Looking for stocks that pass multiple strategies can be helpful, particularly if those strategies differ significantly.Getty Images/iStockphoto
John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
The recent rise of "smart beta" and "factor investing" strategies – both of which involve investing in companies that meet specific balance sheet, profitability, valuation or fundamental criteria – has opened up a world of possibilities for investors.
You can now choose from among scores, perhaps hundreds, of quantitative strategies that target specific types of stocks. Want to invest in companies that are paying high dividends or buying back a lot of their shares? There's a fund for that. Like steady, low-volatility plays? There are funds for that, too. Want stocks that have a variety of high-quality characteristics, such as high profit margins or returns on equity? Still more funds fit the bill.
With all of these strategies now on the table, which one should you pick? Well, as someone who has been practising factor investing since long before these new funds existed, my advice is not to use one. It's to use two.
Or three.
Or maybe even four.
Let me explain. Good factor investing or smart beta strategies work because they exploit an inefficiency in the market. For example, a number of these strategies look for "low-volatility" stocks – that is, those shares whose ups and downs tend to be less dramatic than those of the broader market. Studies have shown that low-volatility stocks have outperformed higher-volatility picks over the long-term.
Investing in low-volatility stocks can thus be a profitable approach. But there's a lot more to a stock than its level of volatility. A low-volatility stock can have terrible growth numbers, or be loaded down with debt, making its lack of volatility a pleasant footnote to a terrible story.
Because of that, some strategies employ multiple metrics. That's what my Guru Strategies do. These approaches are based on the published strategies by great investors such as Warren Buffett, Benjamin Graham and Peter Lynch, and each of those gurus used a variety of metrics when analyzing a stock. Mr. Lynch, one of the most successful mutual fund managers of all time, said for example that he looked at the price-to-earnings ratio, earnings-per-share growth rate, inventory-to-sales ratio, debt-to-equity ratio and free cash flow yield, among other factors.
But I have found that taking it a step further – that is, looking for stocks that pass multiple strategies – can help even more, particularly if those strategies differ significantly. For example, if a stock passes a conservative, value-focused approach and a growth and momentum-oriented strategy, you know that you are getting a company and stock that are strong when looked at from a variety of different angles. Because you are not relying on one particular style of investing – growth, value, momentum – you can also build a portfolio that is more likely to hold up when one particular style goes out of favour, which happens all the time in the stock market. That can help smooth out your returns and mitigate major short-term losses, which make you more likely to stay the course over the long term, and more likely to benefit from the power of compounding returns.
What sort of North American stocks are currently getting approval from two or more of my models? Here's a sampling:
Marcus & Millichap (MMI)
This brokerage firm, with a $900-million (U.S.) market cap, specializes in commercial real estate investment sales, financing, research and advisory services. Calabasas, Calif.-based M&M gets strong interest from my Lynch-based growth-at-a-reasonable-price model and an approach I base on the writings of star value fund manager Joel Greenblatt. A few of its key fundamentals: a reasonable 14.4 P/E ratio, a 41-per-cent long-term EPS growth rate, and a 47-per-cent return on capital.
CCL Industries (CCL.B)
This Toronto-based specialty packaging firm, which has a nearly $8-billion (Canadian) market cap, has grown earnings per share at a 36-per-cent clip over the long term and gets interest from my Lynch-based model and my Momentum Investor approach, which looks for high-growth, red-hot picks. A few other reasons CCL rates highly: It has a 12-month relative strength of 93 (meaning it has outperformed 93 per cent of all other stocks in the market over the past year), a 19-per-cent return on equity and a 0.74 P/E-to-growth ratio (a metric Mr. Lynch developed that divides a firm's P/E ratio by its long-term EPS growth rate).
Sanderson Farms (SAFM)
Headquartered in Laurel, Miss., Sanderson is the third-largest poultry producer in the United States. The company, with a market cap of $2-billion (U.S.), gets high marks from the strategy I base on the writings of Ken Fisher, who pioneered the price-to-sales ratio as a valuation metric. Sanderson's 0.72 P/S ratio impresses the model, as do its 7.2-per-cent average three-year net profit margins and 1-per-cent debt-to-equity ratio. Sanderson also gets high marks from my Lynch-based model, thanks to its 12.3 P/E ratio and 34-per-cent long-term EPS growth rate, which makes for a 0.36 P/E-to-growth ratio.
Disclosure: I'm long MMI and SAFM.