It is very easy to overcomplicate investing. Picking stocks is more an art than a science. To consistently pick winners, you need to have a wealth of experience in both the stock market and business management. You also need to have enough time to be able to conduct a detailed analysis of your target.
There are many different strategies out there that will help you accomplish your goals with minimal input. Various checklists from the world’s most renowned investors, along with evaluation strategies, can be found all over the internet. Some of these are more complicated than others. In the quest to find the perfect plan, it is easy to overcomplicate valuation methodologies. Unfortunately, the more sophisticated the strategy is, the less likely you will follow it continuously, which makes the point of using a set strategy redundant.
Simple Is Best
Simple is best when looking for investment strategies. One of the most straightforward and easy to understand value strategies that I have come across over the years only has four components. To qualify, a stock must trade at a forward price-earnings (P/E) ratio of less than 12 and the company must have a cash-rich balance sheet with a positive free cash flow. When I say cash-rich balance sheet, I mean a net cash balance, which has the added effect of lowering the P/E ratio further when adjusting for cash. The fourth and final component is that the company in question must pay a dividend. It can often take many months or even years for the market to bring a company’s valuation out of value territory, and a positive dividend income will help boost your returns during this period. To help in the process of cutting losers and letting winners run, you can also incorporate a 20% stop-loss into the strategy and limit of 50% to 75%, depending on the initial purchase price.
The strategy is designed to take some of the risks out of investing. Buying companies that only have a positive cash balance removes the need to analyze debt and the effect it will have on the business. Further, this rule should help steer you away from any overleveraged high-risk companies. Secondly, the low P/E multiple is the margin of safety here. Over the years, the P/E has proven itself to be the most straightforward and reliable valuation metric for investors following all strategies.
However, a simple approach such as this does have risks. For example, there is no assessment of the businesses competitive advantage, return on capital or management’s past performance. That is why a stop-loss should be part of the strategy. These factors are never going to 100% identify and even rigorous analysis can leave stones unturned, which may come back to haunt you at a later date. With this being the case, to save time, effort and money, a stop-loss may be the better option.
Screen Results
Some companies pass the simple screening criteria above even in the current market. These companies have a market capitalization of more than $5 billion, a net cash balance, a positive free cash flow, a rolling forward P/E of less than 12 and offer at least a token dividend yield. Prudential Financial Inc. (PRU, Financial) tops the list with a rolling forward P/E of 7.3, dividend yield of 3.5% and gearing of -4.3%, although as a financial services firm, this figures Prudential’s net cash could fall back to a net debt position in the near future (the current figures are only a snapshot of the company’s financial position). HP Inc. (HPQ, Financial) is another stock that meets all of the screening criteria. Shares in the company trade at a rolling forward P/E of nine, support dividend yield of 3.9%, and the company has a positive free cash flow and cash rich balance sheet, according to my figures. Three other qualifying companies are XL Group (XL, Financial), Juniper Networks Inc. (JNPR, Financial) and Alaska Air Group Inc. (ALK, Financial), all of which warrant further research.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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