I'm always on the lookout for innovative strategies to improve returns and generate alpha for my portfolio (isn't everyone?), so I'm going to take the next few posts to create a series on the results of my research. Today, we'll look at which factors can add value to your portfolio. Later, we'll evaluate strategies that follow the "experts" and discuss how to glean our wisdom from the "crowd."
Historically, investors in the US stock market have seen a positive return in the neighborhood of 6% to 8% over the long term. Of course, the precise average depends on whom you ask and a wide variety of factors, but the reality is that none of us is really in the marker for that kind of "long-term." We don't have 100 years to ride out the full story of ups and downs and may, in fact, lose money through the course of a decade or two or three by owning a stake in a market index.
The US is also in a different place than it was 100+ years ago. We aren't growing at exponential rates, as we were as a developing nation. But there are opportunities to invest in nations that are recapitulating our developmental progress, like India, Brazil, and even China (ignoring the communism). That said, the US has had plenty of successful companies, and investors have made trillions of dollars in the past decade even with a net flat return on the S&P 500.
With that in mind, how do we identify and capitalize on opportunities that will outperform the market going forward?
First, we look to value investing, which has different meanings for different investors. Some look at a simple price-to-earnings ratio to determine if a stock is cheap or expensive relative to its peers and market segment. A low P/E is certainly a decent starting point, and entire strategies are built on this approach, but to take it a step further, there is a more predictive measure of future performance.
A stock, at its core, is a valuation of a series of future risky (not guaranteed) cashflows. What I look for is a growing free cashflow. This (along with sales growth expectations) is the key component of the valuation process I use to measure the value of a stock. According to a study published in Quantitative Strategies for Achieving Alpha by quantitative analyst Richard Tortoriello, free cashflow growth is a very accurate predictor of future returns. Begin with the end in mind: Look to the cashflow.
Second, I look to acquire these winners when the price has suffered a recent bruising. Quantifiable, one-time events that send the stock price plummeting are the ideal buying signals for me. In the short term (in between material events), stock movements are a function of market sentiment, and, following those hits, many investors will exaggerate the downside out of fear. If the move was further south than a proper valuation would warrant, I jump on that stock, and more often than not, it will recover what was lost during the fear-driven selloff.
To find these events, screen for the big losers of the day. If the stock is down on a one-time (or short-term) issue that you can put a dollar value on, but the stock has fallen further than it should have, look to acquire it.
These are two methods I use to buy low and sell high using fundamental information, but next time we'll look at how to use experts' research to your advantage when you're allocating equities in your portfolio.