We are introducing a new two-part model portfolio of Focus List Stocks. This model portfolio will consist of “best ideas” selected from our past and future Long Idea and Danger Zone stock research. The two groups will be tracked separately as long and short portfolios, and also together as a market-neutral portfolio.
This report covers our initial Focus List (Short) Model Portfolio selected from our Danger Zone research. This portfolio is designed for investors who are focused on avoiding portfolio blow-ups or hedging with short positions.
Why a ‘Focus List’ Model Portfolio?
The goal of this portfolio is to show how our proprietary forensic accounting research empowers investors to identify alpha-generating investment ideas more efficiently than traditional research. Our research team adds a qualitative view to the quantitative insights that our Robo-Analyst technology provides on a firm’s true return on invested capital (ROIC) and economic earnings[1] when publishing Danger Zone Ideas.
Avoid the Pitfalls Inherent in Sell-Side ‘Focus Lists’
As previously stated (here and here), investors should approach sell-side research with caution. With our Focus List, investors can be assured they are getting a diligently reviewed list of objectively selected “best ideas”. With the Focus Lists that are available from most Wall Street sell-side research firms, investors are forced to wonder if they are getting a list of investment banking’s “best clients.”
Focus List Model Portfolio Methodology
Our risk/reward rating system is the first hurdle for all published stock ideas. Danger Zone stocks earn an Unattractive-or worse rating at the time of publication. Ratings are based on the five most important criteria for assessing a stock’s risk/reward profile, which account for “Earnings Quality” and “Valuation.”
- Quality of Earnings measures how reported accounting income compares to economic earnings.
- Return on Invested Capital (ROIC) measures the cash on cash returns of the company.
- Free Cash Flow Yield measures the true cash yield of the company.
- Price to Economic Book Value measures the growth expectations embedded in the stock price.
- Growth Appreciation Period measures the number of years of future profit growth required to justify the current valuation of the stock.
Under this rating system, Danger Zone stocks are generally characterized by low/declining ROIC, misleading earnings and high market-implied profit expectations. However, the rating system alone does not determine Danger Zone stocks. They are also evaluated on the following qualitative factors:
- Growth and profitability trends relative to peers and market expectations.
- Executive compensation plans and incentive alignment risk.
- Competitive market position and advantages, or lack thereof.
- Assessing valuation under optimistic, neutral and pessimistic scenarios.
- The risk of the firm being acquired at a premium (i.e. ‘stupid money’ risk).
Stocks ideas that pass the dual screening by our Robo-Analyst and research staff are eligible for Focus List inclusion after they have been published as a Danger Zone report. The Focus List (Short) model portfolio will target our top 20-30 sell warnings as determined by our Investment Committee.
The portfolio’s performance will be reviewed regularly. Individual stocks may be added or removed in the interim as warranted. To support sector diversification, we seek to limit the number of stocks per sector (or sub-sector) on the list to roughly 20% of the portfolio.
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