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 25th
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....
On the 16th of October Oprah Winfrey purchased a 10% (6.4 million shares) stake in Weight Watchers (WTW) worth $43 million. In 2 days that stake was at one point worth $119,404,000, some may think that's a bit fishy, using your name to solely increase the price of a stock. The company has seen a steady decline in revenue over the last 4 years which has been attributed to mobile fitness devices and apps. For Oprah it makes sense to enter into a deal and purchase a stake in the company, 
