Here’s My Process For Finding Winning Stock Picks…

It’s not easy to explain my job to friends and relatives. Some think I’m a blogger or writer, others an accountant or financial adviser. I guess you could say that I’m all those things — and none of them.

Truth be told, I spend most of the workday reading. Economic reports, trade journals, fund manager commentary, conference call transcripts… you name it. It might be after lunch some days before I get anything written down on paper or the computer screen. Fortunately, my bosses want their analysts to be well-informed, so they graciously pick up the tab for subscriptions to countless online publications and financial data providers.

It’s one of the perks of the job as Chief Investment Strategist of High-Yield Investing — but also quite essential to stay on top of all my active holdings. One minute I’m elbow-deep reading about how the China trade war, the next I’m reading about the latest clinical trial results for a new oncology drug. I’m constantly in search of new investment ideas to file away and potentially explore in future issues.

My loyal readers subscribe to my newsletter to learn about an exciting new recommendation in every monthly issue. But where do they come from? Believe it or not, that’s one of the most common questions I get. So today I want to spend some time addressing this.

First off, I want to remind everyone that I don’t receive a penny of compensation (financial or otherwise) from the companies or funds endorsed in my newsletters. And company policy prohibits employees from acting on buy and sell recommendations until after publication.

Unhappy readers don’t renew subscriptions — it’s that simple. So I do my best to present money-making ideas each month, while also providing valuable educational content to make you a better investor along the way.

But let’s get right to it. First off, let me tell you what I don’t do…

Unworthy Until Proven Otherwise…

For one thing, I’m not a big proponent of technical analysis. I rely on fundamental metrics such as sales and earnings, not esoteric indicators like Bollinger bands and stochastic oscillators and MACD indicators. I’m far more interested in a company’s growth potential than whether its stock chart resembles a double head and shoulders pattern.

Nor will you find me using complicated “systems.” Just not my thing. Even some of the most powerful “quant” funds utilizing sophisticated mathematical algorithms and computer programs haven’t done any better than your run-of-the-mill index fund.

I’m an investor, not a day trader looking to enter a stock at $50 and exit a few hours later at $51. My goal is to methodically build wealth over time by finding exceptional businesses with strong cash flow generation that distribute generous dividends and deliver superior total returns. Once found, I latch on to these companies and don’t let go (not without good reason, anyway).

Of course, that’s always easier said than done. I liken the process to hunting for diamonds.

That’s exactly why I read extensively, to cover a lot of ground in search of new ideas. Inspiration can come from anywhere. And it doesn’t always take much to spark my interest — sometimes just a sentence or two. When that happens, I’ll jot down the ticker symbol so I can return later for a deeper dive.

At any given time, I’ve got maybe 20 or 30 of these raw prospects in the hopper. I don’t know their full investment merits just yet, only that they possess the requisite 4% minimum yield to qualify for our portfolio and that they caught my eye for one reason or another.

These might be viable portfolio candidates. They might not. I won’t know for sure until they have been measured and inspected. Either way, it’s guilty until proven innocent. I always start under the assumption that a stock is unworthy until it convinces me otherwise.

Many prospects fail to make it past the first round — perhaps they have severe balance sheet deficiencies or some other fatal flaw. Or I might have reservations about the industry as a whole.

The Charlie Munger Test

If there are no obvious red flags (and the dividend appears to be on solid ground), then it’s time to dig a bit deeper. I put every serious candidate through a gauntlet that I like to call the “Munger test” (named for Warren Buffett’s longtime business partner Charlie Munger).

Munger and Buffett use four filters to determine whether a stock deserves a coveted spot in their portfolio. I happen to be a big believer in each of them. A single “no” response is an automatic disqualifier for me. Interestingly, three of these four criteria are qualitative rather than quantitative, as some of the most important traits can’t be directly measured.

Here they are:
1) Is the business model sound and easily understood?
2) Does management have integrity and is it trustworthy?
3) Is the business protected by an economic moat and does it belong to an industry with favorable long-term economics?
4) Is the stock reasonably priced relative to the business’ fair value?

It’s really more of a checklist than anything else. Still, asking these four questions will go a long way toward separating the wheat from the chaff.

Look For Moats And Value

That’s particularly true with regard to economic moats. Unless this is your first time reading my work, then you’ve probably know I’ve stressed their importance many times before.

Moats are one of the pillars of my process.

In the business world, success invites competition, which inevitably erodes profits and drives down returns. Only companies encircled by defensive moats can fend off competition and generate sustainable excess returns over time.

What can happen to defenseless companies that lack a moat? Just ask Radio Shack or Toys R Us.

The wider and deeper the moat (metaphorically speaking) the better protected the company. Like Buffett, I look for fortifications that are nearly “unbreachable,” but even shallow ones can make a big difference. You’ll find moats surrounding all the world’s greatest, most profitable business… Apple (Nasdaq: AAPL), Visa (NYSE: V), Amazon (Nasdaq: AMZN), Coca-Cola (NYSE: KO), Wal-Mart (NYSE: WMT)…

Most of my current and former holdings possess some type of unique competitive advantage that forms a protective moat.

Qualcomm (Nasdaq: QCOM), for example, has patents and intellectual property that safeguard its technologies and generate billions in annual licensing income.

If you find a business with a wide moat, a competent management team, a strong yield, and a reasonable price, then you’ve got a viable candidate. But just to be sure, I insist that their returns on invested capital (RoIC) exceed their weighted average cost of capital (WACC).

That’s the only true way for a business to create lasting shareholder value over time.

I look for rare businesses that generate superior free cash flows relative to their size. Buffett refers to this cash flow stream as “owner earnings,” or what’s left for owners after all the bills and capital expenditures are paid. This is the pool of cash that can be used for dividends, buybacks, acquisitions, or internal growth projects.

The value of any business is inherently tied to these future owner earnings discounted back into today’s dollars. So they factor much heavier in my calculations than simplistic metrics such as price/earnings ratios. Of course, I also evaluate and monitor a host of other things such as operating margins and inventory levels and balance sheet structure, along with countless industry-specific metrics. They help round out the picture.

Closing Thoughts

Up until this point, the entire process has been “bottom-up,” meaning I examine each company on its own merits without much regard to big-picture macroeconomic trends. First-rate businesses can prosper even when facing economic headwinds.

But we’d much rather see tailwinds.

That’s why I also pay close attention to Fed interest rate policy, the strength of the dollar, housing starts, commodity prices and numerous other variables that can sway the outlook for a specific sector. When these are aligned in favor of a business we already like, a good prospect suddenly becomes great (especially if it fills a gap in our portfolio).

It’s this kind of approach that has led us to a string of winners over the years. Perhaps even better, they create an income stream that allows our readers a comfortable living in retirement when the time comes.

It’s not too late for you to get started, either. If you’d like to learn how to join us — and get access to the names of my latest picks — I invite you to read this short report.