7 Most Important Criteria for Picking Stocks

TheStreet.com, Spring, 2012. This article was written with Oliver Pursche, the Co-Portfolio Manager of the GMG Defensive Beta Fund. It was part of a series of articles developed under an agreement with thestreet.com to work with a variety of contributors and assist them in delivering actionable investment ideas each week.

NEW YORK (TheStreet) — Stock selection is more critical than ever, as Europe’s elections probably won’t help solve the continent’s debt problems while the U.S. economy may already be slowing.

As disciplined investment managers, we take a fundamental and technical approach to selecting securities. Here are our initial screening criteria, which we refine further with proprietary analysis. On its own, however, it offers important information on three critical variables for stock selection: cash flow, revenue and valuation.

• Dividend over 2.5%

• Has increased dividend in past 3 years

• Beta below 1 (versus S&P 500)

• Revenue growth for past 3 years (2007 and 2008 eliminated almost all companies based on this criteria)

• Gross and or operating margin growth for past 3 years

• Price-to-book-value ratio below that of peer group

• Price-to-cash-flow below that of peer group

When I was young, my mother taught me to look three times before crossing the street: left, right, left. I believe this sage advice (I’m still here today) can be applied to selecting securities as well.

First, look to your left: the cash-flow you will receive. For that, nothing beats dividend-paying stocks. Study after study clearly demonstrates that dividend-paying stocks have less volatility and better long-term total returns than non-dividend-paying stocks. Moreover, companies that have a history of increasing their dividends tend to be the stronger performers in that group. The chart below makes this painfully (for some) obvious.

Parenthetically, markets will do what they will do, and no one has timed the them — at least no one we know — with any success on a consistent basis. Accordingly, focusing on lower-volatility stocks (a beta below 1) is also critical.

Now look to your right: future growth and what is coming down the road. Companies and their accountants have elevated the manipulation of earnings and balance-sheet items to an art form. However, one item that is nearly impossible to skew, especially over longer periods of time (absent of fraud, of course) is net sales, i.e., revenue growth. If a company is growing net revenues and margins, odds are they are doing a lot more things right than wrong.

Now look to your left again — just to make sure the current valuation isn’t too high. Price-to-book and price-to-cash-flow are two of our favorite metrics for this.

Naturally, there is no such thing as a foolproof or error-free investment strategy or analysis. Stocks that meet these criteria can still falter, but in our experience, they tend to do pretty well, especially during uncertain times.