Selecting Stocks
When selecting individual stocks to invest in there are
literally tens of thousands to choose from. In order to find the best
investment opportunities it is necessary to filter out the stocks that don't
serve our investment objectives.
Using a website like www.digitallook.com the task can be
reasonably quick and simple.
Sectors
There are certain sectors I avoid due to the fact I don't
understand the business model or I feel the competition and profits in these
sectors hinder their investment attractiveness. Examples of areas I avoid
include Banking and Insurance (too complex) and Travel and Leisure (cyclical
and highly competitive). Other areas such as REITs and Oil and Mining companies
I usually prefer to invest in ETF or ETC of the commodities they are associated
with.
I also want to invest in industries I see having a future. A
chain of shops that sell CDs is in a dying industry and best to be avoided.
Size
Investing in smaller stocks gives the investor the potential
to make more money (it's much more possible a $100m company can double in value
than a $100b company). Smaller stocks do carry more risk and should not make up
a large proportion of your portfolio. Filtering out companies with a market cap
below $500m is probably a good starting point.
Dividend Yield
I tend to demand a dividend yield above 4%. Currently in the
FTSE100 33 stocks yield more than 4% so there are plenty of decent
opportunities.
Check that the dividend is sustainable and secure. Make sure
there is some cover to the dividend and that the company can afford to keep
paying it in the future. Also check that the dividend is consistent and has
been steady of rising over the last 3 years. Avoid any company that has reduced
its dividend.
Check analyst forecasts for future dividend and make sure
they are steady or rising. Again avoid any stocks that show falling future
dividends.
Director Dealings
As a final check I like to see what the insiders are doing.
Directors of the company have to disclose by law every time they buy or sell
stock in their company. These guys clearly know a lot more about the company
than the average investor does. If they are selling then it is a clear warning
sign not to invest.
Valuing Stocks
So now you've found a promising stock in a sector you are
comfortable with and the directors aren't running for the hills. The dividend
looks stable/rising. How can we estimate the expected future returns of the
investment.
Yield
The first part is the yield. I prefer to use the 3 year
average dividend to calculate the yield. Admittedly this penalises growth
companies but I see these as being less predictable so I can live with that. To
calculate the 3 year average dividend you simply divide the total of the last 3
years of dividends by 3.
Dividend 2011 40p
Dividend 2010 35p
Dividend 2009 30p
The above company would have an average 3 year dividend of 35p. If the current share price is 500p
then the 3 year average dividend is 7%.
Growth
For the growth rate I use analyst estimates. I assume
analysts know something but I don't trust them 100% so I will adjust their
growth estimates to more conservative levels. Depending on the size of the
company I will use between 33% and 40% of analyst growth estimates. For example
if analysts estimate an average 10% annual dividend growth per year for the
next 3 years I will use a 4% growth for a big company and 3.3% for a smaller
stock. This gives us a margin of safety on the growth rates.
Adjustment
Finally comes what I call adjustment. Stocks have been fairly
expensive in comparison to the past. There are a number of reasons for this but
I want to include an adjustment in my model to reflect a reversion to the mean.
I set the mean as being a 5.5% average dividend yield. So for a stock with a
2.75% dividend it would need to half in price to give a 5.5% dividend. I would
then discount this over 20 years:
1-((2.75%/5.5%)^(1/20))
= -3.4%
Final Verdict
Using the three factors above we can come to a conservative
estimate of the future returns we expect from such an investment.
Expected Return = Dividend
Yield + Growth Estimate + Adjustment
Our margin of safety comes from using a 3 year average
dividend yield, which if we are only investing in stocks with rising or steady
dividends will always be less or equal to the current yield. The growth
estimate is reduced by 60-67% of analyst estimates giving us some breathing
space if the company misses its targets. The adjustment factor ensures that we
avoid over priced companies. Even growth companies have to eventually revert to
more modest valuations as they mature and this takes into account this factor.
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