The Cabot Undervalued Stocks Advisor Stock Selection Process

I like to occasionally recap my complete stock selection process for investors, so that you have clear expectations, and can take full advantage of capital gain opportunities.

My stock-picking strategy has been refined over the course of 28 years, and has been quite stable for the last six years. My investment goals are:

1.    Minimize stock market risk.
2.    Achieve capital gains, with dividends as a welcome addition to total return.
3.    Outperform the U.S. stock markets.

When I look at stocks, I don’t listen to media pundits or forecast industry trends. I go right to the numbers and price charts, which represent today’s reality, as opposed to potentially-biased speculation.

Here are my stock screens, which specifically exist in order to screen out common risk factors such as high P/E’s, debt burdens, and a lack of earnings growth:

1.    EPS expected to grow 15% or more, both this year and next year; or, if the stock pays a dividend, I will reduce that 15% standard goal by the amount of the dividend yield. (e.g. 12% EPS growth plus a 3% dividend yield)
2.    The P/E should be lower than the EPS growth rate. (e.g. 18% EPS growth, with a P/E below 18)
3.    Long-term debt-to-capitalization ratios of 40% or less.
4.    Price charts that reflect near-term capital gain potential.
5.    Share price support at 18 or higher, which eliminates another layer of volatility.

This is both a growth strategy and a value strategy. The growth component is reflected in the stringent EPS growth rate requirement. The value component is reflected in the P/E and debt requirements.

I know that there are many perceptions of what “value” means in the investment world. Some people think value means low share prices or poor stock charts or simply big lumbering blue chip companies with big dividends and a lack of earnings growth. But to me, value means a strong balance sheet, and a share price that will attract both institutional buyers and M&A buyout offers.

One of the important reasons that my stock selection process is so stringent is that the numbers are constantly changing after the stocks are added to my portfolios. If the earnings growth rates decline due to a slowing business cycle, or the P/Es increase due to rising share prices, I want to have enough wiggle room so that the stock remains undervalued and attractive. I don’t want to be constantly recommending that people buy and sell stocks like Whirlpool and Adobe Systems. These are great companies. I will occasionally remove such companies from my portfolios, and when I do so, you can be sure that other opportunities abound.

A recent review of over 500 stocks in my investment universe delivered a total of 23 stocks that currently meet all of my investment criteria. Those stock picks are concentrated within the following sectors: housing, construction & building materials, finance (mostly banks & investment firms), technology (mostly software), and travel.

Quite a few of those undervalued growth stocks currently appear in Cabot Undervalued Stocks Advisor, including Adobe Systems (ADBE), Applied Materials (AMAT), Carnival (CCL), Chemtura (CHMT), Goldman Sachs (GS), Kraft Heinz (KHC), Vertex Pharmaceuticals (VRTX), Vulcan Materials (VMC) and Whirlpool (WHR).

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