If there’s one thing we can all agree on as investors, it’s that we want our portfolios to beat the market.
One of the most popular benchmarks for the market is the FTSE 100 index of big-cap companies. Even if your focus is on smaller growth stocks, beating the Footsie is still a respectable achievement.
Today, I want to share with you a strategy I’ve been developing to help improve my own investing results. In theory, this could be a simple and almost foolproof way to beat the market. In practice, nothing is guaranteed. But I’m increasingly confident that this strategy should work well for me over long periods.
Shoot for the stars
One strategy used by many investors is to choose a small number of stocks with the potential to deliver very large profits. These are usually small-caps, often in the oil, mining or technology sectors.
There’s no doubt that some of these companies can deliver spectacular returns. The problem is that many of them lack proven business models or profitable assets. It’s inevitable that some of these will fail, leaving shareholders with large losses.
A particular risk is that as small private investors we aren’t able to get in on new opportunities early enough to enjoy big gains. Very often, insiders and institutional investors are the only ones who can buy the stock when it’s still cheap enough to provide big profits.
Successful professional investors in speculative stocks tend to do a lot of research. They usually spread their clients’ money across a large number of companies. So an occasional disaster doesn’t hurt too much.
For private investors, such large portfolios are often hard to manage and research adequately. In my experience, it’s difficult to succeed with such a high-risk strategy over long periods. At some point, big losses are likely.
Protect your profits like Buffett
If you make a 50% loss on one stock, you’ll need a 100% gain on another just to break even (assuming both positions are the same size). Losing 50% isn’t that difficult, but making a 100% is generally much harder.
This is why the world’s third-richest man, US billionaire Warren Buffett, says that his number one rule of investing is ‘never lose money’.
Buffett’s rule number two is ‘never forget Rule No. 1′.
Of course, all investors lose money sometimes, including Buffett. But with an estimated fortune of $82bn, I think we can say that the Berkshire Hathaway chairman’s focus on achieving a margin of safety in his investments has served him well.
Avoid the losers
The reality is that the stock market is full of really clever people trying to find growth opportunities. I can’t out-smart all of them, so over the last few years I’ve started to take a different approach to beating the market.
Although I still look for winners, I spend more of my time trying to avoid the losers. This is a more powerful approach than you might think.
Over the last year, the biggest loser in the FTSE 100 has fallen by 42% (Micro Focus International). If we expand our search to the FTSE All Share, the biggest loser (Carpetright) has fallen by 82%.
The market includes all of the big winners and losers. So by avoiding big losers such as these, we should be able to improve our portfolio returns and reduce the risk of big losses.
How to find some winners
Of course, we still need some winners to deliver worthwhile profits. But the good news is that the rules I’ve devised for avoiding potential losers also seem to help me spot stocks I might want to buy.
Here are five of the rules I use to screen the market and find potential buys.
1. Valuation: Shares that are very cheap or expensive can sometimes deliver big profits. But what happens more often, in my experience, is that these extreme valuations are a warning.
Stocks that are too expensive often deliver below-average returns, as you’d expect. And shares that are too cheap are sometimes value traps — stocks with underlying problems that keep falling.
To avoid these risks I prefer to buy shares with a forecast P/E of between about 6 and 20.
2. Profits: Most of us wouldn’t buy a used car that was broken down. In my view, investing in a company that’s never made a profit is similarly risky. It’s hard to be sure how much cash will be required before the company can start making money. And some companies never manage to break into profit.
For these reasons, I don’t invest in unprofitable companies, unless they’re established businesses in temporary difficulties.
3. Debt: This is one of the biggest risks for equity investors, in my view. Debt is senior to equity. This means that if a company starts to struggle with debt repayments, shareholders are often required to contribute fresh cash to help restructure that debt. And the shares themselves will often lose 80%-90% of their value.
Although heavily-indebted companies do sometimes operate successfully, the risks are higher. I don’t usually invest in companies whose net debt is more than four times their annual profit.
4. Dividend yield: In my view, dividends are a useful indicator of cash generation and management discipline. If debt is stable or falling and the company can still pay dividends, then the business must be producing at least some free cash flow.
I prefer to restrict myself to dividend-paying stocks, even if the yield is quite low.
5. Growth: Rapid growth can trigger big share price gains. But even mature businesses need to deliver some growth in order to stay ahead of inflation and avoid shrinking.
I generally rule out companies where sales are expected to fall over the coming year. I also prefer to buy stocks where earnings per share are forecast to rise, at least in line with inflation.
What next?
Finding companies that tick all of these boxes isn’t easy. I usually add stocks to my portfolio gradually as opportunities arise. If you’re interested in receiving some stock ideas chosen using similar rules to those I’ve described above, then read on…
