The stock market is often talked about like it’s one thing where an investor only has the choice of being in or out of “the market.” The usual perpetrators like the media and brokerage industry (you know, the people that always have something to sell) deserve most of the blame for this. In actuality, as I’m sure you’re aware, there are thousands of different publicly traded companies. Each one is different in its own right and each one can have a different purpose in your portfolio.
Within the investment industry, it’s common to hear stocks broken down by size (large, mid and small caps), style (growth vs. value, which I think is extremely misleading) and sector/industry. I think most of these classifications are somewhat useless and we really need to break things down to a deeper level to gain insight on the most important features which drive performance in various market regimes as well as their ultimate purpose in a portfolio in relation to an investor’s goals and distribution needs. In this post, I’ll outline the different ways that I classify stocks to create my own “mental models” which I use when building portfolios.
I think the most important financial components to understand for a company are the following:
- Balance Sheet: Understanding the amount and type of liabilities. I prefer to partner with companies with little to no debt. If a company does have debt, they better have used it in a very productive and prudent manner.
- Cash Flow Profile: Is it a capital intensive business that requires continual reinvestment (large capital expenditures) leaving the company with little Free Cash Flow? I like to look at a ratio of CapEx to Cash Flow from Operations to get a sense of this metric.
- Capital Allocation Profile: Assuming the company generates Free Cash Flow, what are they doing with it? Are they acquiring companies, paying down debt or returning it to shareholders via dividends or buybacks?
- Business Model & Industry of Operation: Notice that this is last
Based on these metrics, I will then classify each stock from a high level perspective as either Growth, Income or Blend, and then a subset of these as Compounder, Staying Power, Secular/Cyclical Growth, Unique Assets, and Antifragile. Here’s my explanation of each:
High Level View: Growth, Income or Blend
You can only invest for two things – Growth or Income. Growth investments make money if the price appreciates and Income investments make money by generating cash flow for you each year. Many investments can offer both, like a stock that pays a dividend, so I count these as Blend/Hybrid investments. Generally speaking, but not always, in this market environment if a stock has a dividend yield of less than 1% I’m usually looking at it from a Growth perspective, between 1% and 2.5% as a Blend, and above 2.5% is often more of an Income investment.
Blend
This Growth & Income total return approach can be a really great form of investing and some of the best dividend growers fall into this category. I think many Income-oriented investors write-off some of these stocks because the dividend yield might only be 1.5% or 2%. But if the company is increasing the dividend by 15%+ per year, your yield-on-investment will double after 5 years. Compounding is a beautiful thing.
Growth
If a stock does not pay a dividend then it is a pure Growth investment because the only way you can make money is if you sell it for a higher price than you purchased it. This is the most aggressive way to invest.
Income
I view many stocks as pure Income investments even though it is a stock and the price per share can rise and fall over time. These tend to be more mature companies that are paying out a large portion of their net income each year as dividends. I think pass-through entities like MLPs and REITs should be viewed purely as Income investments as well. When I’m investing in something for Income, assuming I’m happy with the valuation at time of purchase, I don’t really care about the month to month fluctuation in the price of the stock; I only care about whether or not that company is paying me the dividend and hopefully increasing the dividend over time. We’re not playing the game of “wanting it to go up” anymore because that’s a Growth mindset so any appreciation in price is just an added bonus. When investing for Income I actually want stocks to go down because lower prices mean higher yields – and what we care about is the yield.
Subsets
Compounders
These are the types of companies that you can hold for very long periods of time. In order for me to classify a company as a perennial compounder, they need to: 1) earn high returns on invested capital, 2) have a business model that generates sustainable free cash flow and 3) uses the FCF to both reinvest in the business (at a high ROIC) and buyback stock. This creates an enormous compounding effect by both raising the numerator of any metric (e.g. sales, profits, cash flow, etc.) AND reducing the denominator (share count). I tend to view these more in the Growth or Blend category. Past examples that my clients have owned include companies like Ross Stores, O’Reilly Auto Parts and Mastercard.
Staying Power
What matters here is the sustainability of the business model and cash flows. This category tends to be similar to the Compounders with the difference being that the companies tend to use the free cash flow for acquisitions to strengthen their market position or pay it out as dividends instead of buying back stock. This has less of a compounding effect and isn’t as tax efficient, but these can still be great investments. These tend to fall more in the Income or Blend categories.
Secular or Cyclical Growth “Stories”
These are companies that have a nice tailwind that will hopefully last for anywhere from 3 to 10 years. The difference between these and Compounders is that the line of business tends to be cyclical rather than repetitive – like commodity related companies, industrials and certain technology based themes. I include Technology because, while the cycle might be a lot longer than the normal business cycle, technology is often disrupted by the next wave of innovation so it’s hard for a company to stay at the top and see a continual runway of growth. These are ones you try to catch near the trough of a cycle and sell near the peak. You’ll probably be seeing some posts on companies in this category in the near future.
Unique Assets
The assets these companies own are either irreplaceable, proprietary or unique and can’t be replicated. This scarcity or exclusivity can be the main source of value for a company if used properly as a competitive advantage. With the proliferation of ETFs, stocks all too often just trade at valuations in line with their industry as one large group. This can create opportunities for investors that aren’t lazy and are willing to dig deeper to differentiate and find these hidden gems. See this post on Vail Resorts.
Antifragile
These are companies/assets that actually benefit from your typical investment or market risks. This can include companies that see business improve during a recession, from market volatility, or from stresses in the traditional financial/banking system. It’s good to be diversified and have investments that zig when your more traditional investments zag. See here, here and here as examples.
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These are the main ways that I classify and view stocks. There are others but they’re really of no interest to me because I have found these to be best when investing for the long haul. I believe that less is more, and if you apply the list of 4 criteria above (balance sheet, cash flow profile, etc.), you whittle down the list of potential investment options pretty quickly. Hopefully this post helps you see things from a new angle that you maybe hadn’t thought of before.
Thanks for following!
-Nick