How to select a portfolio

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In this edition of the Alpha Letter, we cover: 

  • Stocks & Options: Retail traders have taken over - but it’s not the first time

  • Dividend Investing: How to find good dividend growth stocks 

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Stocks & Options

Is anything really new in investing?

When you look at the 100+ year history of modern markets, you realize nothing is really new in investing. 

As famous hedge fund manager Ray Dalio likes to say, just about everything in the market is “just another one of those”, meaning nearly everything that happens in markets is a variation on something that has already happened.

The media likes to create the impression that unusual events are unprecedented and pose some existential risk to the markets or humanity as a whole. This is almost always a massive over-exaggeration but it happens because it helps media companies sell ad space.

For example, the financial media likes to opine about the massive amount of “unprecedented” retail involvement in the market and debate daily how dangerous it is.

But check out this Forbes cover from 1998:

The only thing that really happens in markets is that human emotions of fear and greed interact with each other and cause prices to move up and down, sometimes in dramatic fashion.

In my experience, the only thing to really avoid in the market is to avoid getting sucked into an illogical vortex of greed or fear so powerful that you end up losing it all.

You just have to stay in the game. Steady gains are perfectly acceptable. Over a long period of time, you’ll do well.

If you’re going to be more aggressive, you need to stay in the game long enough to get the one 20-bagger you’ll need to make your decade (or even your entire investing career).

Dividend Investing

Let’s talk about investment selection. I found this informative piece on Seeking Alpha on narrowing down the potential opportunity field from the 7,500 available public companies to a reasonable field of potential investments to analyze.

For a dividend investing portfolio, the author’s first criteria was that potential target companies should yield more than the current dividend yield of the S&P 500, which is 1.5%.

Here are all the criteria:

While this list of criteria works well for dividend growth investing, this process can be applied to any investing strategy. If you’re looking to construct your own portfolio from scratch, I highly recommend using this process to build a list of potential investments to dig into.

There’s absolutely no way one person can have a firm grasp on all 7,500 publicly-traded companies. If you’re going to actively pick your own stocks, you likely need to focus on a type of strategy and one to three sectors.

If you’re worried about diversification, you can put half your portfolio into passive market index funds, and then actively manage the other half of your portfolio in one sector or industry that you really understand. Alternatively, you could also create a concentrated large cap portfolio and only invest in 10 to 20 large cap companies across a variety of industries.

Here’s an example for managing your own portfolio: Say you're a growth investor focused on software. You’d create a list like the one above that includes a minimum 5-year sales growth rate of 10%, a P/E ratio that’s either negative or above 20, and a market cap below $50 billion.

Now back to the dividend investing list above.

Using the criteria above, we get 393 companies. 

That’s still way too many to analyze. To narrow it down, the author strips out companies without five years of dividend growth history.

After filtering the list a bit, the author creates a formula to measure and rank each remaining company. The formula includes current yield, dividend growth history, payout ratio, debt/equity ratio, EPS growth, and several other factors.

The author uses this formula to narrow the field down to 25 companies that rank highly in all the important dividend-related metrics.

I won’t give away their entire list here (check out the article for their full process and list of dividend growth companies), but here are a few of the ones that stood out to me:

  • Aflac (NYSE: AFL) $39 billion insurance company with a 2.30% dividend yield with a history of strong growth (the stock is up 39% over the last year and 66% over the last five years).

  • Clorox (NYSE: CLX) Consumer staple company with $22 billion market cap and a 2.59% yield.

  • Southern Copper Corporation (NYSE: SCCO) Mining company that has benefited greatly from the rise in commodity prices - it’s up 83% over the last year. Yielding 3.94%, which is great for an investor entering now given that the stock has already appreciated so much recently. 

What we are reading

Alpha Thought