An Inside Look At How I Pick Stocks

Nathan Slaughter's picture

Monday, June 10, 2019 - 12:00am

by Nathan Slaughter

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 in the unfolding China trade war assessing how it will impact the profits of companies like CVR Energy (NYSE: CVI), the next I'm reading about the latest clinical trial results for a new oncology drug that GlaxoSmithKline (NYSE: GSK) is bringing to market.

But that's not the only reason I spend half the day reading. I am also constantly in search of new investment ideas to file away and potentially explore in future issues. I closed 15 positions in High-Yield Investing last year (12 of them for gains) and parlayed those profits into 14 new ones. There is a never-ending process of recycling the proceeds from one security to the next.

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 that issue.

Think of it as a behind-the-scenes look at what happens on the set when the cameras aren't rolling.


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Unworthy Until Proven Otherwise...
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 at least three days after publication. So my advice is always 100% unbiased.

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. Where do I find these recommendations? How do I choose one candidate over another?

First off, let me tell you what I don't do.

For one thing, I'm not a big proponent of technical analysis. I rely on fundamental metrics such as sales and earnings, not esoteric 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.

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. Literally.

I live a few hours from the Crater of Diamonds, a state park in Arkansas that sits on top of the eroded remains of an ancient volcanic kimberlite pipe. It's the only place in the world where the public can dig for diamonds -- and keep any they find. Visitors have unearthed an average of 600 diamonds annually over the past decade, including a flawless 8.5-carat gem in 2016.

Diamond Diggers At Crater Of Diamond State Park In Arkansas
Crater of Diamond State Park 
Source: Doug Wertman

But ore grades are low -- about two carats per hundred tons of material. So it usually takes quite a bit of searching and sifting through dirt and gravel to find a stone that shines.
My investment process is no different.

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. Currently, that includes names such as Nokia (NYSE: NOK) and Telefonica (NYSE: TEF). 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) has patents and intellectual property that safeguard its technologies and generate billions in annual licensing income.

Las Vegas Sands (NYSE: LVS) was granted operation concessions for its casino resorts in markets where few other competitors are allowed, an impenetrable barrier to entry.

CoreSite's (NYSE: COR) data centers contain mission-critical software and hardware that can be costly and disruptive for third-party renters to move, a high switching cost that makes revenues sticky.

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.

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).

How To Get My Latest Picks
That's certainly the case with my most recent recommendation in High-Yield Investing. Booming employment and rising discretionary income have translated to increased consumer spending on travel and leisure activities -- and what better place to spend a few dollars than an amusement park. 

Did I mention this company has also produced nine straight years of record results -- nearly tripling its dividend since 2012? After passing all my tests with flying colors, I added it to my portfolio in our most recent issue. So if you'd like to learn more about my newsletter and get the name of this pick, go here now.

Nathan Slaughter does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.