The results are in. Magna International, my stock pick for The Globe and Mail's 2012 My One and Only Stock-Picking Contest, placed second of 13 entries. I suspect that the 46-per-cent return that Magna chalked up in 2012 has piqued the interest of more than a few investors. Consequently, I thought that my personal approach to selecting stocks, which is the one I used to choose Magna, would be an ideal topic for this article, my inaugural investing column for The Globe and Mail.
My first stop when I begin a stock search is a stock screener. It is an efficient way to unearth potential investing gems from among the thousands of publicly-traded companies I could buy. I use the screener that is part of the client toolkit offered by my discount broker. Most brokers provide something similar. The free screeners from TMX Money, CNBC, finviz.com and The Globe and Mail could also serve my purpose: produce a list of stocks for further investigation.
Choosing the right screening criteria is the key to generating a list that includes some stocks that I eventually purchase. Based on trial and error, I have found that a screen built using the following factors is effective.
1. Listed on a North American stock exchange.
On the global stage, the TSX is a small player with limited diversification. The financial, energy and materials sectors account for more than 70 per cent of the S&P/TSX Composite Index. For an adequate choice of stocks from all business sectors and most regions of the world, I base my screens on companies listed on both Canadian and U.S. exchanges. These exchanges provide good diversification while keeping the trading process convenient and low cost.
2. Suitable business sector.
I am a strong believer in diversification as a risk management tool. My goal is to invest the stock side of my portfolio equally across these five broad industry sectors: financials, natural resources, utilities, consumer goods and services, industrial goods and services. If my portfolio needs rebalancing, I will filter for the sector that needs a boost.
3. Company size.
I avoid penny stocks and small companies because of their inherent risk. I use two filters to screen out these companies: share price of $5 or greater and market capitalization greater than $200-million.
4. Effective management.
This is probably the most important, but most difficult, factor to assess when hunting for good stocks. Return on equity (ROE), the net income earned as a per cent of shareholders' investment, will assess how effectively management uses the money invested in its business. I look for companies with a ROE of 5 per cent or more.
5. Growing profits.
I want to invest in companies that make money and have growing profits. A filter for earnings per share (EPS) growth of at least 5 per cent addresses this requirement.
I like companies that return a portion of their profits to shareholders in the form of a regular dividend. I screen for stocks that pay a dividend of 2 per cent or more.
7. Manageable debt.
Borrowing money can help a company build its business, but too much debt can be lethal, especially in a rising interest rate environment. My broker's screener has a filter for total debt/total capital. I screen for a ratio of 0.5 or less.
8. Sufficient liquidity.
I want to own stocks that trade frequently enough that I can sell a position quickly if the need arises. Screening for stocks trading 25,000 shares a day or more covers off this requirement.
9. Reasonable valuation.
If a stock is fully valued based on standard investing metrics, the potential for superior profits is low. To avoid overpaying, I target stocks with a price over earnings ratio of 15 or less and a price over book value of 1.5 or less.
A screener constructed using these nine factors will usually generate a short list of stocks. If no stocks pass muster, I relax one or two of the factors and rerun the screen.
The screener lists some basic information about the stocks that make the cut. One or two stocks usually stand out because of attractive financial metrics or my prior knowledge of the company. I investigate these companies first. Magna caught my eye because it had recently eliminated its dual-class share structure and bought out the founding owner, both possible catalysts for share price appreciation.
A visit to the company's website is mandatory to see how the firm presents itself to the public and to review the latest annual report, investor presentations and press releases. I also check out the company profile at established financial websites and read any research available from my broker. My objective is to figure out whether the business has a promising future, the revenue and earning numbers make sense and the management is competent. In the end, my decision to buy a stock is a decision to invest in the company that issued the stock.
No stock-picking method will perform on demand. Profits do not necessarily accrue within a handy time frame such as a contest period. Some stocks will deliver excellent returns, others will not. A particular stock-picking method is just one of the tools that an investor can use to build a diversified portfolio of cash, stocks and bonds.
Gail Bebee is Canada's independent voice on personal finance and author of No Hype –The Straight Goods on Investing Your Money, a popular book of investing basics for Canadians from a financial industry outsider viewpoint. Through her writing, speaking and teaching, Gail shows people how to take control of their money and achieve their financial goals. Her column will appear monthly on the Financial Road Map site. Her website is www.gailbebee.com