Drafting Fundamentally Sound Stocks For Your Portfolio

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The annual NFL Draft has become one of America's most widely anticipated sports-related events, with thousands of people flocking to New York's Radio City Music Hall last month to witness the festivities. Millions more watched on TV or followed on the Internet.

If you were one of the many who watched the live coverage of the draft, you at times may have felt more like you were watching a value investing symposium than a sporting event. Terms like "great value pick", "rising stock", and "too risky at that price" get bandied about constantly by analysts come Draft time.

It's for good reason -- building an NFL team is in many ways not all that different from building an investment portfolio. General managers are continually weighing risk and reward in trying to value different players, just as good investor weighs risk and reward in evaluating company and stock. In both cases, they look at fundamentals (for G.M.s, it's 40-yard dash times, height and weight, yards-per-carry; for investors, it's things like earnings growth, return on equity, and debt levels), as well as intangibles (leadership ability and "character" matter to the G.M.s, while factors like pricing power and brand recognition matter to investors).

In both cases, value is also huge. A particular player may be far too risky a pick to be taken in Round 1, but a bargain if still on the board in Round 3. Similarly, the stock of a particular company may be a bad buy at 30 times earnings, but a very good bet at 8 times earnings. Good G.M.s and investors also must be able to assess whether short-term problems -- injury, underperformance, etc. -- are signs of long-term trouble, or mere blips on the radar. And they must be able to separate hype from reality.

The parallels are more than just interesting; there are lessons that investors can take from the Draft. The first is that you need to do your homework -- the best NFL teams spend tremendous resources on talent evaluation, and analyze Draft prospects from a myriad of angles. Investors should practice a similar due diligence before buying stocks, using strategies that put a company and its stock through a gamut of financial and fundamental tests.

Here are a couple more lessons the Draft can teach investors:

Great Companies/Players Are Worth a Higher Price: In a letter to Berkshire Hathaway shareholders, Warren Buffett once said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." The New York Giants must have been thinking something similar in 2004, when they traded two first-round picks and a third-round pick for the number one overall pick, quarterback Eli Manning. It wasn't cheap, but Manning has proved worth it, leading the Giants to two Super Bowl victories in the past five seasons.

Right now, my Guru Strategies (each of which is based on the approach of a different investing great) think discount retailer The TJX Companies ( TJX ) is a bit like Manning was back in 2004. It's not exactly dirt-cheap, trading for 21 times trailing 12-month earnings and at a free cash flow yield of just 2.7%. But it's a wonderful business: It's increased earnings per share in every year of the past decade, has about half as much debt as annual earnings, and sports a 47% return on equity. My Buffett-, Peter Lynch-, and James O'Shaughnessy-based strategies think the higher-than-average price tag is worth it for a business like that.

Look Under the Radar: Injuries, a lack of talent around them, playing for a small school -- for numerous reasons, good players often fall through the Draft cracks. A great example is Tom Brady, who was overlooked in part because he split time during his senior season at Michigan with a younger, more highly touted quarterback. He fell to the Patriots in the sixth round of the 2000 Draft. Three Super Bowl titles later, he's a lock for the Hall of Fame.

Similarly, the market has many strong "sleeper" stocks that may be too small, unexciting, or blandly named to get the attention of most investors. Take J2 Global Inc. ( JCOM ). While dozens of analysts follow the big tech firms, only about seven follow this cloud computer services small-cap, and most investors probably don't know the company. They should. It has upped EPS in all but two years of the past decade, has no long-term debt, and a 16.0% earnings yield, reasons why it gets strong interest from my Buffett- and Joel Greenblatt-based models.

If You're Going to Take Risks, Do It on the Cheap: Marshall University running back Ahmad Bradshaw was considered a top talent heading into the 2007 Draft, but some off-field brushes with the law made him too risky to be an early-round pick. But when he fell all the way to the seventh and final round, the New York Giants snatched him up on the cheap -- and it paid off: Bradshaw has been a major contributor on two Super Bowl-winning Giants squads.

My strategies see a similar story in oil giant BP PLC ( BP ). The firm has had a ton of bad press -- deservedly so -- for its Gulf of Mexico spill, and more potential lawsuit payouts loom. But its fundamentals are good (39.3% debt/equity ratio; 22% return on equity; 5.1% dividend yield), and it's dirt cheap, trading for just 4.9 times earnings, 0.3 times sales, and 1.01 times book value. All of that helps earn it high marks from my Lynch-, David Dreman-, and O'Shaughnessy-based strategies.

There's one final broader lesson to take from the Draft, though it has more to do with what happens well after the selections are made: Give your picks the chance to succeed, but don't get too emotionally attached to them. Just as the most sure-fire NFL prospects can fall flat on their faces, so too can the most solid-looking stocks. Teams must continually re-evaluate players and be willing to dump failed prospects they once were enamored with; investors must continually re-evaluate their holdings and be willing to sell stocks they once adored when their outlooks change. In both cases it means admitting you were wrong, which is painful. But holding onto mistakes only makes it more difficult to win over the long term.

Now you're on the clock. Draft wisely.

I'm long JCOM, TJX, and BP.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: BP , JCOM , TJX

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