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Jan 3, 2020

Good Stock Bad Stock

by Ian Duncan MacDonald

After the mutual fund that my investment advisor put my life savings into lost $300,000, I took back what remained and vowed to find a safer way to invest. Since my background was in creating commercial credit risk scoring systems, I wondered could a scoring system sort common stocks from “best” to “worse”.

In creating commercial credit risk scores, I had to score 2,000,000 Canadian businesses from highest to lowest credit risk. A bank who ran several thousand customers through it commented that it was “remarkably predictive”. Almost 30 years later, that scoring system is still in use every day making thousands of commercial risk decisions.

There are only 12,927 stocks traded on all the North American public stock exchanges, a predictive stock scoring system for such a small community is easier to construct than one encompassing millions of businesses. All the financial data needed to score each stock is freely available.

If you, too, were to construct a stock scoring system, the first step would be to determine your objective. My objective was to identify companies who would give me an annual dividend income equivalent to at least six percent of the value of my portfolio plus show constant share price increases. Your bank, like mine, can give you easy access to all the free data elements needed to identify all stocks from most desirable to least desirable, according to whatever criteria you choose.

When you construct a scoring matrix, you are trying to duplicate the selection and weighing process that your brain goes through in making a decision. The items I selected to weigh were:

  1. The Current Price of the Stock: The buying and selling of stocks in a stock exchange determines its current price. A high valued stock is safer than a stock trading for pennies.
  2. What the Price of the Stock was Four Years Ago: A stock whose price increases year after year is more attractive than one that is shrinking. It has stock price growth momentum.
  3. The Number of Shares Traded on Average Daily: Stocks that large numbers of investors are interested in have a greater chance for price growth than those that are ignored.
  4. How Many Analysts Rated the Stock as a Buy: Analyst buy recommendations (opinions) influence speculators. Speculators’ stock purchases drive up share prices.
  5. How Many Analysts Rated the Stock a Strong Buy: An analyst who rates a stock a “strong buy” is putting his reputation on the line. It encourages buyers to buy and holders to hold.
  6. The Dividend Percent Paid: If my objective was an overall six percent dividend income from the total portfolio, stocks paying more or less than six percent needed to be identified and graded.
  7. Accountings Book Value of the Stock: How many dollars would be returned to shareholders if they liquidated a company? You would like it greater than its current share price.
  8. The Price to Earnings Ratio(P/E) of the Stock: How many years of earnings would it take to match the current share price? A low P/E ratio shows potential share price growth.
  9. The Stock’s Operating Margin Percentage: Dividends are subtracted from the Operating Margin. The higher the operating margin percentage, the safer your dividends.

Identifying the nine measurable items was just my first step. Now I needed to compare how each stock compares to another within each of the nine criteria. For example, for (PRICE), I slotted a stock’s current price into one of the following ten categories. It requires a similar grading system for all nine categories. (View all nine gradations in Chapter 12 of the book Income and Wealth from Self-Directed Investing).

Price

I gave stocks purchased for between;

$0 and 99 cents a score of 1

between $1 and $1.99        =          a score of 2

between $2 and $4.99        =          a score of 3

between $5 and $9.99        =          a score of 4

between $10 and 14.99     =          a score of 5

between $15 and $19.99   =          a score of 6

between $20 and $29.99   =          a score of 7

between $30 and $49.99   =          a score of 8

between $50 and $99.99   =          a score of 9

over $100 the score was 10

Thus, a stock like the Royal Bank (RBC) trading for $107 scores a 10 in the PRICE category while RE Royalties (RE), trading for nine cents a share, scored a one. Interestingly, when I added all the sub scores from the nine categories (PRICE to OPERATING MARGIN) the grand score for the Royal Bank was 76, while RE Royalties scored only a nine, although it was paying a dividend of 5.90% and the Royal Bank was paying a dividend of only 3.80%. Paying a high dividend today does not mean a company will still be around to pay the dividend next month, nor that a company with a low score has potential to increase its share price. You need to score all nine factors to get a complete picture of a stock’s potential. The higher the grand score, the more desirable the stock.

A friend turned my scoring matrix into a PC computer program. All those who use it, now only need to key in the nine items from a stock’s OVERVIEW page. The program instantly displays a stock’s grand score.

Using the SELECTOR software in my bank’s self-directed website, I now generated a list of all Canadian stocks who paid a dividend of 3.5% or greater (anything lower than 3.5% would make it difficult to realize my objective of a six percent dividend return from the entire portfolio.) Out of the 4,521 Canadian stocks on the TSX, 654 were paying 3.5% or more. I scored these 654 stocks. I then excluded 366 preferred shares. Despite their higher dividends, preferred shares scored poorly. There was a 98.5% likelihood that all preferred shares would show a capital loss. They really are just a loan, competing with bonds and bank loans.

The highest score was 76. Ten companies scored over 70. There were 133 companies scoring less than 20. There were only two stocks for less than eight dollars that scored over 60.

My objective was to purchase twenty good dividend stocks scoring over 50. Twenty stocks diversified my risk. Only five percent of my life savings is ever at risk in any one stock. In any year, I have found I might replace two out of the twenty stocks because their scores may have fallen below 50 or their dividend may have shrunk. I found often that as a stock’s price increases, the dividend payout increases in tandem with price. In a market crash, while a stock price may decline, the dividend payments usually continue until the market recovers.

The following are a few of the stocks that were identified by the scoring system and I have now held for years. They are ones that have generated more than a $10,000 capital gain. The best one generated a capital gain of $$36,824. Only two of all the stocks I own are below their purchase price, one for $53 and the other for $3,734. Both of these stocks score well and pay good dividends and I will hold them, expecting them to rebound. If I were to build another portfolio today, there may well be other stocks that would give as good or even better results.

  • PZA – Pizza Piizza Royalty
  • SRU.Un - Smart Centres REIT
  • NWH.UN - Northwest Health Centres
  • NVU.UN - Northview Apartment REIT
  • BTB.UB - BTB REIT
  • BMO – Bank of Montreal
  • LB – Laurentian Bank of Canada
  • CM - Canadian Imperial Bank of Commerce
  • SRU.UN - Smartcentres REIT
  • SMU.UN - Summit Industria

Scoring stocks is a different approach to successfully managing a portfolio. No longer is your portfolio being drained by full-service investment advisory fees or mutual fund charges. With total control, you know exactly what you are invested in and why you are invested in it. Over the years my portfolio has grown by 300% while generating an ever-growing generous income. I do not miss the stress of speculative investing nor investment advisors.

Ian Duncan MacDonald, president of Informus Inc. (www.informus.ca) author of “Income and Wealth from Self Directed Investing” and several novels (all are available from amazon.com/books).