Beat The Market - Attempt 2.0

Laying the ground work to deploy this portfolio for its redemption year!

3 DGR Portfolio - Second Year

This coming up Thursday, May 1st, I will re-allocate the current 3 DGR portfolio with new selections. I’ll share the selections with you in a brief post Wednesday evening, just to document them before the new year begins. Yesterday, I did a preliminary run to lay some groundwork for Wednesday. Here’s what I did, along with some high level metrics.

The Screening Process

I used Finchat.io’s free stock screener to pull the initial universe of stocks this portfolio will select from. Here are the exact metrics and thresholds I used.

Exchanges

• New York Stock Exchange (NYSE)

• Nasdaq Global Select (NasdaqGS)

Criteria

• Revenue 5Y CAGR: At least 5%

• Diluted EPS 5Y CAGR: At least 5%

• Total Return Since Inception CAGR: At least 8%

• Dividend Per Share 5Y CAGR: At least 5%

• Gross Margin 5Y Average: At least 20%

• Return on Invested Capital: At least 15%

• Dividend Per Share 1Y CAGR: At least 1%

• Dividend Per Share 3Y CAGR: At least 1%

The screener produced 77 stocks. Here are the average metrics for all.

• Dividend Yield: 1.37%

• Payout Ratio: 31.12%

• DGR 1Y: 18.09%

• DGR 3Y: 15.66%

• DGR 5Y: 14.72%

• ROIC: 27.66%

• ROCE: 31.01%

• Gross Margin 5Y: 50.08%

• Revenue 5Y: 10.76%

• EPS 5Y: 19.53%

• Total Return CAGR: 17.17%

Valuation

The second step was to run each stock through my Free Cash Flow Valuation tool. This step took a little while, but doing it yesterday will save me time on Wednesday. Out of the 77 stocks, 34 appeared undervalued based on their current Free Cash Flow multiples.

However, instead of solely using valuation in the ranking process, I decided to go one step further and use the expected rate of return. In my opinion, the expected rate of return is a more useful metric because it not only considers how attractively valued a stock is today, but also where it might be headed in the future.

The average expected rate of return for all 77 stocks was 7.80%, made up of the following components:

• Forward Dividend Yield: 1.37%

• Return to Fair Value: -2.85%

• Projected Earnings Growth: 9.28%

Selection Process

The selection process is based on two steps. First, I found the median for the following five metrics:

• ROCE: 24.6%

• ROIC: 22.2%

• 5Y DGR: 13%

• 5Y Revenue: 9%

• 5Y EPS: 14.7%

Each stock was then assigned a score from 1 to 5, depending on how many of these metrics it exceeded.

• 8 stocks scored a perfect 5

• 12 stocks scored a 4

• 15 stocks scored a 3

• 22 stocks scored a 2

• 10 stocks scored a 1

• 10 stocks scored a 0

All stocks were then sorted by their score in descending order, with ROCE used as the secondary sorting criterion. Each stock was assigned a Quality Score from 1 to 77 based on this ranking.

Separately, all stocks were sorted by their expected rate of return in descending order and assigned a Valuation Score from 1 to 77.

Then, I averaged the Quality Score and Valuation Score, sorted the stocks in ascending order, and selected the 20 highest-ranked stocks that also had an expected rate of return of at least 10%.

Here are the average metrics for the selected stocks from this preliminary list (with the averages for all stocks in parentheses for comparison):

• Dividend Yield: 1.15% (1.37%)

• Payout Ratio: 30.14% (31.12%)

• DGR 1Y: 24.44% (18.09%)

• DGR 3Y: 18.92% (15.66%)

• DGR 5Y: 17.49% (14.72%)

• ROIC: 33.01% (27.66%)

• ROCE: 36.76% (31.01%)

• Gross Margin 5Y: 61.72% (50.08%)

• Revenue 5Y: 15.92% (10.76%)

• EPS 5Y: 24.66% (19.53%)

• Total Return CAGR: 21.15% (17.17%)

I’m not listing the 20 stocks chosen in this preliminary run because there might be changes between now and the final selections. There are still three more trading days, so valuations could shift, and we might also get updated metrics. I’ll run the same process Wednesday after the market closes and publish the final list that evening. A few days later, I’ll do a deeper breakdown of the portfolio and share the full spreadsheet with you as well.

Objective

The objective for this portfolio, once again, will be to outperform the S&P 500, measured by the SPY ETF. While the process makes conceptual sense, as we saw last year, that’s no guarantee of a positive outcome. Let’s see how the strategy performs in its second year.