As you begin this contest, you are probably thinking: How do I build my portfolio, what should I choose, what ideas do I select and what ideas do I ignore?
There are many intelligent ways to analyze the financial markets and build a portfolio. Some methods produce practical, actionable ideas; others… not so much. You may have your own way to approach this contest based on what you already know. Maybe this knowledge came from what you learned through courses, your own experience or investments you’ve seen your friends or parents make. However you do it, it’s smart to have a thoughtful method to guide your selections. In investing, having a well-defined process really matters.
As this is my profession, I devote most of my work day to researching and selecting stocks. You may not be able to make that time commitment, but you might be able to take some aspects of my approach and begin to create your own unique perspective on investing. So, let’s dive in—here is how I do what I do.
Step one: Screen / rank stocks from your investment universe
How do I decide what’s the “best company”? I’m a value manager, so I have a particular way of looking at things. I start by analyzing the current valuation of the stock versus its long-term history. I am simply interested in identifying stocks that are statistically cheap. Focusing on what is the cheapest is the best way to narrow your field of focus. I believe that history has already shown which metrics are most important for each sector. For example, banks traditionally trade on price / earnings multiples. When ranking banks, I look for opportunities where a company is trading one standard deviation below its long-term average. Consistently identifying good businesses trading below their long-term average valuation is a starting point for investment success.
Step two: Fundamental analysis
Now we have a short list and we’ll look more closely. We’ll take a deeper dive into the accounting statements and we’ll also analyze corporate strategy. Does the strategy make sense, is it too aggressive (what dangers are they ignoring?) or too conservative (what opportunities are they missing?). We meet with management to ask them these questions. We’ll listen to what they’re saying and how they say it—are they enthusiastic, curious about the competition or ignoring it? We’ll also tune in to what they’re not saying—are they evasive?
We build a model that allows us to assess the company’s long-term potential, and stress-test key drivers in the business. When companies face short-term operational issues, markets overreact. This creates buying opportunities. We want to assess the earnings power of the business once management’s actions have addressed the transitory problem. For example, consider the investment in Empire Limited, operator of the Sobey’s grocery store chain. We want to understand the earnings power of its business in Western Canada when successfully integrated and not experiencing an energy-driven economic slowdown. Ultimately, we use this to value the business…what’s it worth? This is the key question! We organize this knowledge to create an investment thesis that clearly outlines our position. We are looking for an investment idea that is contrary to the consensus perspective—something the majority is overlooking.
The litmus test
Finally, there’s the ultimate test of whether we have a potential winner: what’s the price?
We might believe a stock is worth $50, but it’s trading at $30. Are we seeing something that others are overlooking? Or is Mr. Market seeing something that we’re overlooking? Which view is a more accurate take on this company’s value? At this stage, it can help to be part of a team, where some team members play “devil’s advocate” by challenging and probing your ideas, asking you to defend them.
Keeping it real
Even though this is a contest, I’d also recommend a final gut check on your selections. Would you take your own hard-earned money and buy this stock? I have my own version of this gut check because a large part of my net worth and my family’s net worth is invested in funds that I manage. This reminds me that this process is much more than just an academic exercise—it has real-life consequences. I believe more portfolio managers should eat their own cooking.
Next time… Keeping your emotions in check
Colum McKinley, CFA
Portfolio Manager, Canadian Equities, CIBC Asset Management