U.S. Top Stock Picks
As if it should have come as a surprise. The sharp sell-off of the prior week, driven by geopolitical concerns surrounding North Korea, set up the umpteenth buy-dip-as-quick-as-you-can event seen since equity markets went ballistic with central bank lower-for-longer monetary policies. This time, a -1.7% move off of S&P 500 all-time highs last week (-2.8% for the Nasdaq-100) was all that the computer algos needed to jump on the equity dip Monday morning. Unusually, equity indexes saw another big down day right away on Thursday. The VIX volatility index put on a show, as the index spiked to 17 last Friday before the index re-plunged -35% behind the weight of the hoard of volatility short sellers Monday only to spike back up towards 16 by Friday. The market is getting anxious.
We don’t want to sound like Chicken Littles, but the U.S. equity indexes are in rare air and many of the component stocks have been unjustly bid up (well beyond levels justified by company fundamentals) only due to the passive investing craze (recall that passive investor managers are required to buy all stocks in an index when new equity inflows arrive). One of these days, the index traders keen on buying each dip will get seriously burned when the dip accelerates to the downside, instead of bouncing back up as we are all accustomed to. Given how inveterate this buy-the-dip phenomenon has become in traders’ mentality, it will be very interesting to see how traders react when their position get underwater, and stay underwater.
We think/fear that traders will be very, very slow to sell out on a dip that morphs into a correction and then possibly into a bear market. Pain will be great the day the dip does not come back up. Adding fuel to the fire on the day of reckoning (likely the weeks of reckoning) is Margin Debt shown below. Too many people are playing with borrowed money, getting leveraged up to the hilt. The gods on the stock market disapprove of this greediness, and they will let margin debt traders know this…just as the gods have done each time in the past.
That said, U.S. equity indexes are not the only game in town, lest the TINA (there is no alternative to U.S. equities) investors, who have sunk too deep into the Kool-Aid, tells us the contrary. We are not necessarily bearish on index investing, if done in an intelligent manner and based on sound analysis. Our successful Dynamic Global Rotation (DGR) strategy, which takes a macro approach to industry and country selection, uses ETFs to easily access non-U.S. equities in a cost-efficient manner. There is always a bull market-in-the-making in some asset class, for investors willing to overcome their home bias. Even in the U.S. and European equity space, admittedly unattractive based on the benchmark indexes seized upon by passive investors, a skilled analyst can dig deeper (beyond the crowded high-flyers like Facebook and Amazon) and unearth solid companies worthy of a long-term investment.
And it precisely in these unearthed gems where investors, not keen on playing the nearly unwinnable market-timing game, are advised to park their investment dollars. Motivated by our strong conviction that company fundamentals and valuations will win out over central bank monetary policy experiments and euphoria in high flying stocks, we have shown that our intellectual and data resources allow us to build fundamentally solid equity portfolios that out-perform passive, index funds over the business cycle. As we have mentioned in previous Commentaries, we believe that now is the time to abandon passive index investing and get back to Benjamin Graham-style company analysis on the U.S. and European equity markets. The low-hanging fruit has long since been picked in the U.S. and Europe: it is now time to work to earn your investment returns.
This week we introduce our U.S. Top Picks portfolio. Our U.S. portfolio is live and available on the Interactive Brokers and Folio platforms. In addition, our positions can be followed in full transparency on our site.
We first explain our construction methodology and share some current positions. We then provide the portfolio specs and present the year-to-date live performance.
Portfolio Construction
A portfolio is a collection of stocks that fit together and interact. Our U.S. top picks portfolios synthesize three over-arching investment styles:
- Ultra Growth
- Ultra Value
- Ultra Yield
The interaction of these different styles smoothes portfolio performance over the business cycle and, most importantly, reduces portfolio volatility. Our Growth pocket scans the universe of all U.S. equities for companies with the fastest revenue growth rate over the current year AND the projected rate of growth over the next three years. The goal is to select companies with dynamic growth and the fastest expected rate of change in revenue among peers (ultra growth). While the projected revenue growth rate is the determinate criteria, our selection is refined by considering analysts’ revisions to Earning per Share (EPS) over the next 4-months and 1-year in addition to analysts’ revisions to their revenue estimates for the company, again on a 4-month and 1-year horizon. In addition, we require that our growth companies are profitable. We measure the company’s net margin rate for the current fiscal year and for the next fiscal year using consensus forecasts. Obviously the relationship between bottom line earnings and top line revenue is crucial to assess whether the firm is capable of remunerating its shareholders. Finally we consider the financial situation of the company in order to assure that no debt problem exists and cash flow is positive.
Among the growth stocks in our U.S. Top Picks portfolio, we are holding a position in Coherent, Inc. Coherent, Inc. engages in the design, manufacture, and trade of laser diodes and equipment. The Specialty Lasers and Systems segment manufactures configurable products serving the microelectronics, scientific research, and government programs.
While the stock is not cheap, Coherent is enjoying crazy revenue growth and analysts are falling over themselves constantly revising EPS and revenue forecasts to the upside.
The stock price is in a powerful uptrend and just suffered a bout of profit-taking in August (-23% from July highs). Currently trading at $215, the consensus price target on the stock is at $290 (with a high estimate at $325 and a low estimate at $275.
This is not a low beta stock at 1.6, but with a red hot business model, strong profitability and a healthy financial situation (positive cash flow, low debt), Coherent is worth the ride for patient investors.
Our Value pocket screens companies first and foremost based on the ratio of enterprise value to revenue (EBITDA), both for the current fiscal year and the upcoming fiscal year. The ultra value companies in the portfolio have the lowest EV/EBITDA among peers. Supporting this company valuation metric, we consider the company’s stock price-to-earnings ratio (PER) for the current and upcoming fiscal years. Low PER firms rise to the top of our selection. As with growth stocks, we again screen companies based on profitability and financial situation (debt). We also prefer firms with a good visibility, or business predictability, in this category. Our visibility measure is based on the dispersion of analysts’ estimates for the upcoming fiscal years. The tighter the analysts’ forecasts, the better the visibility we have on the company’s potential earnings. Finally, we consider the recommendations and price targets of the consensus of analysts, should a final filter be needed to separate candidates for our value selection.
Greenbrier Companies, Inc., one of our value selections, is a true gem – one of the few fundamentally solid U.S.-listed firms not already trading at cycle highs. Greenbrier engages in the design, manufacture, and distribution of railroad freight car equipment. The company operates through several segments: Manufacturing; Wheels & Parts; Leasing & Services; and GBW Joint Venture. The Manufacturing segment includes double-stack intermodal railcars, tank cars, and marine vessels. The Wheels & Parts segment produces railroad accessories and provides wheel and axle maintenance and services. The Leasing & Services segment offers management solutions to railcars for railroads, shippers, and carriers. Straddling the Machinery & Equipment industry and the Transportation industry, Greenbrier is therefore an economically-sensitive company most likely to outperform during periods of strong economic growth.
Greenbrier was included in our portfolio due to its extremely low enterprise value-to-revenue ratio. At 0.59x 2017 estimates and 0.63x 2018 estimates, Greenbrier is a quintessential value play. With stable, strong sales growth forecast for 2017 and the next two years, coupled with no debt/leverage, it’s hard to see Greenbrier underperforming in broad market, whatever macro events impact the financial market and economy.
In addition, the right- hand figure shows that Greenbrier’s stock is very reasonably priced at 12.6x 2017 estimated earnings (compared to 21.5x for the S&P 500).
While EPS has cooled off from the torrid pace of 2015/2016, this slowdown has been fully incorporated into the share price by now. After the run-up in 2014 to above $70/share, the market priced in the slower pace of EPS growth that we are now experiencing by bring the share price down to $20 in early 2016. Already back up to $44/share, Greenbrier’s stock is now in a healthy uptrend, targeting $52/share, the median forecast of analysts following the stock. The time is buy is now – the market will not wait for you!
Our Yield pocket looks for stocks the highest dividend yield, subject to having sufficient profitability (net margin) and a strong financial situation (positive cash flow) to maintain and/or raise the dividend. Again, we consider the company visibility in selecting our ultra yield stocks. Lastly, we look at the quality of company publications relative to analysts’ expectations. We attribute a higher score to companies who consistently announce above the consensus forecast.
We have unearthed lots of great yield firms in our U.S. Top Picks portfolio which pay on average an annual dividend of 8.5%. We’ll share an off-the-radar pick, Whitestone REIT.
Whitestone REIT is a real estate company, which acquires, owns, manages, develops, and redevelops commercial properties in markets in major metropolitan areas. In addition to the 9% annual dividend Whitestone pays its shareholders on a monthly basis (or a 0.75% cash flow coming into your portfolio each month), the company is rock solid. The company should have no problems meeting this dividend obligation. The group’s high margin levels account for strong profits to continue paying its dividend. Moreover, there is high visibility into the group’s activities for the coming years. Outlooks on future revenues from analysts covering the equity remain similar. Such hardly dispersed estimates support highly predictable sales for the current and upcoming fiscal years. Lastly, the company has been releasing figures that are above expectations. Together, this recipe makes for an ideal dividend stock to tuck away in an investment portfolio.
Our U.S. portfolio currently holds 29 companies. We offer our readers full transparency and post each week our full portfolio holdings. Readers can consult our U.S. Top Picks portfolio here and replicate any or all of our selections.
While our first objective in our Top Picks portfolio is to find solid companies based both of current financial statements and forward projections based on the analyst consensus, we also apply a quantitative overlay, making our Top Picks portfolios loosely “techno-fundamental” strategies. We limit, however, our quantitative analysis of the stock price to our weekly trend indicators as a complement to our fundamental analysis. The composite weekly absolute trend score from the WMA Trend Model plus the composite weekly relative trend score from the WMA Sector Allocation model must remain above a certain threshold for the stock to remain in the portfolio. The objective is both to avoid camping out in a stock that turns out to be a value trap as well as being vigilant to cases where price anticipates changes in company fundamentals. Readers can find our U.S. Total Market Techno/Fundamental Allocation Model updated after each Friday close.
Portfolio Specifications
Our investment universe for the U.S. Top Picks portfolio is all U.S. traded stocks, subject to coverage of the company by at least three analysts. Again, our analysis is forward-looking and our fundamental scores depend to a large part upon consensus forecasts. The appropriate benchmark is the Russell 3000 index.
We rebalance our Top Picks portfolios weekly, as company fundamentals do not change on a daily basis. Just as importantly, weekly rebalancing avoids overtrading, as intra-week price movements tend to contain a lot of noise.
In terms of number of positions, the portfolio holds generally between 25 to 35 positions. We feel that a roughly 4% allocation to a single firm sufficiently expresses our fundamental convictions in the company’s business while not assuming excessive company-specific risk.
Portfolio Performance
Our U.S. Top Picks Portfolio is up +27.4% year-to-date versus +10.2% for the S&P 500. Our Top Picks portfolios are not get-rich-quick trading portfolios, but rather thoughtful equity allocations to firms meeting our rigorous fundamental criteria. Our selections will rise and fall with the markets, but with a very high probability of rising more in up-cycles and falling less in down-cycles. Indeed, over time, readers can discover that our portfolios are true alpha-producing strategies.
Conclusion
We recommend that long-term investors get back to Benjamin Graham basics and understand the companies that they are investing in. Passive investing implies buying crappy, overvalued companies along with potentially good companies. We invite readers to consult regularly our U.S. Total Market Techno/Fundamental Allocation Model for investing ideas and even mimic our successful allocation, provided in full transparency, for do-it-yourself investors. Investing in companies offering strong fundamentals provides a reassuring, tangible motivation for the investment and, over the long-term, will reward the patient investor.