An introduction to selection criteria’s to identify potential quality companies and sensible sector exposure limits within a portfolio
This paper was written to assist those not qualifying for government pension to make sage investment decisions. It aims to shed light on the methodologies involved in identifying prospective quality companies for further in depth evaluation. In other words I will talk about a selection criteria, which must inevitably involve some form of filtering.
Adopting a conservative approach with less need for sophisticated filters
One can opt to take the more conservative option by investing via LICs (Listed investment Companies ), where the evaluation of quality companies and determining value is a much more straightforward matter. This was illustrated in my prior paper on the subject. The advantage of investing in a large cap LIC is it will mostly cover the entire index for you.
However, to enhance your overall returns, you could also include in your portfolio a small cap LIC, on the expectation you expect small caps to outperform large caps. Another option is to include a LIC whose investments are principally overseas, should you consider the prospects are superior abroad.
It’s a matter of feeling comfortable with an investment strategy that reflects you aims and risk appetite.Sector exposure is also important to the extent we don’t want to
be overweight and risk a larger fall than applies to the index.
Sector weightingsTo recap it’s risky to be materially overweight in any one sector relative to the ASX. Their website provide relevant free information on sector weightings and performance. But it can be devilishly difficult to find. This paper sets out the detailed search steps for you.
However, before that, I need to quickly dispel the questionable common theme diversification in itself provides quality and safety.
The questionable theme of quality through diversification.This is the idea that a diverse mixture across different asset classes affords safety since as one sector falls it will be compensated by a rise in another asset class held in a portfolio. This is only true at times and it’s a terrible idea if you were only to be invested in shares and interest bearing securities. By way of example take the present US market where most interest rates are fixed whereas in Australia they are mostly variable. The risk for a US investor is if both inflation and interest move up faster than is anticipated, both Bonds and shares will both fall. That’s not the case for Australia because variable rates apply here (as in so many points over the 90 bank bill rate) so shares could fall but it doesn’t mean a fall in interest bearing securities. But nor does it mean one asset class affords protection over the other.
And if there was to be much higher interest rates in Australia I think it very likely house prices, consumer discretionary shares and banks would all fall simultaneously. The so called safe haven gold sector long term is one of the worst long term performers whose price does not keep pace with inflation. That doesn’t mean all the shares in the sector are duds, as you have some that performed very well.
Sensible sector limits
Rather obviously there is nothing wrong with diversification, except don’t presume it will always protect you, to offset falls in one asset class with rises in another. Instead what I propose for you is to consider a few simple rules:1. No share or individual security to exceed 5- 10% of your total investment portfolio. I use 6%.
2. No sector exposure exceeds 15 to 20 % of your total portfolio. I usually use 15%.
Limiting exposure to sectors
However, one can calculate accurately each sectors current relationship with the total index at any time. I invite you now to follow these links from the ASX website
Firstly go to the ASX website https://www.asx.com.au/index.htm#· Starting from home click on the top heading called Products and · Scroll down to the heading Indices – click on that.
This will take you to the screen headed ‘What are indices.’
· Scroll down under that until you see the sub heading of ‘Types to sector indices.’ · Click on sector indices
· Scroll down the heading and narrative headed ‘Types of indices’, until you see the minor heading: to learn more, please refer to the overview of Sector indices.
· Click on that and it will take you to the indices. You are S&P/ASX 200 Consumer Discretionary Index
An introduction to filtersAs you may recall Professor Benjamin Graham is known as the father of Value investing, who introduced the ideas of more value orientated share selection criteria’s. He authored 2 books namely Security Analysis and its much friendlier publication, Intelligent Investor.
Graham’s selection criteria was as follows:
· An earnings-to-price yield twice the AAA bond yield.
· A PE ratio (price-earnings ratio) less than 40% of the highest price-earnings ratio for the share over the past five years.
· A dividend yield of at least two-thirds the AAA bond yield.
· Share price no more than two-thirds of tangible book value per share.
· Total debt less than book value.
· Current ratio greater than two.(Ratio of current assets to current liabilities
· Total debt less than twice ‘net current asset value’.
· Earnings growth of prior 10 years at least at a 7% annual compound rate.
· Stability of growth of earnings in that no more than two declines of 5% or more in year-end earnings in the prior 10 years are permissible.
Comment & Explanation
Both Graham and Buffet were very successful in the early days using these filters to unearth and invest in undervalued entities. Successive acquisitions of undervalued companies, bore fruit in the form of an expanded share price as the quality of consistent earnings per share became much more widely appreciated.
There is nothing wrong with applying that criteria to day except I would suggest there are no companies trading on the ASX who will meet such strict filters. Probably none in the US either. If there was they would be an aberration and likely to be subject to some obscure circumstances that would render the share as ones to be avoided in any case.
To reiterate Graham and Buffet were hugely successful because they were able to operate in an era when quality companies could be bought very cheaply as value investing was virtually unknown.
However, with the use of computers and enhanced investor knowledge such opportunities no longer exist. Buffet has repeatedly told investors as far as Berkshire is concerned the salad days are over. Even so the share price continues to grow along with his reputations as a sage investor and that of co-owner Charlie Munger. These days Buffett/Munger talk about 4 key Filters.1. Understand the business. Research.
2. An enduring competitive advantage. Patents, expertise and circles of virtue.
3. Protective moats- barriers to entry to create advantage.
4. Ensuring you have a fair value and or a margin of safety.
The idea of adopting filters has considerable merit and we can apply more realistic filters today in many different ways.Application of Filters
The easiest way to apply filters is to evaluate shares within sectors or industries to identify new potential buys and sells. The advantage of this approach is it is simple and rather obviously doesn’t involve any additional cost. But it would involve a lot of manual handling (unless you could plug into a google finance or yahoo website that has the info) and even more potentially burdensome calculation.
Alternatively there are many excellent platforms that I have road tested. I prefer Skaffold, because one determines your own filters. Their system gives me maximum flexibility. I never take any notice of model portfolios, although I concede this can be an ideal measure. It’s more a matter I just like to do my own thing so that if I make a mistake I can only blame myself.
I road tested Stock Dr for 3 months and I understand the rudiments of Intelligent investor. All are excellent platforms that have their own inherent strengths and weaknesses. That’s true of course for any system you use and emphasises the importance of understanding their modus operando, as in their particular way or method of doing something.Here are 2 illustrative examples of 2 filters – One for the entire share universe
u Only quality companies (rated by a number of factors inclusive of performance metrics ) with a prior track record
u Grown in share value > 5% past 5 years
u Future consensus growth>5%
u Return on equity >15%
u Has a continuing funding surplus
u Net Debt to equity < 50%
u Safety Margin over intrinsic value
Others filters might be confined to sectors, then broken down to micro, small. Medium, and large caps entities. As you can gather you can build up to a very large number of filters that can be employed across the ASX and abroad. This filter for instance is far less onerous aimed at unearthing a dozen or so names for further in depth analysis.u Fair quality companies (rated by a number of factors inclusive of performance metrics which aren’t too restrictive) with a reasonable prior track record.
u Grown in share value > 5% past 5 years
u Future consensus growth> 7%
u Return on equity >10%
u funding deficit no more than 10%
u Net Debt to equity < 100%
u Don’t have a Safety Margin and allow the stock to be up to 17% over valued.
Value Investing Tutor - University of the 3rd Age.