For this holiday weekend (at least for banks, government, and the stock market), I offer today's email from the AAII regarding the favorite stock picks of the organization's membership.  The essay also serves as a pretty good primer on investing including how to use value and momentum to achieve maximum gain.  For those of you who work in finance or government, enjoy your holiday.  For those who don't, enjoy your week and, as always, stay warm.

Sun, Jan 14, 2018 11:34 am

An AAII Discussion   Stocks AAII Members Follow ... Before we get into a study of the kinds of stocks that AAII members follow, I want to address one final and common investment concern that came through loud and clear in the “Stock Investing Problems” research that I recently conducted. That problem (if you want to call it a problem) is that many AAII members wonder if NOW is the right time to invest. A key tenet to investing is the belief that markets rise over time.  You see, time is the key ... I too used to fret about market tops (or bottoms) until I found the data that I am putting in front of you now.  In a nutshell, research of return periods shows that the average market downturn takes less than eight months to recover — top to trough to top again. Since 1871, market downturns have recovered as follows: 33% of market downturns recover within a month 50% of market downturns recover within 2 months 80% of market downturns recover within 1 year 95% of the time, those big “once or twice in a lifetime drops” return back to even in 3 to 4 years Collectively, since 1871 the time it takes for the market to recover (top to trough to top again) is a mere 7.9 months Unfortunately, most individual investors watch daily, weekly, monthly and quarterly market moves like their life depends on it. So simply think about the data above the next time you fear we are at a top.  Also remember that, unless you have a crystal ball, you will likely never accurately know when we are at a top or a bottom.  Therefore, just simply realize that long-term investing works and that AAII has your back in trying to put in front of you quality investment ideas, tools and direction. In fact those three words reflect the project I am currently working on. Now that we are no longer afraid of Mr. Market, I do want to warn that ... You may be chasing the wrong kinds of stock: Earlier in the week I asked the AAII Membership to share with me three stocks you invest in or follow.  The results were fascinating. I received many, many responses, but the most interesting part of knowing what AAII members invest in was seeing the overlap or intersect between our collective ideas. So let me share with you three of the most-followed stocks and how I view their current investment attractiveness. Some of what I am going to share is not pretty, but I think that as you read my insights, you will start to see that there is a better, more stringent and far easier way to pick interesting stocks to invest in. My method focuses in on Value, Momentum and Quality (VMQ) and I will try to illustrate how I look at these criteria by using the following stocks AAII Members submitted: AT&T (T) AT&T (T) is a popular stock among many AAII members because of its dividend and financial stability. The telecom giant yields in excess of 5.3% and has been growing its dividend by a penny per share for years. It’s also cheap, with a price-to-book ratio of 1.90, a price-to-sales ratio of 1.4 and a price-to-cash-flow ratio of 5.5. If I was only considering valuation and financial strength, an argument could be made for AT&T. I’m not, instead purposely choosing to also look at a stock’s price momentum. This is where AT&T fails. During the second half of last year, AT&T’s price returns lagged the majority of U.S. traded stocks. In other words, it was a so-called value trap: a stock with a cheap valuation, but not a rising price. Investors in aggregate have looked at AT&T and decided it deserves to be cheap. Therefore, AT&T does not qualify as a VMQ stock. UnitedHealth Group (UNH) Investors (and many AAII members) have also shown a favoritism toward UnitedHealth Group (UNH). Shares of the health insurer outperformed nearly three-quarters of U.S. traded stocks during the second half of last year. Good news for those who held the stock. There are underlying reasons for the price increase. The company has been growing its dividend and analysts are raising their earnings expectations — positive signs of underlying quality. Unfortunately, the good news is already priced into the stock. UnitedHealth’s price-to-book ratio of 4.78 is higher than three-quarters of all stocks and its price-to-cash-flow ratio of 63.2 is higher than nearly two-thirds of all stocks. While I wouldn’t say the stock is downright expensive, it is certainly no bargain at its current valuations and therefore not a VMQ stock. General Electric (GE) was also an AAII member favorite Sometimes, a stock does not qualify as a VMQ stock because of its financials. General Electric (GE) is a good example of this. As most of you have probably heard, GE has not been cash flow positive. Its negative cash flow — meaning more cash went out of the business than came in — makes it impossible to calculate a price-to-cash-flow ratio. Could we assess GE’s valuation just on the balance sheet (price to book) and the income statement (price to sales)? Yes, though with a price-to-book ratio about equal to the midpoint for all stocks, GE still does not quality as being cheap. More importantly, by judging a stock’s valuation based on all three financial statements — the balance sheet, the income statement and the cash flow statement (price to cash flow) — we get a quick idea as to whether the company isn’t fundamentally sound even before we overlay our quality analysis. (No ratios or high valuations can signal such things as little cash flow or high leverages.) But, let’s say we just used two instead of three valuation ratios. General Electric still wouldn’t qualify because its stock underperformed nearly 90% of all stocks during the second half of last year. We’d also have the issue of the company’s recent decision to cut its dividend. Data from Ned Davis Research shows shares of companies that cut or suspend their dividend barely rise in price over the long term. So, even if GE’s valuation is completely ignored, it still wouldn’t be a VMQ stock. Simply put, we want good companies trading at low valuations with an outperforming stock price. AT&T, UnitedHealth Group and General Electric do not match these demands. So I provided a quick narrative of what these companies do and why I don’t necessarily favor them for YOU, the individual investor. Remember, all of these companies were submitted as stocks favored or followed by AAII members. I was able to pull all of the reports on these companies and determine the quality of these ideas using an interface that I built, and I will be sharing more about the interface and the VMQ approach in the coming days. I have nothing personal against these member favorites, it’s simply that I don’t think they are the most attractive candidates because they possess too few of the traits associated with upside according to my research.  The way I evaluate and research a stock is influenced by the work done by: Mebane Faber, Cliff Asness, Charlie Munger, Joseph Piotroski, Wesley Gray, Walter Schloss and Robert Arnott. Their collective work along with my own thoughts indicate that investors are better off buying stocks that have Value, Momentum and Quality attributes. Turning Problems Into Solutions I’ve been talking all week about turning problems into solutions, uncovering promising stocks, learning how to evaluate them and knowing what data to use to evaluate them.  The interface I’ve been working on is the backbone of a stock-picking approach that I am following and it leads me to stocks with promising scores in the three areas that count — Value, Momentum and Quality.  In a moment I want to introduce you to a unique VMQ stock, United States Steel Corp. (X) but first here are some insights and distillations about why Value, Momentum and Quality are a preferable way for investors to find winning companies. To jog your memory, and to bring those late to the conversation up to speed, I am providing a thumbnail picture of two of my favorite charts, so you can see the impressive returns garnered from value stocks as well as momentum stocks. The third chart I’m showing below in full size is an important one. Value and Momentum Combined work very well together  The chart below is new to our conversation and probably needs a little explanation.  I received the data from our friends at S&P Dow Jones Indices. This visual shows the performance of High Momentum/High Value (an area I call the Investor Sweet Spot) vs. the overall market as measured by the S&P 500.  You’ll note the 15-year annualized return is about 14.5% vs. about 9.9% for the S&P 500. That’s an annualized return 46% higher than the overall market — achieved simply by combining value attributes with momentum attributes.  To put that into real dollars, for the past 15 years one dollar invested in the overall market would have grown to $4.12 but one dollar invested in High Momentum/High Value would have grown into $7.62 — that’s a huge difference in investment outcomes for those who embrace investing via Value and Momentum. Value and Momentum have some serious backers who have made not only considerable names for themselves but considerable fortunes. In my study of using Value, Momentum and Quality (VMQ) to pick stocks, I came across these quotes and I thought some words of wisdom and encouragement from the best and brightest practitioners in the VMQ area would be beneficial to all of us... Value Investing has some big backers: Walter Schloss: “If a business [stock] is worth a dollar and I can buy it for 40 cents, something good may happen to me.” Warren Buffett: “There seems to be some perverse human characteristic that likes to make easy things difficult.” Benjamin Graham: “Price is not equal to value. Price is what you pay, value is what you get.” Momentum Investing is acknowledged by prominent investors: Eugene Fama: “The premier market anomaly is momentum ... stocks with high past returns tend to have high future returns.” Richard Driehaus: “I would much rather invest in a stock that’s increasing in price and take the risk that it may begin to decline than invest in a stock that’s already in a decline and try to guess when it will turn around.” How Value, Momentum & Quality Direct Me Toward Profitable Investments A common misperception among investors is that if you want a rising price, you should invest in growth stocks. The reality is that you want VALUE. Value investing seeks stocks whose valuations are less than the market average. You are paying a price below what other investors may be willing to pay for the same stock in the future!  Think about that for a minute — that’s what investing is all about.  Buying something now that you can sell in the future for more.  Successful Value Investing gives you an advantage because value stocks have upside. Historical data shows a clear advantage to value investing. Over the last 80 years, value stocks have outperformed growth stocks by 10 percentage points per year on an annualized basis. According to data tabulated by Dartmouth professor Kenneth French, value stocks have returned 18.1% on annualized basis versus 8.1% for growth stocks. There is a simple formula I’ve created to explain why this is the case:  High Valuations = High Expectations = More Room for Disappointment When a company is growing strongly or is expected to grow strongly, buzz starts to grow about the stock. The company is featured in the media, analysts make predictions for a bright future and people start talking about it. As more and more investors buy shares, the stock’s price rises. As the price and valuation rise, so do expectations about the company’s performance. Eventually, expectations reach the point where when the company reports very good but not great quality results, investors are disappointed (they sell) and the stock price falls. This happens time and time again and it is the major downfall of chasing growth stocks. Value stocks do not have this problem. They trade at discounts because investors aren’t expecting great things from them. When a value stock reports good earnings, investors do a double-take. Some start buying the stock, but others are slow to change their perception. This often leads to a long upward ramp where the company can report good earnings for several quarters before buzz starts to really build. In the meantime, those who got into the stock when its valuation was low are enjoying a rising price. If you’ve ever looked at a chart and told yourself, “I wish I had bought the stock when it was still trading at $X price, then value investing is right for you.  Successful Value investing is buying a company when its shares are on sale. It’s how many successful investors have grown wealthy. But as a student of investment research, I have found another component to my stock-picking toolkit that works perfectly with a value investing style  — Momentum. Momentum is somewhat opposite of value — I hope I didn’t lose you there?  Read on, this is important...  Momentum refers to a stock’s price performance. Specifically, momentum stocks have higher returns relative to most other stocks. Momentum works because investors like winners. When a stock is outperforming, investors gravitate toward it and want to own it. This typically leads to further outsized returns. Small-company stocks with strong momentum have realized annualized returns of 19.7% over the past 80 years, versus 9.5% for small-company stocks with weak momentum. A similar differential exists for large-company stocks: 15.0% versus 4.8%, according to data compiled by Kenneth French. Value and momentum pair well together because they are so different. When one underperforms, the other may outperform. Plus, when a value stock has strong price momentum, it tells you that other investors also recognize the stock as a bargain and you get to load up on that stock before the masses even know about it.  Using Momentum is like having access to a poker player’s “tell” when you sit down at the card table — it’s invaluable! Though value and momentum pair well together, trying to use just these two traits together results in a large number of stocks being identified — too many stocks for most investors to successfully choose among. This is where QUALITY comes into play. It enables to you to reduce the list to a manageable level by weeding out the companies with poor financial strength A quality stock has underlying traits associated with more potential for upside returns and a lesser chance of disappointing. Put another way, quality tells you whether or not a company is sound financially. It can keep you from owning stocks of risky companies. To understand Quality, an investor must dig into a company’s financial statement and look at criteria like net income, cash flow, operating assets and revenue.  This can be time consuming but it is worth it because the underlying data in the financial statement should depict how the company is performing, and it is the one area of investing that can’t be faked or hidden for too long. You see, I, prefer companies that aren’t aggressive with their accounting, are careful with how they use shareholder dollars and share their profits with shareholders. I also want to invest in companies that analysts are becoming increasing optimistic about. A Quality overlay can identify such companies. In fact, I am working on a research tool that grades stocks for QUALITY and as soon as I have more to share, I will let you know. The overall goal with the Stock Project I am working on is to be able to regularly present investors with a list of stocks that have the Value, Momentum and Quality attributes that I have been discussing in these emails. I want the list to consist of stocks that I would be comfortable sharing not only with AAII members, but also with my friends and family.  I want the list to contain all the data about each stock so the end user can know where the stock truly excels and how it stacks up not only on Value but also on Momentum and Quality. If you remember one thing from these emails it is to note that: Not all value stocks are buys ... Not all momentum stocks are buys and not all stocks with quality financials are buys ... It is when a company holds attributes of all 3 factors (Value, Momentum and Quality) that I am finding winners and I want to present this data in an organized way that we can all benefit from. I hope you see the value (pun intended) in what I am working on — as promised, here is an additional VMQ stock that looks promising. A VMQ favorite — United States Steel Corp. (X) Integrated steel producer United States Steel Corp. (X) is benefiting from a favorable economic backdrop, particularly economic growth in both the United States and Europe. This growth has led to improved pricing for both flat-rolled and tubular steel. More importantly, it has led to a rebound in sales for the company during the three quarters of 2017. While the VMQ Stocks approach is not focused on growth (because investors too often overpay for growth), it does consider whether a company is becoming more efficient, at turning assets into sales. U.S. Steel is becoming more efficient, as can be seen by the company’s improving asset turnover ratio. If inventory were sitting around versus going out to customers, this ratio would either hold steady or, more likely, decline. Put another way, U.S. Steel is responding to customers’ demands, but not in a way that would suggest management is being too optimistic. The effects of the favorable business momentum can also be seen in what analysts are doing with their earnings estimates for the company. Just last month, two analysts upped their profit projections for both 2017 and 2018, a positive sign. Investors have also taken note, with shares of U.S. Steel outperforming most other stocks over the last six months of 2017. Even with the good business conditions and the rising price, the stock is still trading at a bargain price. Shares of U.S. Steel are priced at just at 0.6 times sales and 27 times cash flow. These valuations are below what the majority of stocks trade for. So I hope you are examining United States Steel Corp. for your portfolio. It is a prime example for those interested in harnessing the promising attributes of using Value, Momentum and Quality to build a portfolio.  Later in the week, I will share with you some important news regarding the stocks we have been discussing. Wishing you ongoing investment success. Charles Rotblut, CFA Editor, AAII Journal  American Association of Individual Investors P.S. If you are not a stock investing kind of person, I understand and I applaud you for reading thus far.  Interestingly, many AAII members join the association because they want to become stock pickers or they want to gain confidence in their stock analysis capabilities.  If that’s YOU, please note that the stock I shared with you in this email could be of interest to you — it has all of the Value, Momentum and Quality attributes that we have been discussing in these emails. If you you don’t have the desire to invest in individual stocks, there are ETFs (exchange-traded funds) that also seek out  value, momentum and quality attributes for the stocks they buy. The biggest of them are iShares Edge MSCI Multifactor USA (LRGF), Alpha Architect Value Momentum Trend (VMOT) and MomentumShares U.S. Quantitative Momentum (QMOM). Just keep in mind that ETFs and mutual funds will not give you the control, flexibility and transparency of individual stock picking ...  Plus following an ETF is not going to give you the insight, education and practical experience you need to become a successful stock picker.  But I do know that these emails coupled with the special project I am working on do have the ability to teach you how to use Value Momentum and Quality to your advantage.  I’ve shared two stocks so far that pass the VMQ test and I intend to share one last stock with you on 1/18/18.