May 6, 2021•877 words
Together with this blog post I am also introducing a new section where I share my current equity holdings. There is no better way to understand the style of an investor than looking at its portfolio. This will make a perfect introduction to this new post since I am going to talk about my process of stock picking.
As I mentioned more than once I heavily rely on intrinsic valuation (Discounted FCF or DDM) to determine whether a company is worth to be included in my portfolio. To run an accurate and full valuation is incredibly time consuming especially if the company is operating in a sector that you never covered before. So filtering the number of companies becomes crucial. I tend to apply two main filters to select the companies that deserve further analysis: 1) Industry Sector 2) expensiveness and balance sheet structure.
The first filter needs to be in accordance with the current market cycle we are in and the upcoming technological trends. What do I mean by that? Historically there are some sectors who perform better in certain contexts, e.g. financials do better when the interest rates are high, telecoms tend to outperform during market crashes. An extensive knowledge of the financial history may come handy in assessing the full potential of a specific sector in a certain moment. Lastly, a great amount of curiosity and critical thinking is the key to detect trends that may soon gain momentum. Intuition is essential to generate alpha. I'll make a concrete example involving this concept.
For the last months I have been quite bullish over hydrogen as replacement of fossil fuels especially in Europe where the countries committed important investments for this cause. Across this sector there are many public companies that are directly and indirectly involved. Key players ranges from manufacturers of hydrogen catalysts (e.g. Thyssenkrupp) to the distributors (e.g. Snam) that permit to transport the fuel cell from the producers to the final users. An interesting fact is that many of the pipes that are already distributing liquid natural gas can interchangeably run hydrogen fuel cells. To produce green hydrogen, the electrolyzers need to be powered by solar panel or wind turbines that transfer energy through cables (e.g. Prysmian). Also, Airbus is far beyond Boeing in the project of a passenger aircraft fueled by hydrogen. Perhaps the prices of the stocks that are linked to this trend take already account of this factors but it is worth promoting them to the next step.
This is just one example of how brainstorming over a sector makes you find several potentially interesting names. But, as I just mentioned, curiosity and critical thinking are essential to link the dots.
The second filter concerns a quick look at the key ratios, with particular emphasis on:
- P/E (or EV/EBITDA)
- Interest coverage ratio
I use the P/E ratio as a general indicator for the expensiveness of a stock. It's not perfect but if compared with the P/E of the sector, it can quickly delineate if the company is trading at a discount or premium. EV/EBITDA tends to be more representative of the company's result since it ignores some tweaks that the accountants may use during the year. If the company is not profitable and has both negative PE and EBITDA, well that's not my stock. I make very few exception eg. when I decide to allocate a small fraction of my stake on early-stage tech companies. Contrarily if the PE ratio is shooting the moon I spend the next minutes wondering for what effing reason I didn't buy it a couple of months before - not the best mental model though.
Interest coverage ratio and debt/equity allow me to understand in the first place if the company is capable to payback the interest expenses and in the second place - but equally important - how the company is sensitive to the interest rate level. If the company makes use of huge amount of leverage you need to verify if it will have enough resources to face an increasing financial costs.I avoid buying highly indebted stocks when I expect a rise in the treasury yields, such as in this moment in time.
P/B gives me an idea of how much the price of the stock is backed by assets (better if tangible), but also you can feel the growth the street is expecting from the stock. In other words, if the PB is below 1 you are most likely looking at a business which has a negative growth rate expectation e.g. tobacco companies. If the PB ratio is 10 you are looking at a company for which the market has a stable growth expectation. Avoid using this ratio with tech companies because it's not of a great help.
I tried to put in writing what happens almost everyday in my mind. I hope you can find it easy to understand and helpful. Stay tuned for the publication of the monthly macro view and further contents about my investment process.
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