A logical investment framework for stock selection

Lincoln Indicators
Written by

Lincoln Indicators

Feb 22nd, 2022
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For many, investing successfully in the stock market is jeopardised by a myriad of psychological hurdles. Booms and busts are driven by greed and fear, while holding onto losing investments can stem from pride and hope.

Lincoln Indicators Golden Rules – the Three Primary Golden Rules and the Secondary Golden Rules – ensure investors have a sound, intelligent, and objective stock selection framework that can be tailored to each individual investor’s needs – in other words, an investment compass.

The Golden Rules have underpinned the success of Lincoln Indicators and our ability to deliver some of the best performing ASX stocks, with strong outperformance in bull and bear markets for more than 25 years. It’s helping investors make informed decisions when trying to determine what stock to buy on the ASX.

Primary Golden Rules:

Golden Rule 1: Financial Health – a data-driven objective analysis of a company’s financials. A company’s investment rating and insolvency risk are calculated by combining 14 key accounting ratios extracted from its financial statements through Stock Doctor.

Golden Rule 2: Past Financial Performance – a company’s track record and past performance metrics can be a reliable indicator of its future performance. It’s an essential quantitative barometer to help further measure the true fundamental quality and investment potential of growth and income stocks.

Golden Rule 3: Outlook and Active Risks – To overcome the backward-looking bias with Golden Rule 1 and 2, this approach focuses on assessing known facts to ensure a company can maintain its Financial Health and Past Financial Performance. This involves a qualitative analysis of the company, its outlook, and potential risks.

 

These three rules are the core pillars of our high-conviction stock selection strategy that helps investors build a portfolio of high return investments, financially healthy quality stocks for capital growth or provide a dividend income stream. They focus on high-quality businesses with robust fundamentals rather than opinions and speculation. Financial Health remains the cornerstone of our approach.

The Secondary Golden Rules are then used to tailor these stocks to an investor’s own personal preference, tolerance to risk, style, and investment goals. Not all secondary Golden Rules will be relevant to every investor. Proactive investors are encouraged to use a combination of these rules to help refine their own stock selection strategy.

 

Golden Rule 4: Share Price Sentiment

Stock prices represent the market’s perception of value based on the future expectations of a company’s earnings. Therefore, the share price trend can help highlight the fundamental qualities and active risks in a business. When the share price is declining relative to the market, this often means heightened risks in the business that should be investigated.

And while this can create a great opportunity to buy quality stocks – such as Stock Doctor’s Star Stocks at lower prices – investors will need to conduct thorough due diligence on a weak trending stock to ensure they are comfortable with Outlook and Active Risks (Golden Rule 3) and to establish confidence in the business.

Golden Rule 5: Share Price Value

Unlike physical assets, the value of a company can be hard to quantify because it relies on numerous forward assumptions. Cash flows need to be projected into the future and discounted at an internal rate of return. As a result, determining share price value involves subjective decisions.

At Lincoln Indicators, instead of concentrating on inherent biases in opinion, we focus on the facts – and high-quality stocks tend to cost more based on these facts. When a company is financially healthy (Golden Rule 1), generates high returns on equity, and has a competitive advantage via wide net-profit margins (Golden Rule 2) – these facts mean the stock tends to trade at a premium to valuation or high valuation multiples.

Therefore, to own these high-quality growth and income stocks, investors should be prepared to pay a premium.

Golden Rule 6: Liquidity and Size

Investors need to determine if there is a liquidity constraint on the shares they wish to transact. The volume of share transactions must be high enough (liquid) so investors can enter, and more importantly – exit within the timeframe and at the price they want.

This fluidity allows investors to deploy sufficient capital into an investment and buy stocks while also ensuring there are enough buyers on the other side of the ‘order book’ when it comes time to sell. Traditionally, larger market capitalised stocks tend to be less volatile and have a higher volume traded than smaller capitalised companies.

Golden Rule 7: Principal Activities

Investors should understand a company’s principal activities before investing. As an owner of a stock, an investor is a part-owner in the business. As such, investors need to ensure they understand its operational model (e.g., how it generates sales), gain familiarity with the products or services it provides, and ensure it aligns with their values.

Furthermore, investors should seek an understanding of the opportunities and threats that may impact the earnings potential of the company, as well as its industry. Ideally, company leaders should also have their ‘own skin’ in the game through personal holdings, demonstrating their belief in the company and its future – this is more prevalent and important in smaller to mid-size companies.

Golden Rule 8: Price Sensitive Announcements

Investors also need to stay abreast of company news and announcements, as these events can have a material impact on a company’s stock price (both positively and negatively). Investors should ensure companies have robust, transparent, and thorough disclosure processes in place that ensure the market is updated in a timely and accurate way.

Golden Rule 9: Follow You Appropriate Rules

Investors should apply the Golden Rule framework to their own investment objectives and tolerance to risk, and they should be disciplined in their portfolio decision-making process. In other words, be systematic with buy and sell decisions, and – while challenging at times – do not let emotions such as fear or greed interfere.

 

At Lincoln Indicators, our quantitative data-driven methodology has identified some of the best quality ASX stocks to buy – what we call our Star Stocks for income and growth. Get a free copy of the Golden Rules white paper to understand this investment framework further.

If you would like to see our Golden Rules in action and view some of our Star Stocks, start a FREE trial with Stock Doctor today.

Lincoln Indicators
Written by

Lincoln Indicators

Feb 22nd, 2022
Related topics
Information in this communication is current as of publication unless otherwise stated. It is provided for educational purposes only and may not reflect current market data or opinion. It should not be relied upon in respect to any current investment decision. Investments can go up and down. Past performance is not a reliable indicator of future performance.

Important: This communication is issued by Lincoln Indicators Pty Ltd (Lincoln) ABN 23 006 715 573, as Corporate Authorised Representative of Lincoln Financial Group Pty Ltd ABN 70 609 751 966, AFSL 483167. This communication may contain general financial product advice or forward-looking statements regarding our intent, belief or current expectations with respect to the market conditions. Caution is advised to place undue reliance on these forward-looking statements, as our advice has been prepared without taking account of your personal circumstances. Therefore, you should consider its appropriateness, in light of your objectives, financial situation and needs, before acting on it. Before acting on any advice, you should consider the appropriateness of the advice and we recommend you obtain financial, legal and taxation advice before making a decision. Please refer to our Important Information and Financial Services Guide (FSG) for more information at www.lincolnindicators.com.au . If our advice relates to the acquisition or possible acquisition of a particular financial product, you should obtain a copy of and consider the Product Disclosure Statement (PDS) at www.lincolnindicators.com.au before making any decision.

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