Profits from stocks come from three potential sources: company growth, income from dividends (or stock buybacks) and an increase in valuation multiples. Since a dollar is a dollar is a dollar, what really matters is the combination of these three things, not any single one in isolation. A reader had some detailed questions on my own approach to analysing these sources of profit, and whether that rules out pricey US stocks.
A few weeks ago I outlined my G.I.V. system (see “Introducing my system for choosing stocks”). It’s what I use to decide, before investing, if stocks have enough profit potential. That includes before I make recommendations to OfWealth readers.
In a sense, the system is very simple. It awards scores from zero to 10 for each of three profit factors: Growth, Income and Valuation upside.
But that doesn’t mean it’s easy for a stock to get past this screen. It must achieve a combined score of at least 20 to get through, however much I like the underlying business.
Not every stock that fails my test will turn out to be a bad investment. A stock could score, say, 10 for growth, zero for income and zero for valuation upside and still turn out okay in the end.
On the other hand, I would view such a stock as a risky prospect at the outset. Promises of ultra high growth, matched with high stock valuations, have a nasty habit of ending in disappointment.
My system leaves far less to chance.
That’s because those stocks that get through can’t be a one trick pony. They must get the maximum score of 10 in at least two categories, or a strong combined score spread across all three categories.
Growth potential alone isn’t enough, if there isn’t lots of valuation upside, and probably at least some dividend income.
Even the highest dividend yields aren’t sufficient, unless accompanied by plenty of valuation upside, and usually with at least modest business growth.
Huge valuation upside – the “margin of safety” between market price and a conservative estimate of true value – won’t suffice without including some dividend income and business growth in the mix.
It’s because each stock’s profit potential is backed by a minimum of two factors – and usually all three – that the chances of success are greatly improved.
This is the system I use to screen all stocks recommended in my new OfWealth Stock Investor service. In the November issue, I recommended a global company with brands that you’re sure to recognise, and a fast growing business in Asia. That stock achieves a combined G.I.V. score of 21, meaning it passes the test.
The company in question is set for solid, if not spectacular, growth of around 5% a year, scoring it 5 in the Growth category. It also has a very healthy dividend yield above 4%, which gives it a score of 7 for Income. Finally, I reckon there is over 40% upside (margin of safety) between the current stock price and fair value. That would take the price-to-earnings (P/E) ratio from a low 7.6 to a more reasonable 10.8. That’s enough to score a 9 for Valuation upside.
Putting that together, and assuming the P/E increase is achieved over three years, the estimated overall profit would be more than 70% in that time (including growth and dividends as well).
Future stock recommendations will achieve their 20+ G.I.V. score in different combinations. But they’ll always have to pass the minimum overall threshold, one way or another.
Right now I’m working on a new recommendation for the December report. The company has most of its businesses based in the USA and Asia, and has a great track record of growth and dividend payments. Oh, and it’s been in business since 1848.
I haven’t completed my full analysis yet. But so far it looks set to score between 21 and 25 in total, being 8 to 10 for Growth, 5 for Income and 8 to 10 for Valuation. Unless I discover any big problems, as I continue my in-depth analysis, I’m looking forward to sharing this new recommendation with subscribers to OfWealth Stock Investor.
A reader called George wrote to me asking for more detail about how this works. Below are his questions, with my answers after each one.
I just had a few questions on your new newsletter and GIV system.
- Will you be using your GIV system for stocking picking in the US markets or are you still staying away due to over price US stocks (bubble)?
Absolutely, I will pick stocks in the US markets. Not least because they’re about half of global markets by market capitalisation. The US has loads of great companies, so it would make no sense to leave this market out.
That said, I will only do so when I find stocks that fit my strict criteria, and can meet the minimum G.I.V. score. That’s harder than usual at the moment, given that the US market in general is so expensive. But of course I’ll always be looking for openings.
Incidentally, when I use the G.I.V. system to score the S&P 500 index it only manages an 8 (3 for Growth, 5 for Income, 0 for Valuation upside).
One really important thing to note. To ensure maximum accessibility for all members, every single stock recommended in OfWealth Stock Investor will be tradable in the US markets. That’s even if it’s a company headquartered in another country.
- Does your newsletter and GIV system apply to equities only? What about bonds, currencies, precious metals (gold).
Yes, it’s purely focused on finding carefully screened stocks. But I’ll continue to write about stock markets in general and other types of investments here in the free OfWealth Briefing.
I’ll also continue to share my recommended overall portfolio allocations (see here for the latest).
- Using your GIV system of three factors: growth prospects, dividend yield, and margin of safety. Are any of three factors weighted differently or the factors evenly weighted? If so, what is your criteria?
Each factor has equal weighting, in the sense that each can score a maximum of 10 points on its own. This reflects the fact that profits can come from all three sources.
That said, each factor has its own scale. I can’t reveal full details here, because otherwise anyone could copy them. But I can reveal enough, hopefully, to give you a good idea. I’ll do that by looking at the extreme ends of the scales.
First there are the zero scores. To get zero for Growth a company must have no growth prospects or a business in long term decline. Zero for Income means there are no cash distributions to shareholders. Zero for Valuation means I judge the stock fully priced in relation to its real value, or overpriced by some amount.
Now let’s turn to the top scores. Getting 10 for Growth means the company should grow for many years, on average, at more than 10% a year. To get 10 for Income the distribution yield (dividends plus net buybacks) must be over 8% a year. Getting 10 for Valuation means at least 50% upside (margin of safety) between the market price and the fair value.
Note that I always use conservative assumptions when valuing stocks. So if I estimate the margin of safety at, say, 40% then the immediate price upside today could in fact be quite a bit more.
Overall the recommendations are most likely to fit one of the following descriptions:
- Deep value stocks with high dividend yield and decent growth prospects
- Value stocks with decent dividend yield and high growth prospects
- Do you periodically re-run the data on picked stocks to see if it drops below the 30 point threshold? Would this now set the stage for a sell signal?
Just to clarify, 30 is the maximum theoretical (and practically unattainable) score of the G.I.V. System. But 20 is the threshold that must be passed by any new recommendation.
All recommended stocks are watched on an ongoing basis. Each monthly report includes portfolio performance tracking, including price movements and dividends received. It also provides commentary on any major company developments.
G.I.V. scores of past recommendations are likely to fall over time. Specifically, if a stock starts with a high score for Valuation, because it’s really cheap, then I’d expect that to drop as the price rises to where it should be. In fact, I’d want it to drop, as I want the price to rise.
Also, cheap stocks tend to have higher dividend yields. This means the Income score may drop a bit as well over time, even if the cash dividends grow in absolute terms.
Anything that still has a combined score above 20 will remain a “buy” recommendation. That means current or new members can still feel comfortable adding to positions.
If the score falls below 20 – because of the potential effect explained above on the Income and Valuation scores – but the stock still has room to run before it reaches its full potential, then it will be changed to a “hold” rating.
However, if there’s a more fundamental change for the worse – such as powerful new competitors, an ill-advised change of business strategy, or new government regulations – or if I think it’s run its course and it’s time to take profits, then I’ll issue a “sell” alert.
- Stock message alert: I take this would be an alert to sell in case a stock goes south quickly. I wouldn’t want to be hung out to dry. I guess the same would apply for a buy signal.
If a company goes south quickly, and I think it’s not just something temporary, then yes – I’d issue a sell alert (see the end of the answer to question 4).
But if it’s just due to general market movements, or excessive investor pessimism, then I wouldn’t issue a sell alert. These are high conviction investments, and most of them are going to be cheap at the outset.
If they get even cheaper, but the underlying business is doing fine, then I’ll usually recommend buying more. Averaging in at an even lower cost is likely to lead to even greater profits in the long run. Whereas selling because of a temporary market blip guarantees a loss, and missing out on the future profit.
I’ve written about good and bad reasons to sell stocks before. See here if you’d like a reminder of my reasoning.
There’s so much more I would write about when and when not to use stop losses. I’ll try to come back to it another day, since it’s an area that causes a lot of confusion. But, for now, suffice to say that I don’t recommend them for my kind of high conviction investing (with an emphasis on value).
- Lastly have you back tested your system in a down market let’s say back in the stock market depressing years of 2007-2009?
Over the years I’ve had plenty of investment successes. I’ve also learnt a lot of lessons, some of them hard ones. The G.I.V. system is the result of that experience, and I believe it’s the best way to maximise the chances of success.
In a market crash, overpriced stocks collapse and can take a long time to get back to their pre-crash levels. Just think of the NASDAQ index, which took 15 years to recover the losses following the market bubble peak in year 2000.
However, the situation is different if you buy well in the first place.
Of course, if there’s a broad market collapse, carefully selected stocks will also, mostly, see their prices fall temporarily. But, usually, they recover pretty quickly, assuming the underlying business remains strong.
In that event, the worst that can happen is that the payoff is delayed by a couple of years. And buying more when they’re cheap, or even cheaper than before, will result in a larger eventual profit.
This is the kind of investments that I’m interested in. If there’s no crash they will do great. If there is a crash, the original investment payoff may be delayed, but the risk is much less than most other stuff and the payoff will still arrive, eventually.
Of course, I can’t claim that every single recommendation I make will end up making huge profits. Whilst I do my best to screen out problems, not a single investor in the world gets it right 100% of the time.
The point is where the results average out. So long as most investments roughly meet expectations and some do even better than expected, then even if there are a few losers the net result will still be highly profitable.
In any case, I still recommend all investors hold other things apart from stocks, not least as a hedge against a stock market correction. (Click here for my latest portfolio recommendations.)
- Not sure if this applies but would you consider the system more of a buy and hold, short-term, or long-term? I guess market timing sort of plays into this system as well?
In most cases, the main profits are likely in the medium term, which I define as anything between two and five years. My experience is that an average expectation of three years is what to expect for the bulk of the gains.
That said, some could pay off much faster, especially if the valuation gap is closed quickly in the markets. Others could be longer term, assuming they have a strong and ongoing growth trajectory, and so are worth holding onto for longer.
When it comes to individual stock market investments, I don’t try to time markets. You never know what’s around the corner. I just make sure that I buy well, which is the best hedge against macro market moves (or, indeed, adverse surprises at the company level).
Hope I didn’t ask too many questions, but I plan on getting into this rather slowly at the same time keeping an open mind.
George T., California, USA
Not at all. They were great questions. And you’re right to take a cautious stance – I would do the same. But I’m glad you are keeping an open mind. That’s an essential trait for any successful investor.
George has given me a good grilling, but I’m glad he did. Hopefully, I’ve answered the questions satisfactorily. But if you think I’ve left anything out then just let me know at the email address below.
In the meantime, I’ll leave you with some feedback on the November report of OfWealth Stock Investor that I received from a couple of early subscribers. I promise I’ll do my best to keep them happy, and all other members of the group.
Very impressive analysis. Well done.
Richard K., NY, USA
Thanks so much for your timely response. I have already read your report. Wow! What a hell of a lot of research you do.
Rod W., Manitoba, Canada
I invite you to click here if you’d like to find out more about OfWealth Stock Investor.
Stay tuned OfWealthers,