How to Pick a "Stock of the Year"

A Guest Article by Pat McKeough
Editor and Publisher of The Successful Investor

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This article is republished by permission from Issue # 6 of Pat McKeough's free newsletter, The McKeough Report. Where his other newsletters and their associated hotlines are subscription-based, include stock analyses and recommendations and reproduction is prohibited, The McKeough Report discusses general investing principles and is free to anyone who wants to subscribe. Information on how to subscribe to The McKeough Report and a special subscription offer for The Successful Investor follow the article.

December, 2000

As you may know, the Globe & Mail began running a yearly stock-picking contest for investment professionals in 1997. The idea is that you pick one-and-only-one stock for the entire year. The paper invited eight of us to participate the first year. Entrants only got invited back in each subsequent year if their pick performed in the top half of all stocks chosen for that year's contest.

I won the 1997 contest. In 1998 and 1999, my choices performed in the upper half of all contest entries. My year 2000 pick, CAE Industries (more on that below) is at the head of the pack, but the contest still has a few more weeks to run.

Beware contest entrants with a hidden agenda

Some investors feel that if an investment professional is willing to recommend a stock in a newspaper quotation or on TV, it must be a safe choice. They assume the professional would recommend the same stock to his or her own clients.

That's true most of the time, because most investment professionals are honest and conscientious. But not always.

The stocks I pick for a contest like this, or for any kind of public attribution, are also my top picks for one or more of our newsletters. For that matter, I bought lots of CAE for my portfolio management clients. However, you need to recognize that a few investment professionals employ a different strategy.

When they get a chance to enter a contest like this, some routinely pick a highly volatile or risky stock. If the stock they pick collapses, they know most people will quickly forget about it. But if they pick a highly volatile stock and it skyrockets, they've acquired some free publicity and potentially valuable bragging rights. In short, to further their own interests, they disregard the interests of people who may act on their published recommendation.

Some investment professionals who are active traders go even further. When they get an opportunity to recommend a stock publicly, they pick something they want to sell. That can generate buying that pushes up the price of the stock, or allows them to unload large quantities without depressing the price. This verges on fraud, yet it happens.

That's why you need to resist the urge to make unqualified assumptions about stocks you read about. You need to consider the source of the recommendation, and the logic and information behind it. You need a healthy sense of skepticism. The person making the recommendation may not have your interests in mind.

Building portfolios, one stock at a time

Investors often ask how we go about picking a stock to buy. Some wonder if we single out stocks that trade at low p/e's (the ratio of share prices to per share earnings), or stocks whose earnings are headed sharply higher. Value-oriented investors may assume we recommend stocks that are trading below some measure of the value of a company's per-share assets, such as book value (what the corporate books say assets are worth per share after deducting liabilities).

We look at all these factors, and many more besides. But we have no set formula for picking buys. Instead, we look for what we call a 'heads-you-win, tails-you-break-even' situation. No stock is perfect -- in fact, if you ever find a stock that seems perfect, it's probably a sell. What you have to do is weigh the pluses and minuses. We try to find recommendations where your potential profit overshadows the risk of loss. In other words, we want to see an attractive balance between risk and potential reward.

To describe our method in computer-age terms, this is very much an analog-style task. If you select stocks in digital fashion, you lose a great deal of information between the 1's and the 0's.

Use portfolios to cut risk even more

Of course, we recognize - you should too - that some of our recommendations are bound to disappoint us. This may happen because we misjudged a stock's potential reward or risk. Or, it may be due to a broad setback that only weighs on certain types of stocks or businesses.

That's why we continually harp on the need to invest in a portfolio of stocks, rather than just one or two. You need to spread your portfolio holdings out across the five main economic sectors: Manufacturing, Resources, the Consumer sector, Finance and Utilities. That way, you avoid concentrating your money in a great company that happens to be active in a sector that's headed for trouble.

Picking one above all

A year ago, I told Successful Investor subscribers that CAE $22 (Toronto symbol CAE; SI Rating: Above-average) was shaping up as 'stock of the year'. I also chose CAE when the Globe & Mail asked me to pick a stock for its yearly 'One and Only One' stock-picking contest. Back then, CAE was under $10. It has since jumped 120%, in a year when many stocks and most other tech stocks and other Manufacturing sector stocks have stumbled badly.

Many investors have asked what made me pick CAE. I could go on for pages about that. But here's the short answer.

• A strong foundation - The company has a long history of earnings and dividends. Just as important, it was absorbing lots of research spending - 12.8% of sales, or about $1.04 per share. According to conventional accounting practice, it treats that spending as an ordinary expense. But CAE's research really is more like an investment, since it pays off nicely. So the company was and is much more profitable than it looked.

• Industry dominance - CAE is the world leader in flight training and simulation devices. This is apt to be a growing field for many years to come, since rising prosperity around the world will lead to more airplane travel and spreading concern for passenger safety.

• Sound business plan - Up till last year, CAE failed to capitalize on its strengths. Since then it has moved to get out of some unrelated lines of businesses and to focus on its flight simulators. In addition to making the equipment, CAE has begun training pilots from charter airlines at its St-Laurent, Que. facility. Eventually, CAE plans to move all its North American pilot training activities to a new facility that it will build beside Toronto's Pearson International Airport. It is currently building a similar flight-training centre in Brazil, and it recently announced plans for a centre in Spain.
  
  Formerly, CAE stayed out of pilot training and left that business to customers who bought its flight training and simulation equipment. But it changed its policy and entered this specialized, lucrative field last year. Pilot training is a $12 billion-a-year industry, or about 10 times larger than CAE's current yearly revenues.

• Absence of broker hoopla - We could just as easily have chosen Nortel Networks, another long-time favorite, as our Stock of the year for 2000. However, one year ago, Nortel was already the subject of a great many brokerage buy recommendations. When a stock has too many enthusiasts, there's no one left to join the party and add to the buying.

Nortel was also solidifying its industry leadership with a series of acquisitions. It was clear to us that any interruption in Nortel's earnings growth, or problems with or an acquisition or two, could have brought on a shrinkage in its p/e ratio -- a 'multiple contraction', as it's sometimes called. That would lead to a big drop in its stock price, like the one it has had in the past three months. Nortel rose from $70 at the start of the year, to a September peak near $125, to recent prices below $60.

Profit from a multiple expansion

CAE, in contrast, has attracted more brokerage interest this year, and gone through a 'multiple expansion'. A year ago, it traded at 12.9 times its latest 12-month earnings. Its earnings have gone up, but its price-to-earnings or p/e ratio has gone up even faster, to the current 25.2. A year ago, the stock deserved to trade at a higher multiple. Today, I'd say CAE's earnings are likely to keep rising, and its p/e could expand slightly this coming year as well. So the stock is still a buy.

Needless to say, CAE's success this year has sparked a lot of interest in our 'stock of the year' for 2001. The only fair way to unveil that choice is through our Successful Investor Hotline. So we plan to devote our December 29, 2000 Hotline to our choice of 'stock of the year' for 2001. We hope you'll take advantage of it by calling the Hotline. Or, better yet, get the Hotline by e-mail -- it's free either way to Successful Investor subscribers.

Published by permission
Copyright 2000 Pat McKeough

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