Picking stocks requires disciplined approach

Could I teach you how to buy a stock in seven paragraphs, really? No. But I can briefly describe what I look for in selecting stocks for our portfolios. It’s not the only way to buy stocks, but it’s what we do.

We’re looking for “undervalued” stocks — who isn’t? For us, a stock’s intrinsic value is based on its demonstrated earnings power. We’re likely to miss high potential companies that aren’t projected to make money anytime soon, but have the potential to be great. My boys and I stopped by the Tesla Motors gallery in Boulder when it opened in 2009. Tesla makes beautiful cars with exciting technology. It might be a wonderful investment. However, to pick a stock, I first want to be able to put a number on its intrinsic value. Without current earnings, it’s tough for this analyst to place a value on the business. To me, current earnings power is one thing that separates speculative bets from more conservative investments.

Contrarian investors tend to buy stocks with low absolute price-earnings ratios, that is the price of a share divided by earnings for a 12-month period. I cut my teeth in a contrarian shop. In today’s market, for example, Merck sells at about eight times its projected earnings power. The inverse of the price-earnings ratio is the earnings yield. For Merck, it’s nearly 12.5 percent, quite a bit higher than what banks are paying depositors. Merck only pays out a portion of its earnings to stockholders in a dividend. The annual dividend yield is 4.7 percent, still better than a bank account, but well below the company’s earnings yield.

In the late-1990’s, I converted from a deep value contrarian to relative price-earnings ratio investing. Instead of being limited only to stocks with the absolute lowest price-earnings ratios, relative price-earnings ratio investors value a stock relative to where it normally trades. This takes a bit of research to determine what the normal price-earnings ratio is for a particular stock or industry, but opens the portfolio up to faster-growing stocks. A technology company that normally sells at 20-times earnings but is now selling at only 10-times earnings might be a much better bargain than a slow-growing utility company that’s currently priced at a lower absolute price-earnings ratio of nine, but has a normal price-earnings ratio of 10-times.

A return to a normal price-earnings ratio ratio takes time, of course. How long it takes is a key variable. An untimely stock might take five years to right itself and return to a more normal valuation. Stocks that are more timely might already be in the process of being revalued at a more normal level. The quicker the stocks return to normal, the higher the investors’ rate of return. After comparing the intrinsic value of a company based on its normal price-earnings ratio to the current price to estimate appreciation potential, investors should estimate how quickly stocks can reach target to calculate the annualized estimated rate of appreciation on each potential investment.

Finally, dividend yields matter. Merck pays investors waiting for the stock to go up 4.7 percent per year. Tesla owners earn nothing. For each of the stocks in our portfolio — and for a set of potential purchase candidates that sit on our “watch list” — we have calculated the total expected return, which is the estimated annual capital appreciation plus the current dividend yield.

After that, portfolio construction takes on much more of a macroeconomic feel. Which industries have strong economic fundamentals and are likely to constitute timely investments? How much diversification outside the U.S. stock market makes sense? Should investors reduce portfolio risk by putting bonds or cash into what is normally an all-stock portfolio? These asset allocation decisions are crucial. But once the macro characteristics of the portfolio have been determined, stock selection mostly boils down to picking stocks in each sector that offer the highest expected return.

The best thing about having a discipline — almost any discipline — is that it reduces the effects that emotions play in investing. Interviewing management creates emotional bonds. Falling in love with cool products can lead to disaster. I love Boston Market restaurants and have ever since I started taking my fiancé to them for a cheap date in the early 1990’s. My devoted patronage didn’t stop the company from going bankrupt, however.

Having a quantitative basis for buying a company; establishing a target price; calculating expected returns, determining timeliness; and buying, selling or holding an investment takes out some of the emotion and can lead to better portfolio performance.