A Systematic Framework For Selecting Financial Stocks

I’ve thought for a long time about better ways to select stocks in the financial sector. Many screens explicitly or indirectly exclude financial stocks. It’s become a somewhat popular chorus in recent years that financials are too risky or too opaque to invest in. However I do not take this view, I’m of the opinion that no asset class or sector is inherently unattractive. There is plenty of money to be made in analyzing financial stocks judging by the portfolios of some of the more renown value funds such as Arlington Value and Tweedy Browne. 

I’ve settled for customizing Piotroski’s Fundamental F-Score as a way of quickly and efficiently sorting promising financial companies from the ugly ones. Recall that the original F-Score is a 9-point scoring system used to screen promising stocks. For each of the 9 measurements that improved over the last year, a company would score a 1; otherwise it would get 0. With scores ranging from 0 to 9, companies with low scores were unattractive and companies with higher scores were attractive. The F-Score alone was found to produce good results historically. However, financial companies are explicitly screened out. Indeed, a lot of the metrics would not apply to financial sector stocks anyways. Therefore I removed from consideration the following tests that I felt were irrelevant to the sector.

- Positive Free Cash Flow

- Current ratio improves over the previous year

- Gross margin improves over the previous year

- Total asset turnover improves over the previous year 

I kept the remaining 5 tests and added one more of my own to capture improvement in overall leverage (from having thrown away the current ratio test), therefore making it a 6-point scoring system, with the following tests:

1) Net income is positive, score 1, otherwise 0
2) Return On Assets latest year is greater than ROA previous year, score 1, otherwise score 0
3) Operating cash flow is greater than Net income, score 1, otherwise 0
4) Ratio of long-term debt to total assets latest year is equal or less than Ratio of long-term debt to total assets previous year, score 1, otherwise 0
5) Shares outstanding latest year is equal or less than Shares outstanding previous year, score 1, otherwise 0
6) (New) Financial leverage (total assets divided by total equity) latest year is equal or les than Financial leverage previous year, score 1, otherwise 0

Using Portfolio123’s screen building tool, I backtested groupings of this modified Piotroski score against an equal-weighted portfolio of all the Financial sector stocks in the total market S&P 1500 index. Portfolios are formed every 4 weeks and held for 1 year from June 1999 to June 2015. 

 

 

While the annually rebalanced portfolios of Financials stocks averaged an annual return of 6.75%, portfolios of stocks with a modified Piotroski score of 5 or 6 (out of 6) returned an average of 8.64%, portfolios of stocks with scores of 3 or 4 averaged 6.54%, while portfolios of stocks that scored 2 or less only returned 4.20%. This suggests that there is a good way of systematically choosing stocks in the financial sector. There might be other systematic methods, and some other criteria should likely be applied, namely the nature of the business, low valuation in relation to earnings or book value, etc. But this is a good, simple starting point for researching financial stocks and is the first criteria I use for selecting and recommending companies in that sector.

5 stocks now!

Here are 5 stock picks I am recommending today for buying. These are short summaries of each and my basis for recommending them. I am also starting another tracking portfolio, KVOV, to track the performance of my picks.

Petsmart (Nasdaq: PETM; last closing price $67.43), a retailer in pet food and supplies, is primarily attractive because of the high level of its “shareholder yield” (dividends, plus net debt payback, plus net common stock repurchase). In particular, the company has reduced its share count by about 20% since 2010, adding a boost to its earnings per share, in addition to its underlying earnings growth. Business could still continue to grow, albeit at a slower pace, in the next few years. The pet supplies industry is becoming a crowded space but Petsmart is the largest company in the market. Some stores are expanding their own pet offerings, but it’ll be a while before (if?) they can become a serious threat. In the meantime, the company is still purchasing large amounts of its stock. It is also reportedly exploring other avenues, such as a sale of the company or a special dividend, which may boost shareholder returns.

Occidental Petroleum (NYSE: OXY; $97.89) has gone up slightly since I mentioned it in April. It is still trading at a large discount to what I believe it is worth and my outlook hasn’t changed.

Guangshen Railway Co. (NYSE: GSH; $20.00) operates railways in the prosperous southern Chinese province of Guangdong. Its main lines connect the three major southern business cities of Guangzhou, Shenzen and Hong Kong, giving the company a very attractive geographic market. Guangshen is affected by slowing economic growth in China, hurting its freight business in particular. However, ongoing reforms in railways in the country to subject them to market prices will be a boost to the company. It also trades cheaply compared to its Book value, even compared to its recent history and after adjusting for cash and debt on the balance sheet. In the meantime, the stock is paying a decent dividend of almost 3%.

Kyocera (NYSE: KYO; $47.37) is a Japanese firm that produces a number of electronic components from lenses for printers to solar cells modules. Their usage can vary from industrial to home to automobiles and often form the unseen parts of branded products. Kyocera looks like the perennially “undervalued” company, its share price oscillated between $40 and $55 over the past five years, often at a slight discount to its book value. Unlike previous years, Kyocera has been making a few more improvements to its financial situation, as exemplified by its Piotroski F-Score. The company still has a rock solid balance sheet with very little debt and financial leverage and a high current ratio.

Axis Capital Holdings (NYSE: AXS; $44.00) is a Bermuda-based firm with the majority of its operations in the United States. Its profits are roughly equally from the insurance and reinsurance businesses. It has moderate amount of leverage for a financial company and has been repurchasing large amounts of its own stock over the last few years, reducing its number of shares outstanding by almost a third since 2007. A good dividend yield of 2.4% and an average Price-to-Book value of about 1.0 make it an attractive purchase.

Recommended stock pick: Occidental Petroleum

Occidental Petroleum (Symbol: OXY) is one of the largest energy companies in the U.S. It operates solely as in the exploration and production of oil and gas reserves (whereas some others might be involved in refining, transmission or retailing of oil, for instance, or even all of the aforementioned). Almost two thirds of Occidental Petroleum’s production comes from the U.S., with California being a particularly important geography where it is the biggest acreage among oil companies operating. The Middle-East accounts for about one third of the company’s production without some smaller contributions from Latin America. The company specializes in unconventional oil recovery techniques, using new technology to recover additional oil from mature fields where conventional extraction methods are no longer useful. Immediate plans for the future include are to divest the California operations into a new separate company, while Occidental Petroleum focuses on the Middle East and the unconventional operations in the Permian basin, namely Texas and New Mexico.

By a lot of measures, Occidental Petroleum has worked out superbly for investors. The company has increased its dividend each year since 2002, now paying out a yield of about 2.7%. With a market capitalization of over $75 Billion, it’s the 5th largest energy company and 47th overall in the S&P 500 index. It had a market capitalization of approximately $9 Billion at the end of 2002. That said, Occidental Petroleum’s stock value has languished in recent years. It went over $110 per share briefly in 2011 before falling to just north of $70 just a few months later and has traded up and down within that range ever since. The stock price is now at $96. This is far from the prettiest picture. That said, I believe Occidental Petroleum has the markings of a profitable investment. I score Occidental Petroleum a 9-on-10 on fundamentals score, reflecting a number of improving operational and financial metrics in the past fiscal year. The company still has high gross profitability over its invested capital, even though it’s somewhat lower than in years past, specifically in the boom years that ended in 2009. It has been consistently profitable and sports a solid balance sheet with much more equity than liabilities. Currently I believe the company has a relatively low enterprise value compared to its asset value. Operating as it is and of course barring some catastrophic unforeseen circumstances, I believe Occidental Petroleum could be worth as much as the equivalent of $190 per share within 5 to 7 years, with the spinoff of the California operations possibly acting as an early catalyst for unlocking part of that value sooner. Therefore I recommend the stock as a buy.

Diclosure: I have a long position in OXY in my Marketocracy portfolio

2013 Overview

2013 is closed for the books and this had been a good year on the stock market and for me also. A while ago, I created a profile and a fund at Marketocracy.com. It is a website for running simulated mutual fund portfolios. The founders state their mission is to find and reward up and coming investment managers, whether they are professionals in the field or amateurs. You are given a hypothetical amount of money to manage according to SEC-like mutual fund rules, including management fees, positions restrictions, etc. There are other websites to run and track simulated portfolios like that and Marketocracy has its shortcomings (I find notably it is not the fastest website, and tracking of corporate events can be improved). But overall it is a great place to showcase your investment management skills and your business.

As of December 31, it showed that my flagship KMF mutual fund was up by almost 28% after fees for the year, compared with almost 32% for the S&P 500 index. However you’ll notice my fund was more or less flat from its start in October 2012 until April 2013. It was almost two-thirds in cash or in short-term bonds in the beginning of the year. That was due to a lack of investing ideas to start and I don’t like to trade on companies when their annual report is close to being due. I scarcely pay attention to quarterly reports and, since the vast majority of companies have their year-end in December, I basically sat on my hands rather than try to put that cash to work in stocks in the latter part of 2012 and in early 2013. So comparing the performance since the beginning of April, when I got around to investing most of the portfolio following the annual reports releases, to December 31, the performance of my fund was 27% after fees, compared to the 22% for the S&P 500 and 24% for the Russell 2000 index, a representative index for small companies.

It is entirely foolish to extrapolate what was basically 9 months’ worth of good performance into the future. Do I expect my outperformance to continue in 2014? While that would be nice, I shouldn’t expect that every single quarter or every year. If anything, all great investors had periods of time where they lagged the market, often for 2-3 years at a time or more. So of all people, I’m very unlikely to be different in that respect. I do, however, have the utmost confidence in my portfolio and my process, and I do think I’ll be able to outperform the market in the long term. As for the stock market in general for 2014, I can’t predict what’s going to happen. Neither can most trained analysts and managers for that matter. So I won’t jump into a fool’s game. Some people think that because the market went up so much in 2013, it must come down in 2014. There’s nothing preordained, just because it went up doesn’t necessarily mean it will come down sooner rather than later. That said, the market does seem to be trading at above average levels compared to overall profits. And I’ve found it to slightly harder these last few months to find new ideas. So maybe we will have a down year, who knows. Since I try to find well-defined undervalued situations, I don’t care much what the stock market will do. I think my portfolio is well protected on the downside and any correction will only help me find more opportunities.

So my fearless prediction for 2014? Like the old saying goes, “it will vary”.

My Marketocracy fund can be found here so you can track my performance for yourself.

The return

An admittedly long time has passed since my last update. It has been a tumultuous year for me. On the personal side, there was the birth of my first child, followed by the return of some of my stepchildren to the household under unfortunate circumstances. We now have a household of five kids. Given that I didn’t have any kids just four years ago, that has been quite the adjustment for me. Meanwhile, on the professional side, I have been on some side projects at work, while also preparing for the next level of the CFA program.

Understandably, writing has taken a back seat amongst all my activities. However that does not mean I have stopped studying, analyzing and refining my investing techniques. A big portion of my off time over the past year has been spent reading and re-reading books, research articles and ideas from all over the blogosphere. A lot of what I’ve seen has been interesting and helpful. A lot of it still has been… less useful. But the important thing has been learning something new every day, trying it out for myself and applying it. That has led me to tweak my investing criteria in different ways. The broad principles of value investing guide me as always, it is to me the most logical philosophy. For the time being I am much more comfortable relying on simple quantitative analysis, à la old school Graham or Schloss style. Investing is never a static discipline and there is always room to grow. I will elaborate in the future on my current views, methods and where I see my thoughts evolving on investing.

In the meantime, while I wasn’t writing for most of the past year, I have continued to actively manage simulated portfolios. I now have profiles on Investopedia.com (profile name: kgateau), Marketocracy.com (kgateau) and the Motley Fool at Fool.com (konradgateau). My profile on Fool.com is publicly available to see. I’ll have to see if the others can also be viewed publicly. I’ll comment on my successes and failures so far and my general portfolio compositions. For now, it is great to be back and writing.

Evolving thoughts: My current quantitative stock selection process

Now that the holidays are over and I have successfully passed the Level 1 of the CFA exam, I’ve gone back to one of my current investment projects. I’ve been working on developing and refining my stock selection method, specifically for non-financial companies (financial companies have distinctly unique financial statements so they won’t be covered here). Forecasting is beyond my means and, gathering from my readings on the topic from James Montier to David Dreman, probably more harmful than anything. In any case, few people can do it reliably, myself not included. In that regards, I’ve decided to focus squarely on the published financials of companies to identify and value opportunities. Like this article by Benjamin Graham points out, as well as various other observations and research from Graham again to Joseph Piotroski to Tweedy Browne Company, it is entirely possible to have objective and somewhat simple stock selection criteria based on the publicly disclosed financial statements while obtaining more than satisfactory results, provided the criteria are logical both in theory and in practice.

My goal is to identify companies that are both safe and cheap with good upside potential. The three are in general linked to each other. Bought at a cheap enough price, most companies can be a good investment opportunity with little downside. Plus, minimizing your chance of a loss is actually a precursor to achieving good returns. I’ve decided to look into four general areas of criteria: 1) financial position 2) improving fundamentals 3) valuation 4) quality. The first two areas are fairly non-controversial, though at the same time I’m sometimes surprised at how little is paid attention to them. First off, I initially screen for adequate financial position, to be more precise I look for a leverage ratio of less than about 2.5 (meaning a company has a capital structure of at least 40% equity, or conversely no more than 60% liabilities) and a current ratio (current assets to current liabilities) of about at least 1. For smaller companies, I tighten the criteria to a leverage ratio of less than 2 and a current ratio of at least 2. The next area I look at is the Piotroski F score. The F score is a convenient summary of 9 fundamental indicators. While it is a quantitative measure, there are no complicated calculations; it is instead more of a checklist of observations. To summarize the F score, it consists of the following tests:

1) If Net Income > 0, score 1
2) If Cash Flow from Operations > 0, score 1
3) If Cash Flow from Operations > Net income, score 1
4) If Return on Assets (ROA) in the current period > ROA previous period, score 1
5) If ratio of Long-term debt in the current period < ratio previous period, score 1 6) If Current Ratio current period > Current Ratio previous period, score 1
7) If number of shares outstanding in the current period < shares outstanding previous period, score 1 8) If Gross margin in the current period > Gross margin previous period, score 1
9) If Asset turnover in the current period > Asset turnover previous period, score 1

Any test that is not met gets a score of 0. The scores are added up for a maximum possible score of 9, so companies with such a rating basically have all the fundamental indicators pointing in the right direction. Some of these criteria can probably be changed as one sees fit and the F score doesn’t explicitly purport to be the be-all, end-all of fundamental summaries. Nonetheless the original observations have been proven to work very well when combined with a low valuation with the aim to avoid likely value traps.

Which leads me into my next area of selection: valuation. Not surprisingly this is probably the area where I focus the most on. In the past I would have at least taken a look at the trailing 12 month price-to-earnings (PE) ratio, or at least the PE for the most recently completed yearly period. Fairly early on in my investment practice, I had already gotten into the habit of virtually ignoring forward PE ratios. It wasn’t uncommon for me to look at stock that was supposedly trading at a seemingly “reasonable” 12 times forward earnings (that is, next year’s estimated earnings) but then I would realize, after taking a quick look at the data, that it was trading at more around 20-25 times last year’s earnings, often quite a bit more, most likely implying that the market was anticipating some bumper jump in earnings. Forward earnings are far more subjective than anything else; it depends on whatever assumptions are put into the estimation. Basically, any prediction, provided that it is optimistic enough, can yield a reasonable-looking forward PE. If a large enough amount of predictions were at least vaguely accurate, this wouldn’t be an issue but since a number of studies point out that forecasts aren’t usually accurate by even generous standards, that means the forward PE probably isn’t worth considering in most cases. One thing you can do with it though is gauge what the market seems to expect from the company and whether or not those expectations are reasonable. Another aspect to consider is that the trailing 12 months PE might be somewhat misleading for cyclical companies. For instance, in mid-2008, you could have bought shares in Posco, a Korean steelmaking company with a healthy balance sheet and decent returns, at over around $120 per share, representing about 9-10 times its 2007 earnings, which would initially look cheap. However that year mostly reflected a high point in the economic cycle. While the company remained profitable, it fell to less than $60 in late 2008 and early 2009 in the great economic crisis. To smooth out the effects of the economic cycle, Graham and Dodd proposed simply taking an average of previous years’ earnings. Taking at least 5 years average, and preferably 10 years, this should be able to encompass both boom and bust periods. Applying this to Posco would have yielded a multiplier well north of 15 times its average earnings, its highest for several years. Therefore I’ve incorporated multiyear averages of earnings into my screening.

Another idea I’ve incorporated for valuation is using Free Cash Flow instead of regular Earnings. Normally this is calculated from the financial statements as Cash Flow from Operations minus Capital Expenditures. Free Cash Flow represents the actual cash that goes to the company, as opposed to using earnings which in some ways is just an accounting figure with little indication of how much cash actually goes to the company. Free Cash Flow represents the amount left over that the company could use to, say, repurchase stock and pay dividends. Also cash flow numbers have the advantage of being less manipulatable than earnings. While thus superior to earnings as a representation of what the company has generated, Free Cash Flow, if non-adjusted, still leaves something to be desired. The capital expenditures number is basically all the capital expenditures, whether it is spent to grow the company or simply maintain its current business level. As Fairholme’s Bruce Berkowitz points out in the latest edition of Security Analysis (one book that I’m currently reading while taking copious notes), a more appropriate definition of free cash flow would be the amount of cash generated that is left over for the company to invest in growth, repurchase stock or repay shareholders. This takes away expenses needed to maintain operations at its current level. Unfortunately, this also happens to be very hard to calculate. Few companies provide detailed information on which spending is for growth and which is for business maintenance. Fortunately, as this article on the blog MagicDiligence points out, there is a way to go around that, by estimating the maintenance expenditure as the depreciation and amortization cash charges in the cash flow statement. Depreciation and amortization represent that the expensing of tangible and intangible assets over their estimated useful life. Since those assets will have to eventually be replaced it is thus entirely feasible to use depreciation and amortization as proxies for maintenance expenditures. In short, Free Cash Flow, as suggested in that article, can be estimated as Cash Flow from Operations minus Amortization & Depreciation (summarized as “Sensible Free Cash Flow” or SFCF). It can be somewhat crude but the general direction and logic is sound in my view. So putting that together with what was mentioned, my current favorite tool for putting a valuation on a company is calculating the ratio of its price compared to its multiyear average of Sensible Free Cash Flow, calculated over a period of at least 5 years, preferably 10 where available.

Finally, in the fourth major aspect of my selection, I decided to look at the quality of the company. In theory, quality companies will deliver superior investment results. As a short aside, in practice, any commitment regardless of quality can produce great results if bought at a low enough price and with enough research, but I will save this topic for another time to explore. This is partly out of convenience because this would take a whole other article, but also because if a couple of methods work well enough for you, you can probably just stick with them for the most part.

Returning to our topic, when quality has been mentioned as being identifiable through the financial numbers, it has often been interpreted that some measure of return on capital is the proxy. One measure that is seen very often is Return on Invested Capital. There are probably a few variations on the calculation but for all intents and purpose the one I am referring to is Net Operating Profit After Tax / (Short-term debt + Long-term liabilities + Equity). Basically, the Invested Capital should be the capital used to acquire the company’s income-generating assets. Starting with this calculation of ROIC, I have modified it a bit along the same lines as I explore the earnings or income issue as mentioned above. Net Operation Profit After Tax is replaced by Free Cash Flow (after depreciation and amortization) as that should better reflect the cash the company can use. I also look at the 5-year average, which should give a better indication of whether this is a quality enterprise, rather than an unusually high or low return on one specific year.

To summarize my four current stock selection criteria, I look at the financial statements for a combination of:
1) Strong financial position, measured by high current ratio and low financial leverage ratio
2) Improving fundamentals, measured by the Piotroski F score
3) Low valuation, measured by low ratio of price to average SFCF
4) Quality, defined by high average SFCF/IC

I’ve collected and processed the financial data for approximately 70 companies so far, with all the caveats that this could entail. A cursory glance at the results would seem to vindicate such a selection on strictly financial statement data. I’ll eventually be going through them more in detail but so far, they seem very robust.