European Top Stock Picks
After eight years of central bank endless liquidity, passive investing has become all the rage. The tidal wave of Federal Reserve, European Central Bank, and Bank of Japan quantitative easing liquidity has lifted all boats, both rickety and seaworthy. Vanguard, the index fund leader, has been laughing all the way to the bank these past years. Lazy investors and financial advisors have been “buying the market”, most notably the S&P 500 index tracker funds, creating huge inflows into component stocks. Remember that for each investment in the S&P 500, Vanguard or State Street (who runs the popular SPY) must in turn buy each company in the index, without any consideration for the company’s valuation or underlying fundamentals. We believe, along with many other astute investment professionals, that the central banksters’ QE experiment has suppressed the invisible hand of the markets and created serious miss-allocations of capital, both in the equity and the bond space.
Motivated by our strong conviction that company fundamentals and valuations will win out over central bank monetary policy experiments, we have shown that our intellectual and data resources allow us to build fundamentally solid equity portfolios that out-perform passive, index funds over the business cycle. One thing is certain: lazy investors who are feeling warm and cozy in their S&P 500 or Nasdaq index funds will probably lose everything – and then some – when the day of reckoning arrives. At the same time, diligent investors who do their homework and build fundamentally solid portfolios will weather whatever storm arrives on financial markets.
With an avant-gardiste flare, we believe that now is the time to abandon passive index investing and get back to Benjamin Graham-style company analysis. We have decided to share our very successful in-house equity selections and our methodology. Hopefully investors can receive inspiration for their own portfolios from our picks.
This week we present our European stock picks. We first explain our construction methodology then provide the portfolio specs and present the year-to-date live performance.
A portfolio is a collection of stocks that fit together and interact. Our top picks portfolios synthesize three over-arching investment styles:
- Ultra Growth
- Ultra Value
- Ultra Yield
The interaction of these different styles smoothes portfolio performance over the business cycle and, most importantly, reduces portfolio volatility. Our Growth pocket scans the universe of all European equities for companies with the fastest revenue growth rate over the current year AND the projected rate of growth over the next three years. The goal is to select companies with dynamic growth and the fastest expected rate of change in revenue among peers (ultra growth). While the projected revenue growth rate is the determinate criteria, our selection is refined by considering analysts’ revisions to Earning per Share (EPS) over the next 4-months and 1-year in addition to analysts’ revisions to their revenue estimates for the company, again on a 4-month and 1-year horizon. In addition, we require that our growth companies are profitable. We measure the company’s net margin rate for the current fiscal year and for the next fiscal year using consensus forecasts. Obviously the relation between bottom line earnings and top line revenue is crucial to assess whether the firm is capable of remunerating its shareholders. Finally we consider the financial situation of the company in order to assure that no debt problem exists and cash flow is positive.
One European growth company currently in our portfolio is ASML Holding NV, which engages in the manufacture and trade of lithography systems for the semiconductor industry. The company has strong revenue growth with sales expected to rise sharply in the coming years. Margins returned by the company are among the highest on the stock exchanges while its sound financial situation allows the firm significant leeway for investment.
For the last 4 months, the company has been enjoying highly positive EPS revisions
Already up +14% in our ASML position, we see this stock as capable of resisting any upcoming period of market turbulence.
Our Value pocket screens companies first and foremost based on the ratio of enterprise value to revenue (EBITDA), both for the current fiscal year and the upcoming fiscal year. The ultra value companies in the portfolio have the lowest EV/EBITDA among peers. Supporting this company valuation metric, we consider the company’s stock price-to-earnings ratio (PER) for the current and upcoming fiscal years. Low PER firms rise to the top of our selection. As with growth stocks, we again screen companies based on profitability and financial situation (debt). We also prefer firms with a good visibility, or business predictability, in this category. Our visibility measure is based on the dispersion of analysts’ estimates for the upcoming fiscal years. The tighter analysts’ forecasts, the better the visibility we have on the company’s potential earnings. Finally, we consider the recommendations and price targets of the consensus of analysts should a final filter be needed to separate candidates for our value selection.
One European value company currently in our portfolio is Arkema, which manufactures and supplies chemical products including the Technical Polymers, Filtration and Adsorption and Organic Peroxides. The enterprise value to sales ratio is at 1.06 for the current period – grossly undervalued. Analysts have a positive opinion on this stock. Average consensus recommends overweighting or purchasing the stock while the average target price set by analysts covering the stock is above current price and offers a tremendous appreciation potential. The PER is at a very attractive 13.7x for 2018 projected earnings.
Our Yield pocket looks for stocks the highest dividend yield, subject to having sufficient profitability (net margin) and a strong financial situation (positive cash flow) to maintain and/or raise the dividend. Again, we consider the company visibility in selecting our ultra yield stocks. Lastly, we look at the quality of company publications relative to analysts’ expectations. We attribute a higher score to companies who consistently announce above the consensus forecast.
One of our current yield stocks is Tryg A/S, a Danish insurer. The company is paying a 7.0% annual dividend with a 63% growth rate in the dividend over one year and a 50% growth rate in the dividend over the past five years. Tryg is in the top of the class in terms of profitability, with net margin forecast to hold above 12% through next year.
Predictability of the business is excellent meaning there is little chance for a bad surprise with Tryg.
Our European portfolio currently holds 29 companies. We offer our readers full transparency and post each week our full portfolio holdings. Readers can consult our European Top Picks portfolio here and replicate any or all of our selections.
While our first objective in our Top Picks portfolio is to find solid companies based both of current financial statements and forward projections based on the analyst consensus, we also apply a quantitative overlay, making our Top Picks portfolios loosely “techno-fundamental” strategies. We limit, however, our quantitative analysis of the stock price to our weekly trend indicators as a complement to our fundamental analysis. The composite weekly absolute trend score from the WMA Trend Model plus the composite weekly relative trend score from the WMA Sector Allocation model must remain above a certain threshold for the stock to remain in the portfolio. The objective is both to avoid camping out in a stock that turns out to be a value trap as well as being vigilant to cases where price anticipates changes in company fundamentals. Readers can find our European Techno/Fundamental Allocation Model updated after each Friday close.
Our investment universe for the European Top Picks portfolio is all European stocks, subject to coverage of the company by at least three analysts. Again our analysis is forward-looking and our fundamental scores depend to a large part upon consensus forecasts. The appropriate benchmark is the Stoxx 600 index.
We rebalance our Top Picks portfolios weekly, as company fundamentals do not change on a daily basis. Just as importantly, weekly rebalancing avoids overtrading, as intra-week price movements tend to contain a lot of noise.
In terms of number of positions, the portfolio may hold between 20 to 40 positions with a soft target of 25 to 30 positions. We feel that a roughly 4% allocation to a single firm sufficiently expresses our fundamental convictions in the company’s business while not assuming excessive company-specific risk.
Our European Top Picks Portfolio is up +20.8% year-to-date versus +7.3% for the DJ Stoxx 600.
We recommend that long-term investors get back to Benjamin Graham basics and understand the companies that they are investing in. Passive investing implies buying crappy, overvalued companies along with potentially good companies. We invite readers to consult regularly our European Techno/Fundamental Allocation Model for investing ideas and even mimic our successful allocation, provided in full transparency, for do-it-yourself investors. Finally, we will be publishing next week our homologue U.S. Top Picks portfolio, which screens the entire Russell 3000 universe of NYSE and Nasdaq stocks in order to select the top growth, value and yield plays.
Like to give your opinion? Go to Comments