Premise:
- Index funds are becoming extremely skewed by a handful of their members due to market capitalization.
- Market volatility provides an opportunity to potentially find companies with strong financials but being punished by a general sell off.
- Applying due diligence and financial principles to determine strong, competitive companies could result in better returns than the S&P 500. This may increase diversity as well due to the market capitalization issue.
Methodology:
- Build a model that would screen the majority of stocks with automated gates.
- Iterate on criteria to produce a manageable number of stocks for the next step of due diligence.
- Review each of the stock outputs for red flags, business model, and future outlook.
- Build fund based on these stocks purchased in equal distribution.
- Timing the market is nearly impossible, so buy when you have the funds to purchase.
- Buy an equal percentage of an S&P 500 index fund each time you purchase the personal fund in order to easily analyze time weighted returns to determine opportunity cost and whether we were successful.
- Perform this exercise yearly as new financials are available.
First Year Results
- After fine tuning our screening methods, we were given a list of 46 stocks by our automated analysis
- We eliminated 20 stocks after reviewing each company’s business model, services/products, etc.
- These stocks were purchased at 3 intervals this year: July 24th, August 24th, and September 24th.
- Results can be found in the table to the right along with the stock picks.
- S&B 26 is the average returns of the stock picks.
Details
In order to build something similar, this is what you’d need to do.
- Determine functions to filter by. These are what we chose:
- ROE – measures profits made for each dollar from shareholder’s equity
- Growth -Utilizing Compound annual growth rate (CAGR) to calculate returns
- EBITDA – measure of profitability
- FCF – cash available for investment or distribution
- D/C- company’s financial leverage
- https://www.investopedia.com/terms/d/debt-to-capitalratio.asp
- This is highly dependent on how the other gates are doing. If there is a lot of debt, but growth and return are abysmal then it’s a bad fit. Could build a nested if to evaluate after the others. Ended up removing this from the initial gates and did it manually.
- Investopedia and Corporate Finance Institute can be useful resources.
- Determine if there are any industries you want to exclude. We excluded these sectors:
- Energy
- Financials
- Real Estate
- In order to determine relative performance you’ll need to benchmark each company against the industry.
- We averaged the last 3 years to determine our benchmark.
- Divide the stock’s metric against the benchmark to determine the relative performance.
- Determine the minimum market cap you want to use.
- Determine the Poor/Moderate/Great breakdown per gate.
- These percentages are based off the relative performance of the stocks in each sector
- For example, if you find that communication Services averages ROE of 10%, then for our gates, moderate ROE would be 12.5% to 20% based on our breakdown, but only for Communication Services.
- ROE
- Poor < 125%
- Moderate >= 125%
- Great > 200%
- Growth
- Poor < 200%
- Moderate >= 200%
- Great > 400%
- EBITDA
- Poor < 80%
- Moderate < 120%
- Great >= 120%
- FCF – Free Cash Flow
- Poor < 80%
- Moderate < 120%
- Great >= 120%
- D/C-may want to manually screen.
- Poor >= 0%
- Moderate >= 50%
- Great >= 120%
- These percentages are based off the relative performance of the stocks in each sector