The Process is as Important as the Product
In the past few weeks several readers have reached out regarding the process you should undertake when finding investment opportunities. Although I am no expert, this week I thought I would take a break from macro research and focus on stock-picking.
Having read about markets and actively invested for four years, only now am I coming to grips with a stock selection process that I think uncovers hidden value in the market. If you follow The Spark portfolio then time will tell its effectiveness. I may have set myself up for a slap down…
There is definitely not enough information out there on investment processes. I have read about the processes of famous investors such as Stanley Druckenmiller and Warren Buffet and I suggest that you do the same, as this will give you huge insight into successful stock-picking. I hope this article will help clarify the steps to a good investment process and I will try to keep it as simple, flexible, and general as possible, so you can tweak it to fit your own investment goals.
Everyone’s process will be different, as choosing the correct investments for you is highly dependent on several factors including age, risk appetite, salary, savings, and so on. I suppose you can use this as a more general guide, handpicking the things you like or using this as a foundation to build and develop your own personal approach. I call it a process because investing should be based around defined goals and boundaries which you adhere to, not aimlessly throwing money at a company and hoping for the best. In the long run, this will never work out. Following the crowd through fear of missing out (FOMO) will also cost you massively, as is evident with the underperformance of many highly valued technology stocks this year.
I will try not to make this article too academic, but there are several terms and concepts you must grasp in order to understand markets, the first of which is:
The Macroeconomic environment
The global macro environment is the first thing I look at before any individual investment. This is called a top-down approach, where I look at the wider investment landscape before narrowing in on certain sectors and companies. This is my preferred approach. Other investors use a bottom-up approach, where they look at the individual merits of a company and pay less regard to the wider economic environment. There are benefits and drawbacks to both, but as I said, I prefer to use the former over the latter.
So, what does research of the macroeconomic environment entail?
Every investor will choose different measures and data to develop an opinion on market direction. In this article, I will discuss several approaches that I use and I suggest further sources of information for use in your own research.
Firstly, I look at credit and bond markets. Where are US Government Bond (GB) Yields at present and what does the yield curve look like? The US GB Yield is regarded as the ‘Risk-free rate’ because the US is highly unlikely to default (not pay back) on its debts. Therefore, an investor would always aim to make returns above the USGB Yield (e.g. US 10-year yield is currently 1.68%), to be compensated for taking on additional risk.
Yields move in the opposite direction to bond prices, so if yields rise, bond prices fall. In tough times, such as March 2020, yields collapsed as investors rushed to the safety of a US GB, ditching risky stocks. The inverse of this occurs when the economy is recovering or improving. Yields rise (prices fall) as investors sell GB’s and buy riskier assets, such as stocks. Therefore, if you think yields will rise, then you should buy stocks. In addition to individual yields, there is also a yield curve. This plots the yield of different GBs, as you see below.
10-year US Treasury Yield minus two-year yield, source: St. Louis Fed wesbite
The bond market is often said to be smarter than the stock market, as it tends to move first and can be a leading indicator of tough times ahead for the stock market. The graph you see above is the yield on the 10-year US GB (think of a 10-year loan you could take out) minus the 2-year yield. As you can see, the curve was inverted (upside down) in 2005/06 and 2018/19. Typically, you would expect to be paid a higher yield (interest payments) to hold a bond for a longer period – you expect to pay a higher interest rate on a longer-term loan I.e. takes longer for the bank to get its money back and higher risk of you not paying back if taken out for a longer period. This is a useful indicator of liquidity in the market, as banks borrow on the short end and lend on the long end, so their profit is the spread between the 2 and 10-year yield. Therefore, when the curve becomes inverted this suggests liquidity is tightening, as banks’ willingness to lend falls as they make less profit. Investors become worried, selling long-dated bonds in favour of short-dated bonds. They do so because short-dated bonds are easier to sell (liquid) and act more like cash.
Inflation is another major factor affecting the macro-economic environment, but it is the reaction to inflation that matters more. If inflation is worrying the market, it means central banks may raise interest rates sooner, or cut Quantitative Easing programmes. Inflation erodes the returns on fixed-income assets like bonds. Why would you want to hold a bond paying 1% a year if inflation is 4% a year? You would be losing 3% in real terms. Therefore, bond yields will also rise in this case, as investors expect central banks to raise interest rates to combat inflation (as higher interest rates lead to lower spending, which reduces inflation).
Usually, higher inflation benefits cyclical stocks such as miners, and energy companies when the economy is improving, and precious metals if the economy is declining. However, lower inflation benefits higher risk equities when the economy is booming, such as technology, renewables, and so on. This is because the discount rate applied to future cash flows of these firms is lower, so investors pay a higher price for them today, driving share prices up.
After the bond market, I look at liquidity and excess liquidity. You can research google for a calculation of excess liquidity, as there is more than one way to skin a cat. However, liquidity is essential in understanding the market environment. As I wrote about last week, we have seen a huge amount of central bank and government spending in the last year. This is when liquidity was ample. Therefore, we saw a huge run-up in stocks, with the S&P 500 up 32% in the last year. Liquidity drives markets, so understanding where excess liquidity is heading is essential to investment decisions.
Other data that can be used to predict where the economy is heading include the ISM manufacturing report (essential, in my opinion), Non-farm payrolls, and consumer confidence, among many others.
ISM Manufacturing PMI (Orange line) against S&P 500 index (Blue line). When ISM manufacturing is below 50 this can be an indicator of a pending market crash. Source: Bloomberg
Finally, you must consider secular growth trends. For example, western nations are getting older, so healthcare is clearly a secular growth trend over the next ten years, as are renewable energy, electric vehicles, and autonomous vehicles. However, there are times when markets get over-excited about such trends, looking too far into the future and under-pricing other assets today. This is the primary reason I invested and continue to hold non-renewables in The Spark’s portfolio today.
Narrowing in
The wider macro-economic view is one of the hardest concepts to grasp, particularly because everyone has their own opinion. Once you have developed your view, it is time to narrow in on industries and sectors that are most likely to thrive within that macro environment. For example, I see the economy continuing to recover over the next few months, and I also anticipate the inflation reading remaining high, so I hold oil stocks. I also added precious metals last week, as I see inflation remaining high, but am concerned that in the next year as liquidity is drained from the market, the economy may falter. This is when the benefits of a diversified portfolio come in, as individual holdings tend to outperform in different environments.
After doing your own macro analysis, it is time to pick stocks within your chosen sector. Unless you have a team of analysts to do the groundwork, you cannot go through every stock in a sector to find the right one. Therefore, many investors use stock screeners. I use Zack’s screener, as it is free, but there are many other screeners which you can use. Once you open a screener, you must choose parameters to narrow down your stock selections. Unfortunately, I cannot tell you the criteria to use, as every sector should have different criteria, and you may have preferences on the size of stocks you hold, for example. I can however show you how I came across Suncor Energy (SU), which I added to the portfolio two weeks ago.
The screen I used to find Suncor energy:
Market: NYSE
Sector: Energy – as I wanted an oil company
Market Cap. > 1bn – boundary set at the beginning of The Spark
Price > $1 – did not want a penny stock, as they can be volatile and risky
Average volume > 200k - I wanted a stock that is liquid and traded often so I can buy/sell with ease
Beta 1 < 2 – Transocean has a Beta of 2.4, and SPOG has a Beta of 0.9, I wanted a stock in between for medium risk/volatility.
Quick Ratio > 0.5 & Current ratio > 1 – Wanted a stock with enough cash to withstand any short-term fluctuations in revenue
Using these criteria gave me 62 potential stocks. Then I used ‘edit criteria’ to add forward PE ratio for the next two years and EPS estimates for the next two years. I exported these into an excel sheet, removing pure gas companies, Chinese stocks, ConocoPhillips (already have exposure through the SPOG ETF), and those with a beta less than 1 (as the ETF has that much volatility already). I was left with roughly 10 stocks.
Once you get to this stage you need to narrow down and analyse a few single stocks, finding those which are cheap relative to their sector, industry, or the market. This could be based upon revenue growth, gross margins, or EV/EBITDA multiples, for example. When I scanned for semiconductor companies, Intel and Micron Technology’s were the most attractively priced on a relative basis using EV/EBITDA.
When you narrow down to several potential investments, you must go in-depth on 3-5 of these companies, understanding their business, potential catalysts, and so on. Why are they trading at a lower valuation compared with their peers? Maybe the market is cautious about management. Therefore, you could check if the company is consistently beating earnings estimates. Intel has recently been dropped by Apple who is now producing its own microchips. Is the market over-exaggerating the revenue downside?
After all due diligence is done, you must then consider position sizing. If the stock has a high beta (high volatility compared to the market), you may want to assign a lower percentage of your capital to this investment. For example, The Spark’s position in Transocean LTD (RIG) was just 2% due to the heightened risk and volatility. Next, what entry price do you find this investment attractive, based on valuation calculations or technical analysis, such as Elliot Wave or support and resistance lines. Some say technical analysis is garbage, but I tend to disagree since many famous investors such as Stanley Druckenmiller use it on a regular basis.
Finally, after all this, the final piece of the puzzle is patience. If you have done all of the above in-depth, you will know everything you need to about your investment, you will trust your analysis, and therefore if the share price falls you will know whether to buy more, hold or sell.
On a final note, selling a stock is one of the most difficult parts of investing. Knowing what time to sell is crucial in successful investing. Generally, I would say there are three reasons to sell a stock. Firstly, you should sell if the fundamental reason for why you purchased the stock has changed. For example, following Facebook’s recent scandal, you may believe regulation will stifle future revenue growth or customer retention. This could be a reason to sell if you are a shareholder of Facebook. The other two reasons to sell are if there is a better opportunity elsewhere (subjective so harder to say), or if the position grows to be too large for your preference/risk/volatility comfort.
I hope this has been helpful and please leave any comments or questions in the form at the bottom of the Newsletter page.
See you next Sunday!
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.