Updated: Jun 10
I received a request to talk about individual stocks. I wanted to provide some insights on how professionals identify investments and how it differs from the individual investor. Due to the restrictions on Registered Investment Advisers making public stock recommendations, we’re doing these disclosures on the front end:
The following is not a recommendation to buy, sell, or act in any way on any specific security or a buy, sell, or act recommendation on individual equities as an asset class. This is simply an example of how we as a firm make decisions on individual equities, for the various investment objectives and risk tolerances of our clients.
When an individual investor asks what stocks we're looking at, it's a complex question and I hope by the end of this you understand why that's impossible for us to answer quickly. Do we as Advisers recognize the opportunity in stocks like Boeing (BA) and United Airlines (UAL) when they both fall 75% from their highs? Absolutely. I remember discussing it with a few industry friends and made the case for a sharp bounce just before they both traded nearly 100% higher. Was I able to make that trade for our clients? Absolutely not. The distinction I’m making is that there is an absolute difference in a ”speculative trade” vs a conservative/prudent investment that achieves an objective
We have a disciplined investment management process that includes identifying companies with above average return on invested capital, solid cash-flows, and a low probability of insolvency. Our primary concern is making sure our clients meet their investment objectives, and those include retiring on time, or not having to reduce income from investments during retirement. That's a completely different analysis than which stocks might double or triple off panic-driven low prices in the next few weeks. There was no assurance Boeing and United would bounce the way they did, in fact, I could have made an almost equally probable case that both would be allowed to go bankrupt. And therein lies a detail to truly understand. If bankruptcy were to happen, common shareholders would likely receive next to nothing, in a similar capacity to the 2009 bailout of General Motors. Most people remember when General Motors received government “bailout” money, but also went bankrupt. GM was recapitalized in the bankruptcy, and the old shareholders were wiped out. “Old” GM shares were canceled. Kaput. Gone. Worthless.
In the case of Boeing, given the importance to the US military and the commercial aviation industry, I believe they’d be saved. However, Boeing the company, and Boeing the stock, are two different things. Even for our most aggressive investors we use a different strategy than selecting companies that have a higher than usual likelihood of bankruptcy. Instead, our approach is to identify companies that have a very high likelihood of above average total return over the next five years.
We don't have the resources to evaluate every single stock on a qualitative or deep research basis, so instead, we screen for companies that fit certain criteria. The criteria for us includes, but is not limited to, Return on Invested Capital, strong Free Cash Flows, and Financial Stability. Our portfolios also have sector diversification requirements to make sure we're not overexposed to any one macro-economic factor. Once we've narrowed the universe of stocks down to companies that fit, we then try to identify which ones are undervalued or properly valued. We believe price matters, not necessarily the actual stock price, but the price you pay for a dollar of corporate earnings or dividends, ratios we use so all stock prices can be evaluated equally, or close to it.
After meeting our criteria, we determine which companies aren't overvalued, fit within our investment objectives, and have the highest propensity for growth given the current, and projected, economic environment. An example would be a discussion we had recently involving two consumer goods companies. As a firm, we have invested client money in Kimberly-Clark (KMB) over the last couple of years. They primarily make paper-based consumer products (Cottonelle, Huggies, Kleenex, Scott, etc...). The stock has done fairly well during this pandemic given the fact that people not only continue to buy paper products, but apparently toilet paper is a new form of currency. However, for paper products to drive revenue of the company higher, people would actually need to start consuming more paper. We as a society have stockpiled toilet paper, but we're not necessarily consuming more of it, in fact, we're likely consuming less because we perceive a shortage, so people are being more conscientious about their paper use at home.
Another strong stock during this time has been Clorox (CLX), which actually set a new high while the rest of the market seemed to be in freefall. It's obvious why, the demand for disinfectants is greater given the pandemic. Clorox would likely be able to increase prices or increase supply and move more volume, at least for the foreseeable future. Clorox also pays a decent dividend, around 2.25%, and has a fairly low beta, a measure we use to determine stock price volatility. Given how well the stock has done recently, we did not buy Clorox, but that example is a great representation of how we compare two companies in the same sector for our portfolio. If both stocks were trading at or near the same price - again, the relative multiple, not the actual stock price - and they both fit our screening criteria, we would have likely sold Kimberly Clark to purchase Clorox simply for the long-term outlook, in our more conservative, income focused portfolio.
Our investment methodology comes from years of research and a deeper understanding of competing methodologies, all being viable. It comes from knowing that a strong discipline, executed well, will outperform the market in the long run, and it comes from understanding client expectations. We maintain these processes and disciplines for our clients, because our role is to execute a process for the client, exactly like we told them we would. Our process has the ability to outperform in the long run, not because we're focused on short-term market returns, but because we're focused on client objectives.
We hope you're staying safe and finding ways to stay productive in these crazy times. Keep checking back for more insights and opinions and know that we're doing everything we can to get portfolios properly positioned during this market event.
All the best,
The Sphere Wealth Management Team