Monday, September 15, 2008

Market Tremors Series - Process

  1. Process

    This is #2 in the Market Tremors series.

    In the last posting, I stated that few retail investors ask and answer the right questions before portfolio construction, with the result that they panic during both bear and bull markets. This panic, whether due to significant market decline or portfolio lag, is the cause of most market underperformance. That is primarily because the investor panics and begins chasing the wrong asset class, at the wrong time.

    I suggest that all investors need to deal with these five questions, in order to have a good chance to outperform the market:

    1. Process;
    2. Rationale;
    3. Emotions;
    4. Holdings;
    5. Market Exposure

    Today, we are looking at Process, through the lens of my own recent portfolio reconstitution. Here’s how I define Process:

    What process and tools did I use to construct this portfolio?
    Have I given myself an edge in some way?

    Firstly, it’s rare that any long term market outperformance is possible without a decent process. If you’ve been outperforming the market without a specific process, then you better chalk it up to luck – and just like in the casino, it’s not likely to last. If you’ve luckily lurched from stock tip and suggestion and back to the same, better quit now and put your winnings in your pocket. Stop now, build and define your process.

    While I don’t suggest my process will fit everyone, it fits me. Here’s mine.

    First, I admit with my time constraints, I just don’t have the time to delve deep into the annual report of every corporation in the areas I have chosen. I used to do that when I bought just small and micro cap stocks, but have neither the time nor the desire to orient my portfolio that way anymore.

    Instead, I use quality “buy side” analysts who have my interests at heart (unlike the conflicted investment banks and their ADHD analysts). Therefore, I extensively use the Morningstar database to find stocks that might interest me.

    Using their database, I screen for stocks based on both “moat” (barriers to competition) and largest discount to fair market value.

    Second, I require all of the stocks I select to have a moat, and preferably a wide moat. I want that implicit margin of safety. I also require that all of the stocks I buy to have some margin of safety in terms of the pricing – the lower the stock price relative to their fair value estimate, the better. Also, I generally want to buy a four or five star rated equity, which, according to Morningstar’s data, have on average significantly outperformed the market over a relatively long period.

    I also check this rating with the S&P report (another buy side rating agency), to see if it’s roughly similar. Again, they report that their four and five star rated equities have significantly outperformed the market on average.

    Third, I also require that the equity be paying a dividend. I am looking for both an above average dividend yield, and recent history of dividend growth (or the possibility that is about to occur). Given the long-term outperformance of dividend-paying stocks, as further boosted by those providing dividend growth, I consider this one of the edges I use in the market.

    Fourth, when looking at the truncated financials, I look for above market average returns on equity and capital (assets), as both are long term drivers of stock price growth. I look for decent earnings per share growth. I also look at overall financial health of the company, accepting a “C” Morningstar rating at the lowest, but looking for better if possible. I also look at the PE ratio to see if that is a relative bargain.

    In terms of my ETF selection, I use a much more “gestalt” process – I usually pick specialty ETFs in areas I think there’ll be considerable growth into the future. Here, I use my general reading, and just plain thinking about the future, to orient towards those ETF buys. I also try to envision those ETF buys ten years out, because that’s my projected holding period in that instance. I look at the valuation ratios but, given I perceive these as the growth portion of my portfolio, are somewhat less concerning than in the stock selection (which I perceive as the value oriented portion of my portfolio). However, I also check relative value measures, like the PE ratio, to ensure I’m not buying the NASDAQ index circa 1999, with a PE of 100.

    Now, the final piece of the process is to print up all these materials I’ve compiled, together with any handwritten notes on the reports. I then do a very brief summary on the equities selection, such as dividend yield, Morningstar ratings and percentage of fair market value the equity is selling at, and a brief narrative overview, including PE ratios, value drivers, exposure to the US market, and/or other odds and sods. I do the same for my ETFs.

    Next we’ll look at “Rationale”, which will be published on Thursday.


The Confused Capitalist


venter said...

How do you decide which companies have a large moat?

Jay Walker said...

Morningstar provides that information. If you want to delve into it yourself, then I recommend the following book, THe LITTLE BOOK THAT BUILDS WEALTH, by Pat Dorsey. I reviewed it here:

and I believe that'll give you some insight into "moat".