Thursday, July 10, 2014

Is There A Better Way Of Stock Picking? (Part II)

Last week I wrote a piece titled "Is There A Better Way Of Stock Picking?". To that question, I shall be slightly hesitant, but say yes, yes I do believe that there is a better way of stock picking!

Again, I have drawn much inspiration from Millenial Invest. In his recent post, he pretty much does a case study evaluating the consumer staples sector with the 3 of the 4 factors that I previous mentioned in the last post. Only momentum was excluded because he found that it did not create a large effect on his results. Oh, the benefit of hindsight, yes?

The most interesting part of his post is actually the different methods of calculation he uses to measure the different factors of Value, Quality and Yield.

For Value, he used (ranked in order of best to worst):
Cash Flow / Price
Sales / Price

For Quality, he used (ranked in order of best to worst):
Change in Net Operating Assets
Free Cash Flow / Short Term Debt
Total Accruals to Total Assets
Return on Invested Capital (ROIC)
Free Cash Flow / Sales
Cash Conversion Cycle
Return on Equity

For Yield, he used (ranked in order of best to worst):
Shareholder Yield
Dividend Yield

Surprisingly, ROE is considered a HORRIBLE metric for quality evaluation, and I think so as well. Change in NOA is a surprising one to me, although I am sure it is a terror to calculate. Free Cash Flow seems like a great place to start, just like EBITDBA and I am glad that the "upgraded" metric that involves these 2 statistics are considered as useful metrics.

In the end, he decided to use create a 4 factor model using:
2) Change in Net Operating Assets
3) Free Cash Flow / Short Term Debt
4) Shareholder Yield

His results?

A nice big outperformance of the consumer staples sector itself!

Personally, if it was me, I would add in some other factors as Debt / Equity ratio and Quick Ratio to look for decent economic strength as well. I think that would be my dimension that replaces momentum (I think momentum is too hard to accurately use as a tool).

Again, is there a better way to stock picking?

If you manage to pick cheap stocks that produce quality earnings and are investor-centric with strong financial strength, I really can't see how that could go wrong. I am once again affirmed as a believer that with plenty of knowledge and experience, it is possible to casually beat an index over a long period.

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