Use this quick checklist to compare stocks and find the best investments for your portfolio
I get a lot of questions about comparing stocks and how to pick stocks for different investing goals. While I usually recommend a larger picture when it comes to building your portfolio, there are a few things I like to look at when finding the best investments.
The topic fits well with Chapter 13 in The Intelligent Investor and our review of the book. We’ve worked past the investing plan chapters in the book and are working through some of the most popular chapters on picking stocks.
Pick up your copy of The Intelligent Investor and follow along with the series. I’m using the 2003 edition with commentary by Jason Zweig, writer of the Wall Street Journal’s Intelligent Investor column.
Check out last week’s review of Chapter 12 and Finding the Tricks and Traps in Income Statements by Julie Rains on Investing to Thrive.
Chapter 13 in the book compares stocks to highlight some of Graham’s requirements for good investments. The chapter is targeted to the defensive investor, someone that just wants a stable return without a lot of stock analysis work.
Graham’s Stock Comparisons Example
The first thing you notice on Graham’s stock comparison is that only one of the companies exists today. The rest have all been sold or merged. This isn’t something to be worried about as investors got cashed out in the others years ago but is just interesting when you compare stocks from decades ago.
Let’s look at the stock comparison used in the book before getting into some problems and maybe a few better metrics to follow. Graham compares the stocks through five measures before leading into his list of requirements for stock investing.
The first measure is profitability where Graham uses earnings per book value though another common profit metric is the net margin (net income divided by revenue). Profitability is a popular measure for investors because investment in shares is a call on future profits.
Stability is measured by changes in the earnings per share of the companies though the book doesn’t explain much as to why earnings changed for each stock. I understand that Graham just wants to compare a few quick numbers for investors that don’t have a lot of time but it seems the analysis is too superficial at times. It isn’t enough just to look at the change in a number without understanding why the number changed.
Graham measures growth by the trend in earnings per share, a fairly common metric followed by investors. I would add sales growth to this as well. Comparing sales growth with earnings growth can help see if the company is taking more market share or just keeping up with market growth as well as if it is able to turn operational efficiency into faster earnings growth.
The financial position of the companies is measured by divided current assets by current liabilities. This is also called the current ratio and measures the company’s ability to meet short-term (less than one year) payment obligations.
Finally, Graham compares the stocks by their percentage gain in share prices.
The chapter concludes with a quick look at seven requirements for investing which will be detailed in the next chapter. These include:
- Adequate size
- Sufficiently strong financial condition
- 20-years of dividend history
- No earnings deficit in past ten years
- 10-year growth of at least a third in earnings per share
- Price of 1.5 times book value or less
- Price of 15 times average earnings (three-year) or less
Some Problems with Graham’s Stock Comparisons
The biggest problem with the stock comparison in the book is that the four companies are in distinct industries and different sectors. If there is one thing you get from this article, remember to ALWAYS compare stocks against others in the same industry or at least the same sector.
Comparing a regional bank against a software provider is going to make one or the other look much better depending on the metric you’re using but it won’t help you pick the better stock.
Some industries trade for much lower price-to-earnings ratios by virtue of slower growth or outlook. Some industries may be cash flow machines, paying out high dividends, but trade for high valuations.
Sectors like consumer staples benefit from stable cash flows and companies can handle a lot of debt. The same cannot be said for many industries in the technology sector where cash flow is more sporadic. Just looking at a debt ratio like debt-to-equity is going to make all the consumer staples stocks look like they have way too much debt compared to stocks in the tech sector but it’s not really the case.
Using a stock screen that looks only for companies with a price-to-earnings of below a certain number or another metric is going to skew your stock picks into specific industries. That’s going to leave you exposed to only the risks in that industry and robs you of the benefits in diversification.
The seven stock requirements are also going to skew a portfolio to very mature and large companies. There’s some safety in only investing in companies that have been around for decades but even the most defensive investor needs exposure to smaller companies.
Not investing in any company that doesn’t have 20 years of dividend history would rule out great investments like Facebook, Google and just about anything in computers.
I highlighted the problem investing in expensive stocks in our chapter one review but a blanket rule for 15-times earnings across all stocks will have you investing in just a few industries. Of the 20,000+ stocks in the Morningstar database, just over 2,000 are trading at a price of 15 times earnings or lower.
It’s OK to invest in value but most of these stocks are in specific sectors like financials, telecom and utilities. You miss almost everything in healthcare and technology.
A final problem with comparing stocks on a simple screen like this is that you’ll constantly be adding new stocks and selling others that no longer meet the criteria. That’s going to add up to a lot of fees at $10 for a buy or sell order on most online investing platforms.
If you do decide to invest based on a stock screen, consider investing just once a quarter or even once a year. Make regular deposits into your investing account to keep saving but hold off to invest so you don’t rack up those fees. When you do invest, consider doing so by building a fund of stocks and exchange traded funds (ETFs) on Motif Investing which allows you to buy or sell the whole group for just one commission.
I’ve moved most of my investing accounts to motif investing on the ability to save money in investing fees and get better diversification in my portfolio. I invest in four funds on the site, each built around an investing theme that I customized, with one of the funds up over 22% so far this year.
What I Look for to Compare Stocks to Buy
Again, never compare the stats of stocks in different industries. It just doesn’t make sense.
If you’ve read some of my other posts, you know I like looking for bigger picture themes when investing in stocks rather than current stats. Some of my favorite ways to pick stocks to buy are on long-term catalysts like demographics and short-term economic issues making some sectors cheap.
Instead of looking at earnings, which can be easily manipulated by management, I like looking at cash flow from operations (CFO) and free cash flow (FCF). These are truer measures of the real cash generating ability of the company and less easily manipulated.
I’ll concede though that the defensive investor, on Graham’s definition, is someone that just wants simple guidelines to compare stocks. The defensive investor isn’t satisfied with just parking their money in an index fund but doesn’t have a lot of time to do detailed stock analysis.
If this sounds like you, try some of these measures for your stock comparison checklist.
Share price-to-book value or to earnings are a good start when comparing stocks in the same sector. Make sure you use earnings from the last four quarters or, better yet, average annual earnings over the last three years.
I do like dividends, might as well get paid while you hold a stock, and will usually screen for at least 1% yield. Stocks in the S&P 500 pay an average 2% yield so this will still keep your screen open to most companies.
Gross margin should be better than peers. Gross margin is the net revenue after paying for raw materials. It’s the first profitability measure I look at and a great way to see a company’s pricing power over suppliers. Cost of goods sold or raw materials are generally similar across an industry but really great management will be able to negotiate better prices and boost the gross margin.
I will look at operating margin, which is the company’s profitability after paying operating expenses (operating profit divided by sales), when comparing stocks but this can be manipulated with all kinds of expenses and adjustments. The gross margin is very useful in seeing the company’s competitive advantage in profitability.
Another profitability measure you can use to compare stocks is Return on invested capital. ROIC measures how well the company uses its capital resources like debt and equity. The equation is a little more difficult but all the pieces are easy to find.
The top part earnings before interest and taxes (EBIT, net of taxes) is also called net operating profit after taxes (NOPAT). It’s a measure of the earnings power of the company. The bottom part of ROIC is the capital invested in the company from debt owners and investors. You can subtract excess cash from the bottom part but finding that is a little further than most investors want to go in comparing stocks.
While even the most defensive investors should have some small- and mid-size stocks, I would keep it to companies of $1 billion or more in market capitalization. This narrows the field to just over 5,000 stocks in the Morningstar universe so there’s still plenty to choose from but it avoids some of the smallest and riskiest names.
Sales growth should be greater than peers in the same industry. This may be skewed if the company is aggressively buying competitors to add sales growth. Be on the lookout for big jumps in sales growth and try to compare stocks on ‘organic’ growth or the growth in their existing business.
Debt-to-equity should be less than competitors. This is a measure of how much financial leverage the company is using. Debt isn’t necessarily a bad thing for companies, especially with historically low interest rates. Using more debt instead of equity (stock) financing means investors don’t have to share the profits.
Still, you want to be wary of any company with a lot more debt than competitors. What happens if the economy stumbles and sales fall? More debt means less flexibility to maneuver and could mean trouble if times get tough.
The Interest coverage ratio is EBIT divided by the interest expense, both available on the company’s income statement. It measures how much the company is earning versus how much it is paying in interest on debt. Look for companies with a higher interest coverage ratio versus others in the industry to find financially healthy stocks that should have no trouble paying debt even in a crisis.
I ran through the eight measures above and it took just under five minutes to find all the information on each stock I was comparing. You can use a screener like Morningstar to find stocks that meet many of the criteria quickly, just filter by each sector to compare stocks in that group.
Filtering Your Stock Comparison and Investing in an Expensive Market
Of course, no company is going to hit all your measures when comparing stocks. The point in the screen is to narrow your choices down to a few stocks that do well on many of the criteria and don’t set off any warning signs in any metrics.
When you’re using these stock comparison measures, you’ll need to do it for each sector individually. That will give you the best of the best stocks in each sector instead of just picks from a few sectors that meet your criteria. This is going to give you a well-rounded portfolio that won’t be exposed to any particular sector or industry.
I need to make one more note about comparisons. Using these metrics is a relative comparison and won’t really tell you if a stock is cheap or expensive. A lower price-to-earnings may tell you that one stock is cheaper relative to another stock but who’s to say that they are not both expensive? All the stocks in the sector or even the entire market could be expensive at the time.
This is really where your asset allocation comes in. Sorry, that’s just investing jargon for splitting your money up into investments like stocks, bonds, real estate and peer loans on Lending Club. When stocks start looking expensive compared to long-term averages, you want to start putting more money in bonds, peer lending and other assets that might not get hit in the next stock market crash.
I highlighted three peer loan investing strategies for different investor types recently. Lending Club just announced an increase in rates which could mean higher returns to investors. Default rates have been creeping up but are still manageable with a diversified portfolio of loans. Peer loans are going to be my biggest asset class addition in 2017 after real estate as I ease back on stock investing.
Don’t miss next week’s review of The Intelligent Investor and Stock Selection for the Defensive Investor.
I like using qualitative factors like long-term catalysts when I compare stocks for my portfolio but I understand that many investors just want a simple stock screen to pick out a few names. Make sure you are comparing stocks within the same sector and diversify your portfolio across sectors. This will help you reduce risk and benefit on the Best of Breed stocks in each industry.