In other words, it is for investors who prefer many good-quality stocks rather than very few high-quality stocks in their portfolio. Quality in this context refers to the depth of research and understanding of a particular stock. Also, it must be noted that focusing on either quality or quantity is a valid investment objective, as each has its pros and cons. Hence, the goal of this article is to guide investors who wish to pursue an investment strategy that prioritises quantity, given the premise that not all investors have the luxury of time.
That said, if an investor had 30 min to assess one stock, what should they focus on?
Qualitatively, the overarching principle is that investors must understand, or at least have an interest in learning about, the business of the stock. This will not count in the 30 min because it can be done anytime, anywhere, just like scrolling through news on the phone. Investors could read about a business on the company website, watch videos on how the sector works, listen to podcasts from industry experts, or, better still, read the company’s annual or financial reports.
On the other hand, being allocated 30 minutes means that an investor must be methodical when it comes to quantitative analysis. Some important aspects an investor should consider are outlined below.
See also: Are you ready to sell your winning stock?
1. Filter the stocks appropriately
The first step in quantitative analysis is to filter the list of stocks that suit the individual investor’s profile. There are many ways to filter a stock, but since the goal is to pick as many eligible stocks as possible, these filters can be much more general and broader.
For example, suppose a filter is based on company size, represented by market capitalisation. In this case, the shortlisted companies can be grouped by size: small caps ($300 million to $2 billion), mid caps ($2 billion to $10 billion), or large caps ($10 billion and above). Examples of other filters include whether a company pays regular dividends, having more than five years of financial reports, the industry or sector a company operates in and whether its share price is volatile (measured by the stock’s beta).
See also: Exploring the different facets of profitability
The key point here is that none of these filters has much to do with the company’s financial results or performance. Essentially, the quantitative analysis should be done after filtering the type of stocks the investor is interested in. Having a larger sample size is especially useful for comparison purposes if an investor is using this strategy.
2. Use a scoring table
After filtering the stock list, it is time to begin the quantitative analysis. One of the most time-effective ways to do this is to have a scoring table. Only companies that pass a certain threshold would be deemed valuable enough to be added to the investor’s portfolio.
The advantage of having a scoring table is that companies can be ranked by their scores and those that barely miss the threshold can be added to the investor’s watchlist.
The weight of each metric in the scoring table can vary based on what the investor prioritises. The question then is, what financial metrics should investors use in this scoring table?
• Historical performance
The first metric is a company’s historical performance. This can range from three years at a minimum to 10 years. The financial performance of a company should include revenue, net income, operating cash flow and free cash flow. The companies can further be scored based on positive figures and consistency. For example, a company with 10 years of increasing revenue, positive net income, and cash flow would score full marks for this component. Every time a company records decreasing revenue, negative income and negative cash flow, their marks would be deducted for negative performance and inconsistency.
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• Profitability
The profitability metric should typically consist of the return on equity (ROE), return on assets (ROA), operating profit margins and cash flow margins. Companies are scored first by their absolute value and then by their relative value. For example, a company would score highly for its operating profit margins if its margins are positive and above the industry or peer average.
• Yields and attractiveness
Yields in this context refer to the company’s earnings and cash flow yields. It is the inverse of the priceto-earnings (P/E) and price-to-cashflow ratios, respectively. A company would score positively if its yields were first above the risk-free rate and second above the industry or peer average. Also, if a company is trading attractively/cheaply, it would score full marks for this metric. Cheap in this context refers to its price multiples, such as price to earnings, EV/Ebitda and the price-to-book ratio compared to its historical average. For example, if a company trades at 10 times P/E, which is below its historical average of 15, it would score positively on this component.
• Financial safety
Financial safety encompasses both a company’s liquidity and solvency. Short-term liquidity can be assessed through a company’s current ratio; anything above one indicates positive liquidity. For longer-term solvency, a company can be scored based on net debt relative to shareholder equity and the interest coverage ratio. A company that scores fully for this component would, for example, be net cash and have an interest coverage ratio of over three times.
• Sentiment
Sentiment is measured and can be scored based on analyst forecasts of the company. A company that has mainly bought calls, with a target price above its current trading price and optimistic earnings projections, would score positively for this metric.
3. Tweaking the table
For investors using a balanced approach, equal weights of 20% can be assigned to each metric. Should an investor prioritise one metric over another, the individual weights can be adjusted accordingly, and this process is relatively simple.
However, it is not advisable to use a balanced approach that assigns equal weights to all five metrics. For most shortlisted companies, in descending order of importance, the highest weight should be assigned to financial safety and profitability, followed by yields and attractiveness, and then historical performance. The lowest weight should be assigned to sentiment. Sometimes exceptions to this sequence can be made, but the individual investor must justify them.
4. Picking and allocating stocks
Once the scoring is complete, investors can allocate the companies based on a point scale. First, an investor should decide what the minimum score is for a stock to be included in the portfolio. For example, this can be above 85%. Anything below this score can be included in the investor’s watchlist, if it is above, say, 75%.
Next, it is essential to differentiate between the companies which have surpassed the threshold. Using the previous example, say three companies scored 85%, 90% and 95% respectively.
The investor should allocate more investment funds to the company that scored 95% than to the one that scored 85%.
5. Conclusion and summary
Although an investor may take more than 30 min the first time they use or develop a scoring table, it is essential to note that the scoring table is flexible and reusable. It is just a matter of searching and filtering data. Once mastered, for an individual stock, the investor should spend no more than 10 min on the initial filter, less than 5 min per metric, and 5 min on allocating the stock based on its score.
The next part of this series will cover how to invest if you have double the time — an hour per stock for investors who wish to have a moderate number of stocks in their portfolio, with a balance between quality and quantity.
Disclaimer: This article is strictly for information purposes only and does not constitute a recommendation, solicitation or expression of views to influence readers to buy or sell stocks. Any personal investments should be made at the investor’s own discretion and/or after consulting licensed investment professionals, at their own risk. The author of this article does not hold or own any stock featured in this article or have a vested interest in it at the time of writing.
