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Attracting Winning Stocks: The MAGNET Stock Selection Process

by Wayne A. Thorp, CFA

Attracting Winning Stocks: The MAGNET Stock Selection Process Splash image

Most quantitative stock screening methodologies have a “style bias,” meaning they focus on growth in sales or earnings, value measures such as low price-earnings or low price-to-book ratios, or share price momentum.

From time to time, you will find blended approaches, such as “growth at a reasonable price” GARP, which straddles the fence of value and growth investing. Similarly, price momentum is sometimes added to a value strategy to find “value on the move.”

Jordan Kimmel takes the process one step further and combines all three—value, growth, and momentum investing approaches—into a singular investing model. His own name for his unique style: The MAGNET Stock Selection Process.

Jordan Kimmel is the managing member of the Magnet Investment Group, LLC, which has previously licensed its stock selection process to John Nuveen & Co. for use in that firm’s unit investment trusts. Kimmel also hosts his own weekly radio show “Profitable Investing With Jordan Kimmel.”

Mr. Kimmel outlines the MAGNET Stock Selection Process in his book “Magnet Investing” (Next Decade, Inc., 2000), currently in its second edition.

The Philosophy

For Kimmel, MAGNET stocks offer a blend of technical and fundamental characteristics “that pull investors into shares, as though by magnetic attraction, resulting in rapid price increase.”

Kimmel believes the MAGNET process “encompasses the best of the momentum aspects of the market, while demanding the downside protection of a value approach, and insisting on top-line revenue growth.”

The MAGNET acronym is as follows:

M Management must be outstanding, and momentum must be improving;

A Acceleration of earnings, revenues and margins;

G Growth rate must exceed valuation;

N New product or management may be the driver;

E Emerging industry or product creates opportunity; and

T Timing needs to be right (technically poised for expected price increase).

Kimmel has created quantitative filters to sift through the stock universe in search of MAGNET stocks. He feels that with today’s computerized screening tools, individual investors can easily identify their own MAGNET stocks.

Furthermore, in what he terms today’s “institution-dominated market,” Kimmel feels that individual investors have an advantage over large mutual funds and pension plans in that they have the flexibility in buying and selling that these large institutions lack.

The MAGNET Approach in Brief

Philosophy and Style

Investors are best-served by investing in stocks using an approach that incorporates strong market momentum along with top-line revenue growth and provides the downside protection of a value approach. Using computerized screening tools, individual investors can use quantitative filters to sift through the stock universe in search of these MAGNET stocks.

Universe of Stocks

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No restrictions on initial universe of stocks against which the MAGNET filters are run.

Criteria for Initial Consideration

Stocks should possess the following MAGNET criteria:

   Management must be outstanding, and momentum must be improving;
A    Acceleration of earnings, revenues and margins;
   Growth rate must exceed valuation;
N    New product or management may be the driver;
   Emerging industry or product creates opportunity; and
   Timing needs to be right (technically poised for expected price increase).

Secondary Factors

Technical indicators are used as confirmation once a company meets the fundamental MAGNET requirements. The indicators include:

  • moving averages,
  • stochastics,
  • moving average convergence/divergence (MACD),
  • relative strength,
  • volume analysis,
  • insider trading, and
  • point & figure charting.

Use the search tool at AAII.com for more information on these technical indicators.

Stock Monitoring and When to Sell

  • Sell if a stock begins to deteriorate on a technical basis.
  • Sell if a stock becomes overvalued relative to the fundamental MAGNET selection criteria.
  • If a stock’s price falls 15%, investigate why the price is dropping and evaluate if there are factors that would point to a recovery.
  • Sell if a stock’s price falls more than 20%.
  • Use trailing stops to help get out of losing trades, but do not make them too tight (which he considers to be 7% to 8%).
  • Do not let tax implications hinder the ability to be invested in the best names possible.
     

MAGNET Criteria

In “Magnet Investing,” Kimmel outlines several factors he considers when seeking out Magnet stocks:

Management & Momentum

Kimmel believes that a company’s management is its most fundamentally important element. Management is responsible for attracting top talent, encouraging innovation from its employees, and providing effective leadership.

To show that management has a vested interest in the company, and that its interests are more closely aligned with those of individual shareholders, Kimmel prefers that management own a “substantial percentage” of its stock. However, he does not quantify what that percentage should be.

A stock’s momentum usually refers to the relationship between the movement of its price and the movement of the overall market. The most common representation of this relationship is relative strength.

There are many ways to measure and present relative strength. Oftentimes, relative strength measures the price performance of an individual stock against a major market index such as the S&P 500. But no matter which measure you may use, MAGNET stocks should have increasing price strength relative to the market for at least the last few months.

Acceleration of Earnings, Revenues and Margins

Growth for the MAGNET model revolves around revenue growth and, to a lesser extent, earnings growth.

As Kimmel puts it, “revenue growth is what it is.” If a company sells more of a product or is able to raise the price of its product, its revenues are going to increase. In his mind, it is difficult—but not impossible—to “manufacture” sales.

Although he does mention earnings growth as one means of identifying growth companies, Kimmel is also extremely critical of Wall Street’s infatuation with earnings, given that earnings are susceptible to “manipulation” by management. As Kimmel puts it, “if you lie about revenues, you go to jail, but it’s perfectly legal to massage earnings.”

Kimmel points out that companies may grow revenues through acquisitions, but these acquisitions are sometimes detrimental to shareholders and the company over the long term. For this reason, the MAGNET model also looks at profit margins—the percentage of revenues a company ends up with as profits. If a company is able to maintain or expand its margins as it makes acquisitions, that is fine with Kimmel.

Kimmel is not impressed by companies that are improving earnings without expending revenue by simply tightening their belts and cutting costs. MAGNET companies with growing revenue and accelerating margins will, by definition, see their earnings increase, in his opinion.

Since margins vary across industries, it is best to compare company levels to industry norms. Also, it is useful to analyze company margin trends over time.

In his book, Kimmel refers to gross profit margins as an indicator of management effectiveness. Gross income is what is left over from revenue after deducting a company’s cost of goods sold, and the gross margin is the percentage of gross income to revenues.

When examining the trend in gross profit margin, Kimmel does not require that it be continually rising. At a minimum, however, it should not show a decline from prior reporting periods.

Margins can also serve as a proxy for examining the quality of management, part of the “M” element of the MAGNET process.

Growth at a Discount

Having provided elements to attract momentum and growth investors, Kimmel caters to value investors by stressing the importance of not overpaying for a company’s growth prospects. This will serve to attract value-oriented investors to MAGNET stocks.

In “Magnet Investing,” Kimmel calls for looking for companies whose current market valuation, as measured by the price-earnings ratio, is no more than one-half its projected growth rate. Therefore, if analysts are forecasting a company’s earnings to grow at 20% annually over the next three to five years, its price-earnings ratio cannot be any higher than 10 to meet the MAGNET selection criteria.

Another way to put this is that a company’s ratio of price-earnings to estimated earnings growth rate, or PEG ratio, must be 0.5 or lower. Kimmel feels that such valuations normally occur just before companies “become popular” with investors or when they have temporarily fallen out of favor with the market.

New Product or Management

When a new management team comes into a company or when a company introduces a new product, this often spurs renewed interest in the company. However, these elements tend to be qualitative in nature and difficult to capture with a quantitative screening approach.

As a proxy, Kimmel points to price momentum—when a company is experiencing increasing price momentum, something is usually going on with the company. This “something” may be new management or a new product.

Price momentum was already captured in the “M” element of the MAGNET approach.

Emerging Industry or Product

Kimmel feels that companies in emerging industries represent good investment opportunities for investors who have a clear understanding of the technologies and processes being used. Again, this represents a qualitative aspect of company analysis. However, Kimmel has said in interviews and publications that companies able to find a new market for their product(s), or that come out with a truly new product, are likely to see accelerating sales and earnings, improving margins, and improving price momentum.

Timing

Kimmel stresses the importance of distinguishing between a good company and a good investment. Sometimes one can find a company that is growing revenues and sales, is improving its margins and is attractively priced—yet it only becomes more attractively priced as its stock price falls (unless earnings are expanding faster than price).

To help him decide when to buy, Kimmel uses several technical indicators to enhance his market timing. He uses technical analysis as confirmation once a company meets the fundamental requirements of the MAGNET model. The indicators he uses include moving averages, stochastics, moving average convergence/divergence (MACD), relative strength, volume analysis, insider trading, and point & figure charting. (Use the Search tool at AAII.com for information on these technical indicators.)

When to Sell

On the sell side of things, Kimmel usually holds a stock for six to nine months. He sells when a stock begins to deteriorate on a technical basis or becomes so overvalued on a fundamental basis relative to the MAGNET selection criteria that it “de-selects” itself. Kimmel also uses trailing stops to help get out of losing positions, but he believes that 7% or 8% stops are too tight. If the price falls 15%, he investigates why the price is dropping and decides where there are factors pointing to a recovery. When the price falls more than 20%, he sells.

Kimmel’s portfolio turnover is high—over 100% per year—yet he doesn’t mind the tax implications of turnover if it allows him to be invested in the strongest names available.

AAII Stock Screens on the MAGNET Approach

As part of AAII’s ongoing Stock Screens series, AAII has developed two new stock screens based on Kimmel’s MAGNET methodology, as outlined in his book. A description of AAII’s MAGNET screens can be seen here.

You can regularly follow these two new screens—and all of the AAII screens—by going to the Stock Screens section of AAII.com. The Web site posts the results of all of the AAII stock screens, including a list of all passing companies, and the performance of hypothetical portfolios of companies passing the various screens. The screens are updated on a monthly basis.

Wayne A. Thorp, CFA is a vice president and senior financial analyst at AAII and editor of Computerized Investing. Follow him on Twitter at @WayneTAAII.


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