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How to narrow your investable universe

Focus less on the stocks you want to buy - and more on the ones that should be excluded from your portfolio at all costs.

‘So what stocks are you looking at?'

It's a question I get from colleagues regularly - and friends occasionally. The implication is that I'm always on the lookout for the next buy idea.

I often have difficulty answering the question to be honest. These days my personal - as well as professional - investment approach is more about excluding stocks from consideration.

The intention is to narrow the 'investable universe'. This is largely pragmatic; there are just too many ASX-listed companies to follow. Analytical time is a scarce resource, so you must have a method for excluding companies from consideration.

Narrowing my investable universe has another benefit. It ensures a laser-sharp focus on the types of companies that I'm interested in. In my case, I'm primarily looking for high-quality businesses to hold for the very long term (that's decades).

Mental filters

Here are some of the 'mental filters' I use to automatically exclude companies from consideration. In my role as an analyst with Intelligent Investor, I'm usually on the 'no' side if companies with the following characteristics are proposed in our Dragons Dens (although of course I understand that my filters might be different from others'):

Resources stocks. After some bad experiences with resources stocks earlier in my investing life, I decided they were outside my circle of competence. I'll admit I was tempted by spin-off South32 (ASX:S32) when it was upgraded in 2015, but in the end I decided not to break my rule. I've not bought a resources stock for a decade now.

Complicated structures. If a company's structure is highly complicated or unusual, you should ask why. Some investors revel in unwinding the intricacies of a complicated business but I just wonder what's being hidden. Complicated structures and businesses usually end up in my too-hard basket.

Small stocks. I don't exclude small stocks completely, but I'm much more risk-averse than I once was. A small company needs to be compelling to attract my attention these days.

Start-ups. While they often fall into the 'small stock' category above, start-ups deserve their own category. I never buy any company that's pre-revenue, and rarely consider anything with revenues less than tens of millions of dollars. Start-ups are just too risky.

Short history of earnings and/or cash flow. I'm primarily interested in companies that are durable, so I'm sceptical of companies that are relatively new. Unless a company has seen a few economic cycles or traversed a few speed bumps, I'm rarely interested. This means I miss big winners such as Afterpay Touch (ASX:APT) and A2 Milk (ASX:A2M), but that's fine with me. Sometimes there's another buying opportunity once the supercharged earnings growth tapers off anyway.

Market darlings. I'm just not interested in companies whose share price has tripled in a year on an exciting narrative. Sometimes these are the same companies as in the 'short history of earnings and/or cash flow' category above.

Fails the smell test. This is a catch-all category. Most good buying opportunities will have some warts, but some companies just don't smell right. Perhaps management is promotional, or there are odd things about the accounting, or the business model doesn't quite make sense. Rather than spend time unravelling what's going on, these companies go into my too-hard basket.

Lots of exclusions

You can imagine that this list results in a lot of automatically excluded companies, including many where my scepticism or fears end up being unfounded. But I'm fine with missing stocks that soar if I also miss many of the duds too.

I believe that good buy ideas are pretty rare. Only the very best should make it into your portfolio; these days if I buy 2-4 stocks a year I'm content.

So if I don't spend a great deal of time seeking out new buy ideas, what do I do?

Essentially, I wait for the stocks I've already identified as quality businesses to come to me. I use my time to get to know the good businesses well, then I wait - for years if necessary - for a reasonable price.

Take Wesfarmers (ASX:WES), which we upgraded to Buy earlier this year. We'd not had a Buy recommendation on the stock for many years but there was a creeping malaise about the company because of profit weakness at Coles and the losses at Bunnings UK. The catalyst for the upgrade was the appointment of a new managing director, who was making the right noises about rejigging the Wesfarmers portfolio.

Value territory

In the case of Seek (ASX:SEK) in 2015 and Flight Centre (ASX:FLT) in 2016, the signals were a series of profit downgrades, which we believed to be temporary issues. These profit downgrades meant both stocks fell into value territory.

Management changes, profit downgrades, bad news, price falls or capital raisings are all signals to revisit a company, its business and its valuation. They're worth watching in case they drop a stock into underpriced territory every few years.

To take advantage, you just need a list of companies you'd like to own and an idea of what price might be good value. Then you wait, wait and wait some more for the stock to come to you. Some will never enter your buy zone of course, but over time you can build a sleep-well-at-night portfolio using this method.

Every company must earn its place in your portfolio. So keep your investable universe small by excluding the wrong type of stocks first. Good quality buy ideas really are few and far between.

Disclosure: The author owns shares in Seek and Wesfarmers.

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