Young Research’s Three Part Screen for Common Stocks

In the late 1990s, I offered my readers a simple three-part screen to make the job of core common stock selection easy and comfortable. It reduced the field of play to what one might call investment-grade common stock issues.

What was the screen? I advised investors to stick with NYSE listed dividend paying stocks trading at less than 3X revenue. When I introduced the screen in 1998, it winnowed the common stock investment universe down to a few hundred issues from an unwildy 7,500+ at the time.

There was still much work to be done to craft a final investment portfolio, but the screen did a nice job of helping investors fish in the lakes stocked with trout and bass and avoid the ones where carp was the dominant species.

I explained the screen to readers as follows:

Rule #1: Stay on the NYSE. You have probably noticed that NASDAQ sotcks can be especially volatile. Most NASDAQ stocks are smaller and less seasoned than their NYSE brethren. Just the other day, computer component supplier Adaptec reported quarterly earnings below Street predictions, and traders hammered the rather thinly traded shares down 40% in a single session. A 40% haircut in one day is volatility beyond what I’m sure you find comfortable.

One way to reduce this volatility is to buy only NYSE stocks for your CORE portfolio. Don’t venture over to the NASDAQ. Yes, I know many fine companies trade on the NASDAQ, but a set of hard-and-fast rules is the tonic you need to stay out of trouble, and hard and fast means some compromising.

Rule #2: Invest only in dividend-paying stocks. By simply eliminating the non-diviend payers, you dump a huge hunk of the speculative stock universe and greatly reduce your field of eligible NYSE candidates for your CORE list.

Rule #3: Pay no more than three times annual revenues. Here, you are relating a given stock’s market cap (price X number of shares outstanding) to annual revenues.

How has the investment-grade common stock universe I described in 1998 performed since? The chart below compares the performance of this exact screen run every quarter from year-end 1998 through March of this year, to the performance of the NASDAQ Composite.

Both the screen and the NASDAQ are capitalization weighted. As you can see, the screen performed slightly better than the NASDAQ, but most importantly, it did so with only about 60% of the risk of the NASDAQ.

The structure of the stock market has changed a lot over the last 20 years and an NYSE listing is much less meaningful today than it was in 1998, but the concept of sticking with quality dividend payers at reasonable prices remains my advised approach for eliminating a huge chunk of the speculative stock universe.

Issues included in that speculative universe that are widely held among mutual funds and ETFs you may own include Facebook, Amazon, Netflix, and Google (here I eliminate the NYSE listing criteria). Not one pays a dividend, and all four trade at more than 3X revenues. You may argue all four are good companies that dominante their space. That may be true, but it was also true of Microsoft, Intel, and Cisco in 1998 (none passed my screen at the time). Ten years later, all three were down and down more than the S&P 500.

Two decades and a couple of ghastly bear markets later, the same focus on quality, dividends, and value remains essential to your long-term investment success no matter how dominant you may believe today’s social media giants have become.

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The Must-Know Investment Concept

The concept of an efficient frontier is central to proper portfolio management, but far too few investors are familiar with its use and application. Brokers and advisors, more interested in pushing product than offering investment counsel, may be to blame. An Efficient Frontier can help you calibrate risk and find the portfolio you are likely to be most comfortable with. Here’s what I wrote about the Efficient Frontier back in 2002:

The concept of an Efficient Frontier is central to everything we do at our companies. First, we lay out our basic investor tenet of diversification and patience built on a framework of value and compound interest. Next, we overlay any investment plan under review with an eye on an Efficient Frontier. I write about this pivotal concept for you in every letter. You will read little or nothing about an Efficient Frontier in other strategy letters. I have no idea why because the concept is so absolutely central to proper portfolio construction. An investor not up to speed on both the mathematics of compound interest and the power of an Efficient Frontier is operating far beyond the fringes of investment reality. In fact, I would go as far as to say that an investor devoid of a thorough working knowledge of these two powerful investment concepts has little chance of achieving a comfortable, rewarding retirement. Hence my inclination to hammer away monthly at both concepts.

As I have written often, an Efficient Frontier is nothing more than the line that connects one optimal portfolio across all levels of risk. An optimal portfolio is the mix of assets that maximizes portfolio returns at a given risk level. My chart illustrates an Efficient Frontier for a combination of two asset classes—long-term corporate bonds and stocks. We have used data from a representative long-term corporate bond fund and a suitable Index 500 fund.

Clearly an Efficient Frontier is about diversification. And investors saving in retirement portfolios or who are already retired want the appropriate mix of bonds and stocks. Here I’m writing to investors 50 years and older, but I’m tempted to mandate that investors in their 40s maintain a solid fixed-income component. I’ll suggest it, if not mandate it.

Exactly what are we looking at? It’s what I refer to as the boomerang. The vertical axis measures return; the horizontal axis measures risk. I always advise you to first gauge risk and much later worry about return. You’ll note, as you travel along an Efficient Frontier from left to right, risk gets greater. How much do you value a good night’s sleep? As I have reminded you often, between 1965 and 1981, a period of 16 years, the Dow fell 10%. Will such an extended period of stock market decline occur in coming years? I don’t know about 16 years, but I can count three. And the stock market is now down for the third consecutive year for the first time since 1950, so you tell me.

Personally, I invest with no view on where the stock market will be next year or the following, for that matter. I invest with the absolute knowledge that, long-term our population increases and that the stock market tends to generate a compound rate of growth that matches the compound rate of growth of GDP. We’re talking about 7% plus, of course, dividends. That’s my basis for investing in stocks—nothing more, nothing less. It’s not prudent to count on making one cent more long-term than the annual compound average GDP growth, plus dividends. If you are banking on more for yourself, you’re barking up the wrong tree.

If you are having trouble managing your portfolio’s risk, look for help at a seasoned, well regarded investment advisory like my family run firm, Richard C. Young & Co., Ltd. Talking with a professional can help you develop a retirement plan that will allow you to avoid crippling losses and achieve your goals. Read more about the concept of an Efficient Frontier by visiting Youngresearch.com here:

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Do Old Investing Rules No Longer Apply?

Do the old rules no longer apply? Can you live on corporate earnings alone? Is ignoring your margin of safety advisable?

It turns out, unsurprisingly that the answer to all these questions is no. Back in November of 1997 I wrote the following (my emphasis added in bold):

Ben Graham’s Margin of Safety

Graham died in 1976, yet his wisdom is as fresh as if he were standing before us today. Ben Graham & Co.’s advice to investors is to evaluate a stock as if you were considering buying the entire company. Graham’s secret of sound investing can be distilled into three words—margin of safety.

Why am I focusing on Graham’s margin of safety? Because we are all happy as sin with the stock market advances of recent years, but I don’t want you to lose perspective. When I was in the institutional brokerage business with Model Roland & Co. in the early 1970s, the Dow fell by 44% in just two years. As bad a year as 1973 was—the Dow fell over 16%—it was only a warm-up for 1974. In 1974, the floor caved in. The Dow plummeted over 27%.

Sixteen Years of Falling Stock Prices

Investors tend to be a little myopic. Many investors are terrific at extrapolating the past into the future. These misguided souls are not investors at all. Rather, they are speculators. Do you know that the Dow was actually down 10% over a 16-year period from its starting point in 1965 to year-end 1981? Do you realize that the yield on the Dow today is less than 40% of its historical average? Stocks are paying an average of only 1.7%, versus the historical average of 4-1/4%. But it’s a new era, you’re thinking. Things are different today. With the Dow at 8100, the old rules no longer apply.

Well, I can tell you for sure, when you’re not getting paid to invest, you’re not getting paid. Pure and simple. Today’s common-stock investor is plunking down his hard-earned money and, in effect, saying, “I will take my gains on the come. Don’t worry about paying me anything today.” It’s the greater fool theory, not investing. I can give you lots of reasons why yield is low today. In the end, you can still say to me, reasons schmeasons, I’m not getting paid! And you would be right.

OK, it is clear that investors are not being paid, but what about corporate earning power? Don’t earnings control stock prices? As far as I know, you still can’t pay your telephone bill or mortgage payment with earnings. Dividends yes—earnings no.

I invest my own money for the long term, and I do not trade or speculate. My portfolio turnover is lower than an index fund’s. The awesome power of compound interest, along with low turnover, taxes and commissions, and a lot of time do wonders for any portfolio. It’s exactly the strategy I write about and advise for you. But even if you are faithfully committed to the long-term power of compound interest, you need to tinker and prune. You want to invest newly available money with an eye toward current market conditions and Ben Graham’s concept of a margin of safety.

All of what I wrote then applies today. Over the last few days investors have been shocked to see some of their favorite stocks getting hammered by events unrelated to earnings. Facebook is facing legal troubles. Amazon is looking down the barrel of federal regulation. Tesla has been rocked by the crash of one of its self-driving cars.

Prices of shares have dropped and could fall further in reaction to their troubles. What will investors be left with? Certainly not a steady stream of dividends.

In 1997, when I wrote the piece above on Ben Graham’s margin of safety, the P/E ratio of the Dow Industrials was 21.2, and its historical range had been from 6 to 24. It would eventually peak in 1999 at 44.2, before crashing back to earth in the dotcom bust. Today’s P/E of 24.75 is higher than the historic average for the Dow, but nothing like the dotcom era.

Higher valuations demand justification. If you can’t rely on your money ever being returned to you in the form of dividends, and instead you plan on selling shares to a greater fool in the future, that’s no justification at all. You need a margin of safety. A steady stream of dividends used to generate compound interest is that margin of safety. Invest accordingly.

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Where do you Begin Investing?

To the uninitiated, investing can seem daunting. There are thousands of stocks, bonds, and mutual funds to choose from, and probably just as many opinions on which you should buy and which you should avoid. Even the most diligent novice can become overwhelmed by the number of decisions that must be made.

To get started, I have long advised a risk-first approach. That means a focus on fixed income.

For most investors, it’s a little hard to know where to even begin. So where do you begin? Tops on my list is your fixed income component. Most investors fail to maintain an adequate mix of fixed income. Ignore my warning at your peril. In today’s environment, it’s not how much you are going to make, but how much of your capital you will keep. Returns ahead are going to be meager. If you are retired, draw no more than 4% out of your portfolio annually. And my tendency is to reduce this already low number. Times are tougher than you may believe. The more than-two-decade decline in interest rates is fading into history. Could rates fall further? Sure rates could give a little more ground, but there just is not much running room left on the downside.

I advised investors of the above over a decade ago and it remains true today. In today’s environment, it’s not how much you are going to make, but how much capital you will keep. Returns ahead are likely to be meager. Think mid-single digits on the high-side.

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The Ten Worst Bets

Almost thirty years ago in 1989, I advised my readers on the ten worst bets for the year. Topping the list was overpriced real estate in New England, New York, and California followed by Japanese stocks and real estate.

My long-time followers may recall how real estate prices fared after that projection.  Housing prices cracked in all three regions and entered a severe downturn. Anybody levered and long in residential real estate took it in the neck.

According to the Case-Shiller real estate indices for Boston, New York, and L.A., the peak to trough decline in prices ranged from 15% to 27%. A 20% down payment on a house was wiped out in the crash. In L.A., it took more than a decade to get back to even after accounting for inflation.

How did Japanese stocks fare in 1989?

The Nikkei 225 index was up almost 30% for the year (in local currency terms).

That was a bad call…

Indeed it was, but only for the first 12 months.

The Nikkei peaked on December 29th of 1989. Over the ensuing 14 years the Japanese shares lost 80% of their value. To this day, the index remains 45% below its all-time high.

My timing was off, but the direction was not.

I don’t mention these past projections to boast. I call them to your attention because both projections were based on a careful consideration of risk. For the prudent investor, risk must always come before return.

Things could have turned out differently for U.S. house prices and Japanese stocks, and that would have been fine. The point is that the risk one had to take to participate in those markets far outweighed the potential reward.

I see many pockets of unfavorable risk/reward relationships in today’s financial markets. Some of these assets may not fare as poorly as house prices and Japanese stocks did 30 years ago, but the prudent approach is to avoid them.

Caution, balance, and diligence remain the mandate for your serious money today.

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You Must Address the Issue of Risk

What risks are lurking in your portfolio? Calm markets have made many investors complacent. Are you one of them? Far too many portfolios that come across my desk are heavily invested in risky assets (yes, the S&P 500 counts) with no counterbalancing assets to tame volatility. Look at my chart below to gain an appreciation of just how helpful counterbalancing assets can be in your portfolio.

Here you are looking at the performance of intermediate-term government bonds (dark blue) in years when the S&P 500 (bright blue) lost value. Since 1950, government bonds have been up in 13 of the 14 years that the S&P 500 has been down.

In 1992 I explained to readers a timeless strategy for counterbalancing their portfolios. No matter where you are today in your investment journey, you must address the issue of risk in your portfolio. Read here what I wrote in 1992.

Regardless of your age or ability to take risk, your investment portfolio should be dominated by common stocks (equities) and related open- and closed-end funds on one side, and U.S. Treasury securities and related mutual funds on the other side….

Maintain balance in your portfolio and do not switch back and forth based on your view of the markets. I don’t want you to be an events-of-the-moment shopper. Emotions are difficult to deal with when investing. If you allow emotions and events of the moment to dictate your investment thinking, you will frequently find yourself drawn to do just the wrong thing at just the wrong time in the market cycle. The old buy high, sell low advice lives on.

Designate a fixed percentage of your portfolio for Treasuries and related mutual funds and a fixed percentage for equities. Your age, financial resources, ability to take risk, and need for current income will combine to dictate how you should balance the two. In broad terms, my advice to you is to keep more than half in equities if you are a younger investor, and more than half in 1-10 year Treasuries if you are an ultra-conservative, income-oriented retired investor. Each of you has a different investment profile, so it’s impossible for me to give you precise percentages. Your key is to set down your needs on paper, make yourself address the issue of risk, and then position your portfolio in two parts. Make changes only if your basic investment goals change.

You maintain balance because you do not have a crystal ball. Each day when I buy The Wall Street Journal, I look to see if tomorrow’s date is on the masthead. Unfortunately, it never is, but it does emphasize that neither you nor I ever has tomorrow’s headlines.

It is the unknown that drives the financial markets over the short and intermediate terms (months to quarters). Unless you are a fortune teller, you must accept short- and intermediate-term swings in the markets created by transient and unknown events. You do not want to invest based upon emotions created by events. Instead, invest with an understanding of the long-term principles of earnings, dividends and economic growth that in the end must govern the markets for financial assets.

If you need assistance realigning your portfolio, or if maintaining balance takes too much time and effort, seek help. Firms like my family owned investment advisory service can take the weight of every-day management of your investments off your shoulders. If you want to learn more about the ways a Barron’s Top 100 registered investment adviser is managing risk for its clients, read through the Richard C. Young & Co., Ltd. monthly client letters here. If you wish, you may sign up to receive an alert each time the newest letter is released. The service is free, even for non-clients, so you can easily gain an understanding of our risk management philosophy.

Don’t let inertia hold you back from addressing the risks of unbalanced investments in your portfolio. Act now.

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What Should You Buy?

Even after a mini-correction in the S&P 500, most stocks still aren’t cheap. So what should you buy?  In 1991 I wrote that utilities offered outstanding relative value compared to other securities.

Utilities Offer Outstanding Relative Value

Three industry groups should be emphasized for new purchases in your portfolio over the next few quarters: electric, gas and telephone utilities. My number one mutual fund portfolio manager (this month’s spotlight), Vanguard Equity Income Fund’s Roger Newell told me recently that electric utilities are now his top industry choice with 18% of his $450 million portfolio now in utilities. Roger Newell is buying electric utilities—18% of his $450 million portfolio—because he feels the 1991 run-up in growth stocks and cyclical stocks has drained money from the utilities, and they now offer compelling relative value.

Today, outstanding would be an overstatement when referring to utilities’ relative value, but there are some interesting opportunities to be had within the sector for the discerning investor. As always, a focus on dividends and dividend growth will serve you well over the long haul.

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A Winning Strategy: Stay in the Game

There are endless cliches about never giving up and quitting being the surest way to lose. Finishing a race is a prerequisite to winning it. My son-in-law, E.J. Smith, managing director of our family run investment council firm, recently explained some of the philosophy behind what it takes to develop a winning investment strategy on his blog Yoursurvivalguy.com. He wrote:

“E.J., Has Your Phone Been Ringing off the Hook?”

Well this was a fun month for the stock market with wild swings from high to low of around 2,000 points in the Dow Jones Industrial Average.

One question I’m asked on a consistent basis is “E.J., is your phone ringing off the hook?” and my answer is “no,” and I know why. Most of you have been educated by Dick Young that investment success is achieved over a lifetime, not a month or two. Investment success is about hitting singles and doubles, taking some walks here and there and sometimes getting hit by a pitch. Staying in the game is key. It’s a winning strategy because it puts compound interest into play. Spend a lifetime compounding money on a consistent basis and you’ll wake up one day and say “Wow, I have a pile of money.” It’s funny, when I ask investors how they achieved their success. They don’t talk about the stock market. They talk about working long hours, putting one foot in front of the other, showing up for work every day and s-a-v-i-n-g as much as they could save. Looking back 40-years, they know how tough it was to save $1,000. Compound that at 8% and it’s $21,725 today. Not a bad start.

Click here to finish reading this post on Yoursurvivalguy.com.

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Compound Interest is Key

For prudent investors, the last three years have meant watching the so-called FAANG stocks (and other speculative shares) rise at a rate that is seemingly unbounded by profits or dividends. The FAANGs have gobbled up an ever-larger portion of the S&P 500 index total market capitalization. Four of the five largest companies in the S&P 500 are now FAANGs.

Today’s market environment feels similar to the late 1990s when speculation was dominant. To successfully navigate the environment then, I advised a focus on patience and compound interest.

Compound Interest Is the Key

Legendary investor Phillip Carret used to say that investing genius consisted of one part patience, and one part compound interest. And Charlie Munger, Warren Buffett’s long-time partner, will tell you that he is rarely without a compound rate-of-return table. As Munger says, “Understanding both the power of compound return and the difficulty of achieving it is the key to investing.”

If you adhere to a base of value, keep your portfolio turnover low to cut costs and taxes, and rely on the miracle of compound interest, you will set yourself on the safest and surest course to profit both this year and in future years. Craft your portfolio with counterweight building blocks that allow you to ride out the vagaries of the marketplace.

Last year was the third consecutive year that growth stocks outran value stocks. But remember, growth and value tend to produce similar returns long term. One sector is ahead for a period, then the other has its day. Back in the two-tier market of the early 1970s, growth stocks had a field day at the expense of value stocks. But over the next decade, it was another matter. Value stocks clobbered growth stocks, and it’s value stock that are cheaper now in 2000.

The same advice can be given today. Patience and compound interest never go out of style.

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Dow Down Over 1,000 Points

What great news for me and for you if you are actually an investor. I mean a real, seasoned investor. One who embraces common sense, patience and the acuity that comes with decades studying the power of consistent cash flow matched with the most powerful word in investing: compounding.

My business is, as are my own portfolios, based on exactly these concepts. Market volatility has zero to do with dividends, interest (the source of cash flow), or compounding. Absolutely zero.

In that I have no plans to sell my major holdings (many owned for decades), I am not concerned about short-term market swings. What does cause me to pay close attention is the potential opportunity to invest my regular cash flow more advantageously than during periods of market buoyancy. That’s just common sense, is it not?

So, let’s look at some of the information I urge my clients to use to make steady, long-term investing decisions. Linked here is intelligence you can actually use to improve your long-term investment acuity.

The Young’s World Money Forecast (my online home base for intelligence gathering) display looks at 10 blue-chip long time Dow dividend payers with solid dividend growth prospects. Keep this invaluable little menu at hand for regular reference during periods of opportunity brought about by normal and expected short-term financial markets volatility.

Warm regards,

Dick

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