Guidelines for Adding and Removing Stocks, Part 2

Last week, we started the conversation about guidelines for determining when to add and remove a stock. We’re going to continue the conversation this week with a focus on investing styles. Specifically, we’re going to address value, size and growth investing. (Part 1 includes a list of the broad characteristics successful stock investing strategies share. If you missed it, you may find reading it to be helpful.)

Value investors seek to buy stocks trading at a perceived discount based on one or more metrics. Perhaps the most commonly used metric is the price-earnings (P/E) ratio. This ratio is simply the current share price divided by earnings for the last four quarters (aka, trailing 12 months or TTM). There are several other valuation measures, including the price-to-book (P/B) and the price-to-sales (P/S) ratios.

Some strategies use just one valuation measure. AAII’s Price-to-Free-Cash Flow screen is one such strategy. It requires a stock’s price-to-free-cash-flow (P/FCF) ratio to be below its five-year average price-to-free-cash-flow ratio and the industry median. No other valuation measure is used by the screen.

Others combine two or more valuation measures. AAII’s Model Shadow Stock Portfolio requires qualifying stocks to have a price-to-book ratio no higher than 0.90 and a price-to-sales ratio less than 1.2. The deletion rules for the portfolio require a stock be removed if its price-to-book ratio rises to three times the initial criterion. Under the current rules, this would be a price-to-book ratio of 2.7. The ratios are periodically adjusted to reflect prevailing market conditions. The philosophy never changes: Buy when the stock is really cheap, sell it when it is no longer a deep value stock.

The Value Grade used in A+ Investor and VMQ Stocks is based on a composite of valuation indicators. The Value Grade uses the price-earnings, price-to-book, price-to-sales, price-to-free-cash-flow and enterprise-value-to-EBITDA  (earnings before interest, taxes, depreciation and amortization) ratios as well as shareholder yield (dividend yield plus the buyback yield). Research by James O’Shaughnessy finds composite valuation measures work better than a single ratio.

Both our Model Shadow Stock Portfolio and our Value Grade have set parameters based on relative valuations. Relative in this case means looking at how a given ratio for a stock compares to the same ratio for all other stocks. The ratios for all stocks are then ranked from low (cheapest) to high (most expensive). Value investors seek to buy stocks trading with low ratios and sell stocks with high ratios.

Value Grades of A and B are assigned to stocks whose composite valuation rankings are in the lowest (bottom 20%) and second-lowest (21% to 40%) quintiles. Such quintiles reflect below-average valuations. The Model Shadow Stock Portfolio’s valuation metrics are set to reflect the bottom 10% of valuation as it follows a deep value strategy. Over the long term, portfolios comprising stocks whose valuations rank in the bottom 40% and particularly in the bottom 20% have had much higher returns than portfolios of stocks with high valuations.

An alternative use of relative valuation is to compare a stock’s current valuation against its historical average range. Doing so tells you whether a stock is trading at ratios that are higher or lower relative to what investors have paid in the past. AAII’s Dividend Investing portfolio uses this methodology. It seeks stocks whose current dividend yields are above their five-year average yields. Portfolio holdings are candidates for deletion when their current yields fall below their five-year average low yields. (Yield and valuation are inversely related, with a high yield signaling a cheaper valuation and a low yield signaling a more expensive valuation.) A similar strategy could be used with other valuation measures.

Before moving on to growth, we’re going to touch on size for a moment. Size refers to market capitalization. Small-cap stocks—especially small-cap value stocks—have outperformed over the long term. The Model Shadow Stock Portfolio seeks stocks whose market caps rank in the approximate smallest 10% of all NYSE-listed stocks. The cap for addition is currently set at $300 million, though the figure is periodically revised to reflect prevailing market conditions.

Some of you may have a preference for larger-company stocks instead. You could require stocks to be a member of the S&P 500 index or the Russell 1000 index. An alternative is to use relative size. The AAII Dreman With Estimate Revisions screen requires stocks to have market caps ranking the largest 30% of all stocks. This sets the floor for qualifying companies at approximately $1.8 billion.

Growth strategies seek improvement in sales and/or earnings. Like valuation, growth metrics can either be absolute or relative. They can also be a combination of the two (just like valuation).

The AAII Neff screen uses absolute growth. It requires a five-year sales growth rate of between 7% and 20%. It also requires future earnings to be expected to grow by the same percentage amount. John Neff wanted good growth, but established an upper limit to increase the odds of the growth rate being sustainable.

William O’Neil uses a combination approach. O’Neil’s CAN SLIM Revised 3rd Edition screen requires a three-year annualized earnings growth rate and a year-over-year quarterly sales growth rate greater than 25%. It also looks for a trend of rising earnings over the past few years and expectations for the growth to continue. (Both the Neff and O’Neil approaches are used by our Stock Superstars Report.)

The A+ Investor Growth Grade uses a composite of growth measures. It considers the year-over-year change in quarterly sales, quarterly earnings and quarterly operating cash flow. It also factors in the five-year growth rates for sales, earnings per share and operating cash flow. Like the Value Grade, the Growth Grade uses a percentile ranking system. In the case of growth, the stocks with the highest growth rates are assigned grades of A and B (strongest 20% and 40%), while the stocks with the slowest growth rates (which may be negative) are assigned grades of D and F (weakest 20% and 40%).

Those wanting additional ideas, including specific criteria, for value or growth can look at AAII’s Factor Stock Screens and Guru Stock Screens. On the webpage for any given screen, click on “Learn How To Do It.” You will find the specific traits that passing stocks are required to have, which you can choose to incorporate in your personal rules for adding and removing stocks.

There’s a lot here, so I’m going to leave you with a few thoughts. There isn’t a single “best” valuation metric. Rather, the data shows that investors get the benefit of value investing by buying stocks trading at below-average valuations. If you have a preference for, say, price-to-sales, price-earnings or some other ratio, use it. Just be consistent in your use of value metrics on the buy and sell side.

For growth, the rates of change sales and earnings tend to be the big indicators, though cash flow is used in some strategies. A consistent pattern of growth is good but be cognizant of the cyclicality of certain industries. (And take seasonality into account if looking at quarterly numbers.) Watch out for very high levels of growth as it is typically not sustainable. For every Amazon.com Inc. (AMZN), there is a very long list of failed companies that enjoyed brief periods of strong growth before flopping.

Finally, regardless of whether you favor growth, value or a blend, a big key to having a successful strategy for buying and selling is to write down your rules. Our Portfolio Composition and Notes Worksheet can be a good place to list those rules.