It has been a year since we first introduced our factor-based quality ranking model. The purpose of the model has always been to find wonderful businesses at fair prices, although the valuation consideration is not reflected by any factor in the model. Our investment approach is to follow businesses only with strong fundamental qualities (e.g., high returns on capitals, healthy balance sheet, sustainable cash flow, low capital requirement) and wait for the right entry points. Select factors with high weights are listed below, and a weighted sum of all factors is calculated for us to assign the score to each stock:
Even without valuation considerations, a hypothetical portfolio of top-ranked stocks picked by the model last year proved to have outperformed the benchmark by a wide margin.
No model is perfect. During the past year, a couple of improvements and adjustments have been applied to our ranking model. Many of them, as described below, echo changes to our investment thinking.
One year since disclosing our top-ranked picks from the model, there are certainly some adjustments to their rankings due to respective businesses developments as well as improvements to our model. As promised to the Seeking Alpha community previously, we are now listing our top-ranked stocks below. Since the beginning of 2018, we have been advocating that there are relatively fewer opportunities now within the States considering the overall valuations. Consequently, this year, we would like to provide two separate lists: one for US equities and the other for foreign ones. We also hope to compare performances to different benchmarks (e.g., the S&P 500 Index (SPY) for the US, the MSCI EAFE Index (EFA) for the overseas). Again, these are the picks which we (and our model) think possess great fundamental qualities in their operating businesses, certainly without the price tag taken into account.
We have six stocks that made it to our Top 13 list last year but did not this year: Credit Acceptance Corp. (CACC), Intuitive Surgical, Waters Corp. (WAT), Tencent, NetEase, and Amgen (AMGN). Most of them "suffer" from our reduced weights in growth/momentum, as well as more emphasis regarding returns on capital.
Below are our Top 13 lists for 2019.
We strongly agree with Warren Buffett's approach to investing in wonderful businesses at a fair price rather than fair businesses at a wonderful price. Our investment time horizon is long term, and time is the sure friend of wonderful businesses (think about compounding and exponential growth, for example).
The ranking model based on a number of quality factors would be useful in terms of stock picking. Business wonderfulness is a must and exceeds price fairness in importance. Sometimes, we do not even think investors should mind paying a bit premium for some of the wonderful businesses.
The above lists (of 26 stocks) should give you a general idea of what companies our ranking model value most. However, no pricing is taken into account. Hence, those truly long-term investors who aim at buying and holding wonderful businesses could follow the names and wait for individual favorable entry points. In terms of valuation, we would recommend investors consider accumulating share at price multiples (e.g., P/E, P/CF, P/S, EV/EBIT) at least below their 5- to 10-year historical averages (or starting with small positions at around historical levels).
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