Stock picking strategies

Two of Morningstar's experts share their insights when investing in equity.
By Morningstar |  04-12-18 | 
 

Pick stocks that beat inflation

Morningstar’s Ian Tam looks specifically for stocks that show strong and growing operating cash flows. You can watch the video and read the transcript.

For stock investors, higher inflation is both a blessing and a curse. Although higher inflation generally means that there is positive economic growth, it also eats away at a company's bottom-line, because costs like receivables, inventories and assets also rise. So, it becomes a bit more difficult for companies to convert that higher spending into retained earnings and in turn investor gains.

One way to combat inflation is to look specifically for stocks that show strong and growing operating cash flows. Strong cash flows as a buffer enable a company to absorb those temporarily higher costs.

To I find such companies, I look at:

  • The 5-year growth rate of operating cash flows, which basically measures on average how much cash flows are growing in each year.
  • The annual and quarterly cash flow momentum - the last four quarters of operating cash flows and compare against the same number one quarter ago and four quarters ago, respectively.
  • 5-year standard deviation of earnings, which basically tells you how consistent a company's earnings are.
  • Annual pre-tax return on capital just to make sure the companies that are in my list are actually profitable.
  • A filter on cash flow to debt.

Finally, I order the list based on degrees of importance. It is these degrees of importance that tell me the order in which my stocks appear.

Valuation-driven investing

Michael Keaveney, Director of Investment Management, Morningstar Canada, on why the focus must be on valuations, not price movement. You can watch the video and read the transcript.

The valuation-driven approach to investing is seen in our equity research, manager selection and investment management work around the world. The approach boils down to determining what an investment is worth and getting it at a discounted price.

Let's paint a very simple picture of the worth of an investment and compare it to the ups and downs of market price. We can see both the advantages and challenges for a valuation-driven investor. The major advantage is that this approach has the potential for delivering excess returns and can also reduce risk.

Valuation-driven investors describe their entry points as having a "margin of safety" or a discount to intrinsic value; this can reduce the downside of making the investment. Another advantage is that it provides discipline, allowing investors to reduce the emotional roller-coaster effects of the markets. Investors can make poor decisions when short-term sentiment is their main guide.

One challenge is really the flipside of that discipline. Valuation-driven investors are contrarian, often buying when sentiment is poor, and selling when sentiment is too positive. It can be tough to maintain a contrarian discipline: People don't like to differ too much from the crowd, but it is needed with this approach.

Another related challenge is that valuation-driven investors must take a long-term view, which isn't easy in our modern world. Finally, the work of establishing true worth is easier said than done. Deep fundamental analysis on the key drivers of returns, is an ongoing requirement.

We believe that valuation driven investing can work for individual securities and asset classes to deliver better risk adjusted returns to investors.

In the words of famed investor Warren Buffett, "Price is what you pay. Value is what you get."

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