The one true path to stock-picking success

We are in for some terrific years on the stockmarket, but you won’t win with off-the-shelf portfolio solutions…picking winners is the key.

PORTFOLIO POINT: Distinguishing between 'growth’ and 'income’ investing is artificial and misleading. With the stockmarket on track for a couple of terrific years, investors would do well to focus on value.

People often separate value investing from growth investing as if they’re opposing practices. Or financial advisers may present investors with differentiated portfolios, as though the stockmarket is a supermarket with neat off-the-shelf solutions that can suit any type of investor.

If you desire income, an adviser may say: “Here you go – these are good businesses with lots of safe, reliable income.” To the growth investor: “and of course, for you today sir/madam, we have this other portfolio that will meet your needs.”

This distorts the true nature of what value investors in the stockmarket do. The stockmarket is a place where pieces of business trade and occasionally – thanks to the market’s volatile nature – mouth-watering opportunities are dished up at prices that would never be considered in the cool and calm environment of a trade sale.

As famed value investor Charlie Munger – arguably half of the brains (but perhaps less than half of the temperament) behind Berkshire Hathaway – once commented:

“The whole concept of dividing it up into 'value’ and 'growth’ strikes me as twaddle. It’s convenient for a bunch of [fund managers and advisers] to get fees prattling about and a way for one adviser to distinguish himself from another. But to me, all intelligent investing is value investing.”

And so one should be wary of promoters of box-fitting approaches to portfolio construction. While I admire the sentiment, you can no more 'design’ a portfolio to produce 10% returns than you can design a portfolio to produce 15% or 20% returns. What the heck, let’s design one to produce 50% or even 100%!

Instead, I prefer taking the approach of building a portfolio of businesses (rather than 'stocks’), purchased at rational prices, whose earnings you are virtually certain will be materially higher in years to come. The market value of such a portfolio will rise (although the pattern of this rise may at times prove uncomfortable), provided the earnings march upwards over the years.

To demonstrate Warren Buffett and Munger’s consternation with the common practice of designing income and growth portfolios, let me share the story of a company and its share price with you. In 2004, the discount variety retail chain, The Reject Shop (a company I have written about here on several occasions), listed at $2.00 with about 100 stores and a profit of $5.6 million on the $15.6 million that its owners had invested and retained in it. Even though it was a small company, according to independent research released by it at the time of the float, it enjoyed extremely strong brand awareness of 89% in the states in which it operated. For another company to try to replicate that would be very difficult and expensive.

Run by esteemed retailer Barry Saunders, The Reject Shop was generating a return of 34% on its equity and the company had no borrowings at all.

As the company got bigger, its profits went up and so did its returns. By 2010, The Reject Shop had grown to 192 stores. In its 2010 half-yearly report, the company revealed it was generating a return on equity of 39% and full-year dividends were now about 31% of the $2.00 float price.

Further, a $2.00 investment in The Reject Shop at the time of the float would have grown to $18.89 pre-tax by 29 May 2010 – a return of 944%, and that’s without reinvesting the dividends.

And my question to you is this: Was The Reject Shop an 'income’ stock or a 'growth’ stock? The answer of course is that it was neither and it was both. And that’s why dividing it up is twaddle.

Ultimately, if you identify sustained, economically-superior businesses whose performance meets your expectations, even for a time, the stockmarket could be closed for several years and provide no cause for concern. A closed stockmarket, however, would be no good for the 'income’ and 'growth’-oriented stock picker.

The big question, of course, is what is the 'rational price’ to pay for such a business?

Well, here’s some estimated valuations and estimated margins of safety from www.skaffold.com to get your research started:

-Estimated valuations for sample ASX companies
Company
ASX
Safety margin (%)
Dividend yield
(%)
Market cap ($bn)
Historical change in intrinsic value
(%)
Forecast change in intrinsic value
(%)
Forecast P/E
Forecast EPS growth (%)
BHP Billiton
BHP
2.78
3.13
186.76
27.54
8.43
9.87
-3.60
Rio Tinto
RIO
0.56
2.36
121.31
25.78
9.19
9.14
-4.81
Commonwealth Bank of Australia
CBA
-0.82
6.44
81.44
9.74
3.35
11.60
5.17
Westpac Banking Corporation
WBC
-7.38
7.17
68.63
11.72
4.31
10.98
-12.70
ANZ Banking Group
ANZ
2.83
6.17
63.56
1.82
5.16
10.74
2.00
News Corp (CHESS)
NWS
-49.05
1.05
46.71
15.13
30.7
15.41
7.54
Telstra Corporation
TLS
-26.51
8.07
43.18
-4.29
7.82
12.17
6.08
Woolworths
WOW
-11.27
4.87
31.70
16.28
10.1
14.52
1.39
Wesfarmers
WES
-49.23
5.5
30.07
-0.74
12.7
15.75
13.40
Newcrest Mining
NCM
-72.19
1.52
20.35
21.06
42.1
16.77
20.30
CSL
CSL
-24.49
2.35
19.17
14.12
17.5
19.3
10.20

From this list, you can see that only BHP and ANZ are trading at a discount to their 2012 estimated intrinsic value. You can also see from the 'Forecast Change in IV’ column that while some companies are trading at a premium to their 2012 valuation and show a negative margin of safety (the second column), their intrinsic values are forecast to rise, in some cases by 10% or more annually for the next two years.

The approach I have advocated here for many years should only be applied to high-quality companies. To assist investors in uncovering a company’s financial strength, I introduced Australia to the MQR (Montgomery Quality Rating) back in 2010. Skaffold’s quality scores rate companies from A1 to C5 and are provided and automatically updated for every listed company. The idea has since been a hit with private and professional investors, who hitherto knew little of quality ratings or quality scores and were certainly not discussing them in 2010 or before.

Of course, quality can be subjective but there are some basic rules. For example, even if your author had fallen off the wagon and produced a growth portfolio or income portfolio, he would not include Rio in either. This is because Rio is a company whose intrinsic value in 2014 is expected to be less than in 2004 (see chart).

Source: Skaffold

Since 2004, Rio’s value has grown much more slowly than BHP’s over the last decade, because the company paid $39 billion for Alcan at the top of the market in 2007 and then raised a dilutive $15 billion to pay off the debt, arguably destroying value with both transactions.

In essence, approaching the task of investing in stocks as one might approach investing in a business is fundamental to long-term stockmarket success and as I believe we are in for a terrific couple of years in the stockmarket (don’t ask me when in 2012 I believe you be fully invested), the sooner you can rid yourself of the adviser who advocates growth versus income, the sooner you can turn the stockmarket off and focus on owning the best businesses.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.