Pearce's Picks: IDEAL Way to Find Stocks

09/04/2015 10:00 am EST

Focus: STOCKS

James Pearce

Director of Research, Investing Daily

Jim Pearce, has introduced a new stock ranking system to the portfolio tools he uses at Personal Finance; the system—focused on yield, cash flow, and PE ratios—is designed to isolate potential under- and over-performers.

Steven Halpern:  Our guest today is Jim Pearce, senior editor of Personal Finance and of the Investing Daily family of newsletters.  How are you doing today, Jim?

Jim Pearce:  Doing great, Steve, how are you?

Steven Halpern:  Very good. Today I'd like to discuss your recently introduced stock rating system known as IDEAL.  First, could you explain the overall goals of the system?

Jim Pearce:  Sure, Steve. When I took over as chief investment strategist for Personal Finance late last year, I felt that, with quantitative easing coming to an end, that it would help us and help our subscribers make better stock market selections having some sort of objective system that would help us identify stocks that were more likely to hold up in what I felt was going to be a much more difficult economic environment.  

I've been expecting a two-tier stock market this year, where the overall index is flat, but you do have, you know, the top half stocks that outperform the index and then the bottom half that do not, so I specifically created IDEAL to help us zero in on those stocks that would be, you know, in the upper half, in terms of performance.

Steven Halpern:  Now, Personal Finance has been one of the industry's leading advisory services for over 40 years. Is there anything specific to the current market that compelled you to introduce the system at this point?

Jim Pearce:  Yes. You know, I started out as a stockbroker a little over 30 years ago and something that is difficult to keep in mind, because it's been such a long-term cycle, is that over the course of my entire career, interest rates essentially have been coming down.  

When I started out in 1983, you could get double-digit yields on US Treasury securities, 12, 13, 14%. Of course, now these days, you can barely get a little over 2%, so this very long bull market in bond prices, if not coming to an end, is certainly bottoming out, so the huge difference, I believe, over the last, certainly 30 years, and over the next 30 years, will be the trend in interest rates.  

At best, you know, I think we'll be in a flat interest rate environment for a while, but eventually they'll start going back up and that's something that almost none of us have any experience with as investors.  

Maybe some of, you know, our more seasoned investors can remember the 70s and the 60s when we were not in the declining interest rate environment, but the huge difference is interest rates going forward and that's another reason why I felt like it was really important to have a system that could identify stocks, that did not require, you know, cheap money in order to do well.

Steven Halpern:  Now, the IDEAL system focuses primarily on three variables related to dividend yields, cash flow, and forward P/E ratios.  Could you walk us through these three metrics and explain why they play such a prominent role in the system?

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Jim Pearce:  Sure. So, let's start with the first one which is dividend yields.  If you look at, you know, the past 50 years of stock market returns, dividend yields have made up over half of the total return, so, if you buy stocks at, say, no or little dividend, it's almost like fighting with one hand tied behind your back.  

Now momentum stocks, which have been popular during this bull market, usually don't pay much of a dividend because investors are seeing constant appreciation, but, again, going forward, I don't think that's going to be the case, so investors are going to want to see some kind of economic benefit while they're holding a stock and paying a decent dividend yield is one of the things they're going to look for.  

So, I grade dividend yield on a scale compared to what's currently available from Treasury securities because I think that's the mental calculus that a lot of investors make: if this stock's only yielding 1% but they can get 2% on a 10-year Treasury note, they might decide it's not worth the risk of owning a stock, but if the stock's paying 3% and the alternative is getting 2% on a 10-year Treasury note, then they'd be more motivated to buy the stock.  So, dividend yield is just one of the things I think investors are going to demand more going forward.  

The second component is the growth in that operating cash flow; and what I do is I look at the most recent year compared to the prior two years and the reason why I do that is...I have several friends who are current or former chief financial officers at publicly traded companies and when I asked each of them what was the single most important metric they looked at when they were deciding how much money to invest in CAPEX in the coming year, how much money to set aside for share repurchase programs, how much money they might have available to make acquisitions, the sort of things that all contribute to superior performance, net operating cash flow is what they really look at.  

We all know that earnings, to a certain degree, is an artificial number that can be manipulated with a variety of techniques that are perfectly legal but sometimes mask the true financial health of the company, but net operating cash flow is a pretty honest number.

If a company is seeing the net operating cash flow decline steadily over the past year or two, they're more likely to pull in their horns, not invest in the type of things that they would need to invest in to remain competitive, so it's really important that the company be generating that positive growth and cash flow to be able to compete with the other companies in their sector.  

Then the third one is just the forward P/E ratio compared to the average for all of the stocks in their sector, and, quite frankly, that's just to eliminate over-valued stocks that, in my opinion, have gotten a little ahead of themselves.  

Again, during a bull market—and particularly when the Fed was pumping a lot of money into the economy via quantitative easing—you could justify a stock trading at 50 times forward earnings so long as the economy kept growing with that additional stimulus, but going forward, there's going to be a lot less cash sloshing around in the economy, so momentum stocks are going to have a much tougher time justifying their high valuation.

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So, I'm really looking for companies that are currently trading at a discount to the average forward P/E ratio of their sector peer groups. So, when you combine those three things—a stock that's paying an above-average dividend yield, is growing its net operating cash flow faster than its competitors, and yet is priced, the stock is priced, cheaper than its competitors—that's the winning formula for a stock that's more likely to outperform the index and the type of market I anticipate we're heading into.

Steven Halpern:  So, as you've alluded to, you're looking for stocks both that are potential outperformers as well as those that are expected to underperform.  Let's take this separately.  Could you first discuss a couple of names that might stand out as potentially outperformers?

Jim Pearce: There's two things I look at, one is, I look at companies with high individual Ideal scores, but I can also calculate the average IDEAL score for a sector, so I also look for high scoring stocks in high scoring sectors.  

Right now, according to my system, the most undervalued sector is financials, and they're about 24% undervalued compared to the market average right now, so I then narrow down my search to that sector and try to find some stocks that score a perfect ten or a nine.  

Those are the two highest scores, you know, the scale goes from zero to ten, so anything that rates an eight, nine, or a ten, I consider to be a very strong buy candidate. So, for example, right now you have M&T Bank (MTB), which has a perfect IDEAL score of ten.  

It's only trading at 13 times forward earnings.  It's paying a dividend yield of a little under 3% and generating very positive gains in net operating cash flow and, of course, financials, particularly domestic banks here in the United States, they are not as subject to things like changes in currency values—or just the fact that we have a very strong dollar—because they generate virtually all of their income domestically, to where those exchange rates aren't particularly relevant, plus they're just in a very strong geographic market. So, M&T Bank is an example of a very high scoring stock in a high scoring sector.  

Now, in addition to that, I also look for stocks that score high individually and have a compelling reason to believe that they're probably going to outperform going forward.  A recent example, in fact something that happened just this week, is Best Buy (BBY).  

Most of us think of Best Buy as an electronics retailer, and they still, to a large degree, are.  However, there's a subtle change going on with Best Buy that my IDEAL system picked up on about four months ago when it rated Best Buy a perfect ten.  At that time it was trading in the mid to upper 30s.  

Just earlier this week, they announced their quarterly earnings and mentioned that one of the reasons why their domestic sales increased much greater than expected was a jump in sales in home appliances and, you know, big screen television/home theater kind of equipment.  What those things have in common is that they're a play on the housing market.  

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You don't think of Best Buy so much as a play on the housing market.  Most people think of stocks like Home Depot (HD), but when somebody buys a new house, they need appliances and people who are fortunate to have enough money to have a home theater room spend thousands and thousands of dollars and that's not the kind of stuff they can't readily buy online, you know, through Amazon (AMZN).  

You know, for a long time, Best Buy was selling things like music CDs and video DVDs.  Well, all those things now are digital and can just be downloaded, so Best Buy wisely got out of that business, moved aggressively into things like appliances and home theaters, and now it's really starting to pay off.  

The stock did jump up this week but it's still undervalued and, I think, a great buy going forward. So, there are two examples of high scoring IDEAL stocks that should do very well in whatever economic environment we're moving into.

Steven Halpern:  Now, we only have a minute, but perhaps you'd mention a sector or two where your IDEAL system suggests that investor should stay away.

Jim Pearce:  Sure, so the worst—the sector that appears to be most over-valued at the moment—which will come as no surprise—is healthcare.  It's about 30% over-valued compared to the market average.  Biotech stocks have had a great run, but some of them appear to be over-valued, particularly Edwards Lifesciences (EW).  

There's a stock that's basically the opposite of what I just described in terms of having fundamentals. A lot of these biotech stocks pay no dividend; most of them are trading at huge valuations.  For example, Edwards is trading at about 30 times forward earnings, which compared to other biotech stocks is pretty average, but the sector as a whole has just gotten very rich.  

It pays no dividend, its quarterly earnings growth is actually a negative 79%, yet the stock price really hasn't declined as much as I think it should. So, there's a stock that scores a zero according to my IDEAL system in a sector that's about 30% over-valued.  

Another one, real quick, is Yahoo (YHOO).  It's a tech stock, of course, trading 50 times forward earnings, pays no dividends.  For a while, their big claim to fame was, as you know, they were still going to retain a huge interest in Alibaba (BABA), which, of course, is now looking like it's going to be worth considerably less based on some recent regulations proposed by the Chinese government.

So there's a stock that's moving in the wrong direction.  So, Edwards Life Sciences and Yahoo are examples of two stocks that I think are in for a rough time in the year to come.

Steven Halpern:  Again, our guest is Jim Pearce of Investing Daily.  Thank you so much for your time today.

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