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Equities : Passive Index Investments – Where NOT To Put Your Money

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08/10/2017 | 12:25pm CEST

After eight years of central bank endless liquidity, passive investing has become all the rage. The tidal wave of Federal Reserve, European Central Bank, and Bank of Japan quantitative easing liquidity has lifted all boats, both rickety and seaworthy. Vanguard, the index fund leader, has been laughing all the way to the bank these past years. Lazy investors and financial advisors have been “buying the market”, most notably the S&P 500 index tracker funds, creating huge inflows into component stocks. Remember that for each investment in the S&P 500, Vanguard or State Street (who runs the popular SPY exchange traded fund) must in turn buy each company in the index, without any consideration for the company’s valuation or underlying fundamentals. We believe, along with many other astute investment professionals, that the central banksters’ QE experiment has suppressed the invisible hand of the markets and created serious miss-allocations of capital, both in the equity and the bond space.

Disclaimer: the opinions in this article do not necessarily reflect those of 4-Traders.com and the stock recommendations are our own and not those of 4-Traders.com.

Motivated by our strong conviction that company fundamentals and valuations will win out over central bank monetary policy experiments, we have shown that our intellectual and data resources allow us to build fundamentally solid equity portfolios that largely out-perform passive, index funds over the business cycle.  One thing is certain: lazy investors who are feeling warm and cozy in their S&P 500 or Nasdaq index funds will probably lose everything – and then some – when the day of reckoning arrives. At the same time, diligent investors who do their homework and build portfolios consisting of fundamentally solid companies will weather whatever storm arrives on financial markets.

With an avant-gardiste flare, we believe that now is the time to abandon passive index investing and get back to Benjamin Graham-style company analysis. We share below some of our equity selections and our investment methodology. Hopefully investors can receive inspiration for their own portfolios from our stock picks.

This week we present our European top stock picks and next week our U.S. top stock picks. We first provide some insight into our overall construction methodology then share some of our current equity picks.

Portfolio Construction

A portfolio is a collection of stocks that fit together and interact. Our top picks portfolios synthesize three over-arching investment styles:

• Growth
• Value
• Yield

The interaction of these different styles smooths portfolio performance over the business cycle and, most importantly, reduces portfolio volatility.  Our Growth pocket scans the universe of all European equities for companies with the fastest revenue growth rate over the current year and the projected rate of growth over the next three years. The goal is to select companies with dynamic growth and the fastest expected rate of change in revenue among peers.

While the projected revenue growth rate is the determinate criteria, our selection is refined by considering all facets of the target company’s business. The best resource to conduct thorough company analysis is 4-Traders.com. The site provides information on company financials and consensus forecasts for key metrics in easy to read charts and tables. In addition 4-Traders’ analysts grade each company based on a dozen financial and qualitative metrics (look under the “Analysis” tab on the company factsheet page). We therefore prefer strong growth companies which have all-around solid businesses.

One European growth company currently in our portfolio is ASML Holding NV, which engages in the manufacture and trade of lithography systems for the semiconductor industry. The company has strong revenue growth with sales expected to rise sharply in the coming years. Margins returned by the company are among the highest on the stock exchanges while its sound financial situation allows the firm significant leeway for investment.



We see that the 4-Traders analysts have ranked ASML relatively high in many categories that we judge important for a growth stock.


Already up +24% in our ASML position, we see this stock as capable of resisting any upcoming period of market turbulence.

Our Value pocket screens companies first and foremost based on the ratio of enterprise value to revenue (EBITDA), both for the current fiscal year and the upcoming fiscal year. The value companies, which you can search for using the Market Screener search engine, have the lowest EV/revenue among peers. Again, we recommend refining the top value stocks based on addition selection criteria which you have access to in the Market Screener tool.

One European value company currently in our portfolio is Arkema, which manufactures and supplies chemical products including the Technical Polymers, Filtration and Adsorption and Organic Peroxides. The enterprise value to sales ratio is at 1.06 for the current period – grossly undervalued. Analysts have a positive opinion on this stock. The consensus recommends overweighting or purchasing the stock while the average target price set by analysts covering the stock is above current price and offers a tremendous appreciation potential. The PER is at a very attractive 13.7x for 2018 projected earnings.




Our Yield pocket looks for stocks with the highest dividend yield, subject to having a sufficiently strong net margin and positive cash flow to maintain and/or raise the dividend. Again, we consider numerous other criteria in refining our yield selection.

One of our current yield stocks is Tryg A/S, a Danish insurer. The company is paying a 7.0% annual dividend with a 63% growth rate in the dividend over one year and a 50% growth rate in the dividend over the past five years. Tryg is in the top of the class in terms of profitability, with net margin forecast to hold above 12% through next year. Predictability of the business is excellent meaning there is little chance for a bad surprise with Tryg.



Our European Top Picks portfolio currently holds 29 companies. We offer our readers full transparency and post each week our full portfolio holdings. Readers can consult our European Top Picks portfolio here and replicate any or all of our selections.

While our first objective in our Top Picks portfolio is to find solid companies based both of current financial statements and forward projections based on the analyst consensus, we also apply a quantitative overlay, making our Top Picks portfolios loosely “techno-fundamental” strategies. We limit, however, our quantitative analysis of the stock price to our weekly trend indicators as a complement to our fundamental analysis. The composite weekly absolute trend score from the WMA Trend Model plus the composite weekly relative trend score from the WMA Sector Allocation model must remain above a certain threshold for the stock to remain in the portfolio. The objective is both to avoid camping out in a stock that turns out to be a value trap as well as being vigilant to cases where price anticipates changes in company fundamentals. Readers can find our European Techno/Fundamental Allocation Model updated after each Friday close.



Portfolio Performance

In addition to the unique WMA allocation model selections, investors can receive inspiration from the purely fundamental-driven selections offered in full transparency by 4-Traders in their WatchLists and live portfolios.  For example, in a difficult-to-understand market, the 4-Traders USA Portfolio is up over +28% year-to-date, compared to +10% for the S&P 500!  Indeed alpha generation is possible for investor’s willing to abandon passive index investing and spend some time researching companies.




We invite readers interested in investing in fundamentally-driven, high alpha generating equity strategies to contact us with questions or send a mail to 4-Traders ([email protected]). 

Conclusion

We recommend that long-term investors get back to Benjamin Graham basics and understand the companies that they are investing in. Passive investing implies buying crappy, overvalued companies along with potentially good companies. We invite do-it-yourself investors to consult regularly our European Techno/Fundamental Allocation Model or the 4-Traders WatchLists for investing ideas. Those with less time to research companies can simply invest directly in our portfolios.  Finally, we will be publishing next week our homologue U.S. Top Picks portfolio and U.S. Techno/Fundamental Allocation Model, which screens the entire Russell 3000 universe of NYSE and Nasdaq stocks in order to select the top growth, value and yield companies.

Owen Williams
© 4-traders.com 2017
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