc.)
  • Lack of correlation between stocks
  • Different asset classes (bonds, stocks, commodities etc.)
  • Lots of others areas

What matters is that you are comfortable with whatever approach you take; you’re going to be using these guidelines to put real money into the stock market.

One of the reasons that I like Simply Wall Street is that you can see at a glance what the most important factors are for an individual company and then decide if it fits your investment strategy. I’m going to share my own approach below and you can see how it might compare to your own ideas.


My investment strategy and approach

I’m going to base my strategy around the following concepts:

  • The business must have strong financial health
  • It must pay a dividend
  • It should be undervalued and room for growth
  • A good track record is preferable
  • It should have a reasonable market capitalization and reliable analysis
  • It may meet some other factors

I will go into each of these in detail below.


Strong financial health

I only want to invest in businesses that have strong financial health. This means that a business should be able to meet its short and long-term commitments. Ideally, it should be able to easily manage its debt, earn more interest than it pays and have enough in assets and free cash flow that external risks don’t cause significant issues.

SWS values each of the measures of a business on a scale of 0 (terrible) to 6 (excellent). I’m looking for businesses that have a financial ‘Health’ score of at least ‘4’.

Paying a dividend

Because I’m going to be tying up my money for at least two or three years, I want to get a return on my investment in that time. This means that I will be limiting my choices to businesses that pay a dividend and that generate enough profit to reliably continue paying them for the next few years. I’m looking for a minimum dividend return of at least 1.5% and a dividend ‘Income’ score of ‘3’ or better.


Undervalued and room for growth

According to a number of commentators, the S&P 500 is either overvalued or fairly-valued at the moment. Because I’m looking for businesses that can beat the return of the S&P 500 over the next few years, I ideally want to find undervalued businesses.

The way that SWS identifies these type of companies is through a valuation process called ‘Discounted Cash Flow’ (DCF). Simply put, DCF uses the projected cash flow and dividends of a business to understand what the business is worth now. When you know the DCF value, you can then view that alongside the current stock price to see how it compares.

I also want to invest in companies that have a reasonable return on assets and a fair price compared to past earnings and future projections. In SWS, this translates to a ‘Value’ score of ‘4’ or better and a DCF equal to or above the current stock price.


A good track record

Although past performance isn’t a guarantee of how well a business will do in future, a reasonable earnings history can still increase confidence in a business. I’d like to see a reasonable growth rate together with good returns on equity, assets and capital. I don’t have a specific SWS score in mind for past earnings, but when I am selecting businesses, it will play into my choices.


Reasonable market capitalization and analysis

One of the dangers of investing is putting your money into a small business, although ‘small’ here is relative when we’re talking about billions of dollars. SWS identifies companies that have a low market cap (the overall worth of all the company’s stocks) or that are not well covered by analyst estimates. (These estimates are used to calculate DCF, among other things). These ‘Red Exclamation Point’ stocks need to be closely examined to see if they are worth including in a portfolio.


Other factors

Some of the other factors that are part of my investment strategy are:

  • Avoid energy stocks — Oil is very volatile at the moment and is likely to be for the short to mid-term, therefor I am avoiding energy stocks and other stocks involved with oil
  • No utility stocks — Utility companies tend to have high levels of debt and low levels of growth and dividends
  • No defense or tobacco stocks — A personal preference, I won’t be investing in aerospace or tobacco businesses

The right investment approach

To get the most out of an investment strategy, it needs to be given the right amount of space and time to work. With that in mind, my approach is:

  • Expect to buy and hold positions for a minimum of 3 years
  • Attempt to match or beat the S&P 500 index over the medium to long term
  • Not to be influenced by short-term, day to day stock movements, trends and news (the ‘emotion’ of the market); this means no day-trading, swing-trading or other short-term targets
  • To have a diversified portfolio — Not more than one or two businesses per industry / sector and a variety of super-large, large, medium and small caps
  • A $2,000 investment in each position, with a maximum of 15–16 positions
  • Rebalancing the portfolio on a quarterly basis
  • A minimum share price of $10 to avoid penny stocks and only trade in liquid positions
  • Hold US stocks only (NYSE and Nasdaq)

As you can see, it’s worth thinking about how various areas will play into your strategy when it comes to choosing which stocks to buy. I’ll be using the guidelines above to make my final choices of stocks to purchase, which I will share in my next blog post.

I hope that you will join me.

Paul.

Disclaimer

  • Paul Maplesden is an independent writer and investor not affiliated with or employed by Simply Wall Street and provided this (and subsequent) blog posts unsolicited
  • Simply Wall Street has not provided funds of any kind for this experiment
  • Any data, analysis, stock picks and methods discussed in these posts are intended purely for entertainment and informational purposes and should not be seen as guidance for your investing needs or recommendations to buy, sell or hold a particular stock or other investment
  • Any information provided is general advice and does not take into account personal circumstances; decisions on investing should be based on your own research, approach and goals and you should always consult with a professional if necessary