By
jdwelch
:
With thousands of stocks to choose from, how does one go about
selecting the next stock to purchase for one's portfolio? I'm sure
most veteran investors have their method down pretty well, but I've
been asked several times recently to describe my own method, and so
I've decided to write this article in the hope that it will help
other new investors (and maybe even some veterans) to come up with
their own approach.
In Part 1, I'll introduce you to the philosophy behind what kind
of stocks I like in my portfolio, and therefore what kinds of
stocks that I'm currently tracking, as well as an overview of "My
Mad Method" for deciding which of the stocks I'm actively tracking
that I might want to add to my portfolio once I've got enough funds
to justify a purchase. I'll cover some of the metrics that I use to
evaluate stocks on my watchlist against each other, and in
Part 2
I'll finish up with the remaining metrics that I use, and how I use
all of those metrics to help me make my buying decisions.
In the Beginning...
My overall goal for my portfolio is to collect the best stocks
that will provide solid, stable, growing dividends for the
remaining years before I retire (currently ~17 years), and
hopefully beyond that. Of course, I'd like some good growth to go
along with those dividends, and as it turns out several studies
have found that dividend paying stocks generally and measurably
outperform nondividend paying stocks over time. So by picking
solid, stable dividend payers with a history of increasing
dividends on a regular basis, and reinvesting those dividends into
these or other positions with the same characteristics, I figure
I've got some pretty good growth baked into my plan. That doesn't
mean that there's no room for some purely speculative growth plays;
there is, but these are generally outnumbered by the dividend
payers.
Of course, I want diversity in my portfolio, as that has been
shown historically to provide a degree of protection from bear
market swings and the general erratic behavior of Mr. Market over
time. For the purposes of this article, I'm going to concentrate on
my equity positions; I have some of my overall portfolio invested
in things like bond funds and the like, but here I'm going to focus
on stocks.
Diversity comes in many forms, but for my taste I've chosen a
mix of stocks from different industries as well as different market
capitalization categories, and included a blend of domestic and
international selections. The industry mix I currently have
includes Technology, Mining (Gold and Silver), Healthcare/Medical
Devices, Utilities, Energy, Consumer Goods & Services, mREITs
and Telecom. Within these broad categories there is a variety of
mega, large, mid and smallcap positions, depending on how many
stocks I have in each industry category, some of which are domestic
stocks and some of which are international stocks within those
other two categorizations. Since I'll be adding to this brew, my
watchlist of potential future stocks has the same basic
characteristics, plus a few industries that I don't yet hold a
position in.
The Watchlist
In order to make good choices to add to my growing portfolio, I
first need a good watchlist. For me, having about 30 stocks on my
active watchlist is a good number; not too few, so I've got some
variety and range to work with, and not so many that it becomes
unwieldy and difficult to zero in on the next great thing. But
which stocks to include? Well, I've already described the diversity
I like, but from there it starts to become more personal.
Watching companies that you know something about takes a bit of
the mystery out of whether or not they'd make good additions to
your portfolio, but I'm also open to new ideas from the various
websites that I frequent, adding new potentials to my watchlist as
I read and learn about these companies that I may not have heard
about previously, or maybe I had heard of them but didn't really
know that much about them. This is the point where I start my due
diligence in earnest, learning about each company and deciding at a
high level whether I want to include it in my watchlist or not.
Here's my current watchlist of 30 stocks, sorted by company
name:
Company

Ticker

Alliance Resource Partners, L.P.

(
ARLP
)

Annaly Capital Mgmt

(
NLY
)

Apple

(
AAPL
)

Citigroup, Inc.

(
C
)

Clorox

(
CLX
)

Compass Minerals Int'l, Inc

(CMP)

Cheniere Energy Partners, L.P.

(CQP)

Chevron Corp

(CVX)

Ebix, Inc.

(EBIX)

Fusionio

(FIO)

France Telecom

(FTE)

General Electric Company

(GE)

Google

(GOOG)

Hasbro, Inc.

(HAS)

Hatteras Financial

(HTS)

IPG Photonics

(IPGP)

Johnson & Johnson

(JNJ)

Lockheed Martin Corp

(LMT)

MAKO Surgical

(MAKO)

Medtronic

(MDT)

MV Oil Trust

(MVO)

National Grid, plc

(NGG)

National Presto Industries

(NPK)

Nokia

(NOK)

Philip Morris International

(PM)

Procter & Gamble

(PG)

Wells Fargo & Co

(WFC)

Waste Management

(WM)

Westport Innovations

(WPRT)

ZipCar, Inc.

(ZIP)

So now I've got a baseline of 30 stocks to work with, companies
that I think I might like to add to my portfolio as I accumulate
enough dividends to make a purchase, or if something I currently
hold falls out of favor with me for whatever reason and I decide to
sell it (that's another article altogether). Where do I go from
here? For example, both Johnson & Johnson and Philip Morris
International are dividend stalwarts with almost identical yields
and P/E ratios, but 2 metrics aren't enough for me to be able to
make a choice between them.
Or, what about JNJ, Medtronic and MAKO Surgical, all medical
device manufacturers? There are compelling but different reasons to
pick any of these three, and if I just looked at their yield and
P/E, I might not get the complete picture; I have limited funds
with which to work, so I want to make an informed decision. Or, now
that they're paying a dividend and their stock price has pulled
back a wee bit (as of time of writing), what about Apple? Would it
be worthwhile to add more shares of AAPL to my current position,
based on the numbers?
In order to narrow down my watchlist of 30 stocks to a few that
I'll be willing to pull the trigger on when I've got enough dry
powder, I employ a rating and ranking method that takes 15
different metrics (i.e., characteristics that can be expressed as a
number) about each member of my watchlist, ranks each stock against
all the others on each metric individually, and then aggregates
those 15 metric ranks together in a final score, which itself is
then ranked, resulting in a value between 1 and 30 being assigned
to each stock, where lower is more desirable than higher. In other
words, I'm going for #1.
To accomplish this task, I take advantage of the formulas and
calculation power available in any basic spreadsheet program. My
tool of choice is Microsoft Excel, but any spreadsheet program
worth its salt should be able to accomplish the same goals. When
using the "rank" function in Excel, you have the option of ranking
the group of cells in a column in either
ascending
order or
descending
order; I will indicate which to use with each metric that I
describe below.
The Metrics
The following is a list of the 15 metrics that I use in My Mad
Method of picking stocks to buy. Most of these metrics and/or their
components are fairly straightforward and should be familiar to
most readers and can be easily found on most popular financial
websites, although some of them are a bit trickier than others to
track down:
 Dividend Yield
 Payout Ratio
 Five Year Dividend Growth Rate
 Current P/E
 Price to Book Ratio
 Return on Equity (ROE)
 Gross Margin
 Net Profit Margin
 Current Ratio
 Five Year Revenue (Sales) Growth Rate
 Trailing Twelve Month ((TTM)) Cash Margin
 PEG Ratio
 Graham Number Ratio
 The BMW Method Root Mean Square (RMS)
 The BMW Method Return Factor
These 15 metrics represent the way that I've come to do a
technical evaluation of the stocks I'm interested in and actively
tracking, but they're not a beallendall list of metrics. You can
pick and chose whichever ones you fancy, but in general I would
keep the ratio of stocks you're evaluating to the number of metrics
you're ranking them by to be roughly 2:1.
In my case, I keep about 28 to 30 stocks in my watchlist, and
use these 15 metrics to rank them. Using more metrics than this
will narrow the difference in the average values of all of them
when compared to each other, which can make the resulting rankings
somewhat "fuzzy," while fewer metrics may not give you the right
indication of which stocks really are more worth your consideration
than the others.
In today's article, I'll cover the first 11 metrics and how I
find and/or calculate them, and how I rank each one on its own; I'm
also assuming that you'll be entering the data into a spreadsheet.
In
Part 2
, I'll present you with the remaining 4 metrics and wrap up how to
aggregate all 15 of them to come up with a single value that can
then be ranked to give your watchlist an overall, visual view into
how those stocks you're interested in stack up against each
other:
1  Dividend Yield
 Enter the percentage Dividend Yield. Rank this metric in
ascending
order.
2  Payout Ratio
 Enter the payout ratio as a percentage, but rank this in
descending
order. If a given stock doesn't have a divided yield, I use 2,000%
for this metric so that it ranks at the bottom.
3  Five Year Dividend Growth Rate
 Also a percentage and relatively easy to find, rank this in
ascending
order. If a given company doesn't have 5 years of growth history to
work with, just enter a zero here, and keep in mind that this
number could be negative.
4  Current P/E
 Enter the current P/E ratio, not the forward P/E. Rank in
descending
order. This number could be negative, which is OK, or you can
simply enter zero for a negative P/E.
5  Price to Book Ratio
 Enter the Price to Book ratio and rank it in
descending
order.
6  Return on Equity (ROE)
 Enter the ROE and rank it in
ascending
order. If a given company doesn't have an ROE figure, enter zero
here.
7  Gross Margin
 Enter the current Gross Margin, or enter a zero if this number is
not reported or is "N/A" in your source. Rank in
ascending
order.
8  Net Profit Margin
 This could be negative, too. Rank in
ascending
order.
9  Current Ratio
 Higher is better here, so enter this and rank it in
ascending
order.
10  Five Year Revenue (Sales) Growth Rate
 This is a percentage. Some companies don't have 5 years of
numbers, in which case use 3 years if available, or just the prior
year's figure if that's all there is. Don't be tempted to use a
better number from a more recent range here; stick to the 5 year
growth number if it's available. Rank this in
ascending
order.
11  Trailing Twelve Months Cash Margin
 Here's where it starts to get a little tricky. What we're looking
for here is an indication of how the company manages its free cash,
since we want a lot of free cash to cover its dividend
distributions. To calculate this, I use the cash flow and income
statements for the company for the last 4 fiscal quarters, whatever
is currently available from my source.
This calculation is made up of the sum of the Operating Cash
Flow, or OCF, for each quarter (from the cash flow statement),
minus the sum of the Property, Plant and Equipment, or PP&E,
dollars spent in each quarter (also from the cash flow statement,
but expressed as a positive number so that it subtracts from the
sum (Operating Cash Flow) properly), and then that result is
divided by the sum of the Sales for the trailing four quarters
(from the income statement). The higher the better, so rank in
ascending
order. Here's the formula:
(SUM(4 quarters' OCF)  ((SUM(4 qtrs' PP&E)*(1))))
/ (SUM(4 qtrs' Sales))
That's it for Part 1. Check out
Part 2
for the details of how I calculate and rank the remaining 4
metrics, how to come up with a single value to use to rank all of
your watchlist, as well as a look at how well this method has
worked for me so far.
Disclosure:
I am long [[MDT]], [[MAKO]], [[NLY]], [[AAPL]], [[NPK]]. I may
initiate a long position in ARLP, HTS and/or NOK in the next 72
hours.
See also
When Can You Really Retire?
on seekingalpha.com