Steadfast Investment Strategy

The Steadfast Investment Strategy

            The Steadfast Investment Strategy is based off of my very short time as an investor, it will probably change as I grow as an investor. I started its development about 3 months before my 25^th birthday and its creation was spurred by my lack of something solid to base my purchases off of. We don’t have photographic memories so we cannot remember why we made every single trade. If we can’t remember why we made that trade a few months ago we might make mistakes and lose some of our money or even worse make a wrong decision.

            I dislike numbers and analytical investing but just this one time (definitely not the last) I will use numbers. The final grade of buying, holding, or selling will be based off a numbers system where I have assigned each sector of my investment strategy a number scale of 1-5 and the scale is as follows: 1= Strong Buy, 2= Buy, 3= Hold, 4= Sell, 5= Strong Sell. Each sector “should” be evaluated separately to omit one sector giving bias to another, which would effectively skew the final grade. Think of it as you are solely basing your purchase of this investment off of the sector you are currently evaluating.

1.     P/E- Find value in the investments that you are making. This is a far reaching term depending on how one might value a company (i.e. adding in potential for future earnings), so let’s put a number to it. Historical market P/E ratios are around 15-25, which is based off of money that the company has already successfully earned, not what it MIGHT earn. P/E ratios will rise when the market thinks that its future (unproven) earnings make that company worth more than it is intrinsically valued at. While it is not a horrible practice to purchase companies that have higher than normal P/E ratios it is a practice that is accepting much more risk because of the unproven earnings. Higher P/E ratios also signify that other investors have already seen value in said company and their interest and subsequent investments have jacked up the price of that investment. So sad, too bad, you missed that opportunity but thankfully there are close to 4000 actively traded companies in the U.S. I would be willing to bet you could find another value company before everyone else does, which is the goal of investing.
     To assign actual values let’s use this model for now: 1= 8-10, 2= 10-15, 3= 15-20, 4= 20-25,5= >25 & 0-8. Now you might be wondering why the value of 5 encompasses two ranges of P/E’s. I do this because there is a certain point were a P/E that is low enough might signal the weakness of a company to earn any revenue at all. In assigning a value of five for the 0-8 range I will in turn hope to shield potential investors from any truly un-valuable companies.  However, with everything there is an exception, the market may truly have missed out on a company however unlikely that is and its P/E might fall in the less than 8 range. I am not saying don’t read into it but if you do make sure you spend some time looking at their income statements to ensure they actually do make money.

2.     Dividend %- What better way to increase your portfolio than to get paid for owning a small percentage of a company! This is where dividends come into play, but buyer beware not all dividend paying companies are equal. Some companies will increase their dividends to make themselves a bit more attractive to investors solely based on their dividend and not their business practices. While dividends directly give value back to the shareholders sometimes there are better ways to do so especially if it helps increase the valuation of your company i.e. spending money on research & development (R&D). In short we want that company to be returning value to the shareholders as effectively as possible wither it is through dividends, R&D, or both.  

     For now we shall use this model to assign actual values. Our median value will be based off of long term inflation averages that are around 3%, plus one percent to ensure that a gain is realized. Making our final median value for inflation of roughly 4%. Our ranges will be: 1= 6-7%, 2= 5-6%, 3= 3-5%, 4= 2-3%, and 5= 0-2% or >7%.

3.     Dividend Consecutive Increase- While a company returning value to their shareholders through dividends is awesome, what’s even better is a consecutive increase over an extended period of time.  Say Santa brings you a lump of coal every year but one and that one year he actually gets you that Red Ryder BB gun, I guarantee you are still going to hate Santa. Then why would you invest in the North Pole Manufacturing when it pops up on your investment radar? Now if Santa brought you a few toys on your first Christmas but increased his gift giving every year until you got a Red Ryder BB gun you just might buy a stock in North Pole Manufacturing.

     For now we shall use this model to assign values. Our base value will be fashioned from our long term holding idea that we should keep a company for at least 3-5 years. Our ranges will be: 1= >20 years, 2= 15-20 years, 3= 10-15 years, 4=5-10 years, and 5= 0-5 years.

4.     Dividend Payout Ratio- Dividend payout ratio is in short the amount paid out in dividends per share divided by earnings per share. This ratio is a bit less used possibly because a lot of stocks aren’t really deemed “dividend stocks”. But if you are hunting dividends then this is something you should analyze. If a company has been issuing dividends for quite some time their payout ratio might be significantly higher than one that has just started to and vice versa. In this case high and low payout ratios may be dependent upon the length of a stocks dividend history.

     To analyze the dividend payout ratio we will have to specify if the company is “young”, “maturing”, or “mature”. First let’s start off with stocks that have a young dividend history. In this strategy we will define “young” as 5 years or less, “maturing” as 5-15 years, and “mature” as 15+ years. For these young stocks good ratios will be much lower than mature ones and if it has a high ratio you should be worried about its ability to sustain that ratio. For now we will use this model for young stocks: 1= 0-25, 2=25-30, 3=30-35, 4=35-40, and 5=40-100. For maturing stocks good ratios will be in the mid to lower ratio range. This should signify that the company has been able to effectively maintain a dividend through an extended period (5 years) and increase the amount of money it gives back to shareholders without hurting the business. For now we will use this model for maturing stocks: 1=25-30, 2=30-35, 3=35-40, 4=40-45, 5=1-25 & 45-100. For mature stocks good ratios will be in the mid to high ratio range. This signifies that the company is near its peak of increasing its payout to shareholders and has successfully increased its payout without hurting its business. For now we will use this model for mature stocks: 1=45-55, 2= 35-45 & 55-65, 3=25-35 & 65-75, 4=15-25 & 75-85, 5=0-15 & 85-100.

5.     Net Profit Margin by %- As we look at a company’s income statement we see all these separate figures that we can quantify like revenue, gross profit, operating profit, and net income from continuing operations. But at the bottom of the line we will always see Net Profit which gives an overarching idea of how much money a company is making or losing.

     While we could focus on the specific dollar amount the company is making that does not help us very much in our evaluation. This is because larger companies will inevitably sell much more than smaller companies. We will look at the net profit margin as a sign of how well the company is ran by its management i.e. are the operating expenses too high for the company to be profitable compared to other companies.

     Our period for which we will assign values will be our holding period which is 3-5 years. The mid-range we will use will be based off of an average of 5 year averages from leading companies across 31 different industries, I found these averages on 16/JAN/15. The final 5 year average we arrive at is 10.04% for these purposes I will round down to 10%. Remember this is an average of 31 industries that vary from 27.1% (real estate) to -1.1% (metals & mining) and net profit margin is only a small part (but integral) of a wide ranging analysis.

For now we shall use this model to assign values. 1=16-20%, 2=12-16%, 3= 8-12%, 4= 4-8%, 5=0-4%. Any values exceeding 20% will still be equal to a 1 and any values below 0% will still be equal to a 5.

6.     Net Profit Margin Increase by % (4 year)- While having a good profit margin is an adequate part of a productive business we never want to settle for what we did last year, we want to continuously improve our business. This means we should look at the increase of net profit margin. This will show us the dedication of management to the streamlining of their business model.

To find our mid value we will take the same approach as net profit margin by %, meaning using values from each of the 31 industries and averaging them to find one specific value. However Net Profit Margin Increase by % is not a common statistic used by investors, to find it we will find the net profit margin increase by % from 2010 to 2013 in one company from each of the industries. The average we arrive at is 3.01290323% rounded down to 3% to make it easy on us.

     For now we shall use this model to assign values: 1=4-5%, 2=3-4%, 3=2-3%, 4=1-2%, 5=0-1%. If it falls below 0% then it will be assigned a value of 5 and if it falls above 5% then it will be assigned a value of 1.

7.     Interest Coverage Ratio- Most companies don’t fully use organically generated cash flow to finance business activities, on the contrary companies will usually take out loans to finance a R&D project, business expansion, or acquisition of another company. This obviously creates a liability that the company must pay off. Interest Coverage Ratio is a metric used to see how able a company can pay it’s interest on it’s debt. Not being able to cover the interest on your debt is the easiest way for a company to go into debt.

     The bare minimum that a company must maintain in ratio is 1 meaning they can pay the interest once over anything lower than that and they risk bankruptcy. A generally accepted minimum that is “okay” is 1.5 meaning they can pay it once over and still have revenue left to finance business activities. But we are not looking for companies that are shooting for the generally accepted minimum, that is why 1.5 will not be our mid ground but our bottom of the scale, a 5 to be specific.

     For now we shall use this model to assign values: 1=3.5-4, 2=3-3.5, 3= 2.5-3, 4=2-2.5, 5=1.5-2. If an interest coverage were to fall below 1.5 it would equal 5 and if an interest coverage were to fall above 4 it would be equal to a 1.

8.     5 year Revenue Growth by %- (7.76%) While I think Net Profit Margin Increase is one of the best ways to discover if a company is effectively managed it isn’t the only way. A company can only decrease operating costs to a certain point, revenue however in theory could see endless growth. Another way to evaluate management is through revenue growth and specifically a long term look at that, let’s say 5 years. We look at longer term growths because it shows a true perspective of dedication from management to bettering their company. This is opposed to short term (quarter to quarter/year to year) flukes that may be due in part to price fluctuations or other uncontrollable factors.

     All industries will have different averages of revenue growth due to economic factors that are largely uncontrollable by businesses. However to put every company/industry on level playing ground I averaged out all industries 5 year Revenue Growth by %, my final percentage was 7.76%. Because we shoot for excellence in the Steadfast Investment Strategy lets round up to 8% and make it our median value.

     For now we shall use this model to assign values: 1=12-15%, 2=9-12%, 3=6-9%, 4=3-6%, 5=0-3%. If a 5 year revenue growth were to fall below 0% it would be ranked as a 5 and if it were to fall above 15% it would be ranked as a 1.

Part 2

            There are plenty of things in the investing world that you can’t quite put a number to but still mean quite a lot in valuing a company like their Leadership, future earnings potential, and Industry growth. In this portion of the Steadfast Investment Strategy I will put a number to these so that they can be incorporated into the framework we have already put forth. Reader beware this section is much more susceptible to emotion and personal bias than the later.

9.     Leadership- One of the most important ones is the leadership of a company specifically their CEO. Some people may completely disagree that a CEO can only have a certain limited effect on a company’s performance and that a company could probably operate without one. This statement may be true but as long term investors we are not looking for companies that simply just “operate” we are looking for companies that flourish in the long run. Companies do not flourish without somebody to give them a path to move along, goals to accomplish, and inspiration on the way. These CEOs can also identify great leadership in others and are able to build a team around them that can help the company flourish as well. They also are not limited to improving their company, they also want to improve the community that they live in or even the world through volunteering and philanthropy.

For leadership we are going to identify 5 specific characteristics that a CEO should have or be implementing at the company he runs. 
1- CEOs background in the industry that he is involved in, did he work in relevant roles before he became CEO of the evaluated company. 
2- Is the CEOs education in a relevant area that is applicable to his industry that he is operating in, this is regardless of the level of the degree (bachelor’s or higher). 
3- CEO is involved in his community and/or philanthropic ventures. 
4- The CEO is innovative making the company a disruptive force in its industry that it operates in.   5- The CEO is not a figurehead, he is a leader, he engages his workers, is open to their suggestions, and lets his shareholders know where the company is at and where it is going in the future good or bad. 

     To quantify these aspects in our framework for evaluating companies we will us this model: 1= All five traits are embodied in the CEO, 2= four of the five traits are embodied by the CEO, 3= three of the five traits are embodied by the CEO, 4= two of the five traits are embodied by the CEO, 5= one of the traits are embodied by the CEO, this category also includes zero traits.

10.  Industry Growth Potential- While there are people and companies out there that have the sole purpose of evaluating industries and their growth potentials for the most of us that is not our job. A good investor will also know that this is in the future which means it is bottom line uncertain to happen even if the smartest people say it is. The best we can do with “potential” or “forward” earnings is an educated guess that at best is usually close to being correct.

     However as a long term investor we just want to look for growth and not necessarily specific numbers. This portion of the strategy will indeed require more in depth analysis than with looking up a company’s P/E. You will have to analyze broad market trends and be able to link them together to formulate your opinion of said Industry Growth Potential. For example we can look at Aluminum, factors that you would need to include are the price of Aluminum, growing uses for aluminum, industry advances in the production process of not only the Aluminum itself but it’s applications, and the list goes on.

     The way we will evaluate this portion is through putting a number to our opinion of the growth potential. For now we will use this model: 1= Very Strong, 2= Strong, 3=Moderate, 4=Weak, 5=Very Weak. Our mid-range is moderate because generally industries will grow based simply off of the continuous growth of an economy, economies may slow their growth but generally do not shrink.

11.  Future Earnings Potential- Future earnings potential will be largely based off of the industry’s future growth. However it is not solely based off of this, a company’s ability to manage itself, adapt to a changing industry, and to innovate will also largely effect its future earnings potential. A company could be in one of the hottest industries around but with bad management that can’t capture part of that industries growth the company will flounder.

     Just like Industry Growth Potential we will have to rely heavily on our ability to link seemingly unrelated figures like commodity prices, industry growth potential, management effectiveness, marketing campaigns, product innovation, etc. together in order to determine a broad future growth analysis. It won’t be easy or quick but it will be quite worth it. Effectively predicting a company’s earnings potential will give you quite the leg up on everyone else.

     For now we will use this model: 1=Very Strong, 2=Strong, 3=Moderate, 4=Weak, 5=Very Weak. Just as industries will generally grow with economies so will companies with their industries. Companies don’t usually have management that wants the business ran into the ground. Growth will normally occur but is just a matter of how much. 

To be Continued....

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