Step-By-Step Instructions for Using the Cassandra Stock Selection Model
It is important to first understand what your total investment portfolio will look like before you embark on the stock investing portion of your portfolio. Accordingly, these step-by-step instructions for using the Cassandra Stock Selection ModelTM start with a discussion of the Intrinsic Value Wealth Creation PyramidTM and a discussion of how your portfolio should be allocated between the various asset classes. Once you have determined your portfolio allocation, you can then start building your stock positions using the instructions contained herein.
While this write-up has some discussion of asset classes other than stocks, the majority of this paper discusses the Cassandra Stock Selection ModelTM for building a stock portfolio. A discussion of the other asset classes can be found in other sections of the Intrinsic Value Wealth ReportTM, including the book, The Intrinsic Value Wealth Creation Pyramid and the Pillars of WealthTM.
- Intrinsic Value Wealth PyramidTM
The Intrinsic Value Wealth Creation PyramidTM shown below suggests our recommended approach for investing. At the bottom of the pyramid, you should have a larger proportion of your investable assets. As you move up the pyramid, you should generally have smaller proportions of your investment portfolio invested due to the increasing risk associated with the asset classes that are higher up in the pyramid.
As a starting point, you should have an amount equal to at least six months of your salary or income in cash and cash equivalents (e.g., money market funds) as an emergency fund in case you lose your job or have another emergency. This is only a general rule of thumb and should be tailored to your own particular needs.
Next, you should begin investing a portion of your investments at intervals (so that you spread your investing out over 18 to 24 months as discussed in the Dollar Cost Averaging section of this write-up) in the following asset classes:
- Dividend paying stocks (all market caps, but primarily large and mid-cap stocks)
- Larger capitalization (large cap) value stocks
- Middle capitalization (mid cap) and small capitalization (small cap) value stocks
- Special situations, alternative investments, and visionary ideas
A portion of your investments could also be put into investment real estate, corporate bonds, U.S. Government Agency securities, and international stocks, as shown on the pyramid.
The bottom of the pyramid shows an investment in entrepreneurial ventures (your own or someone else’s). Entrepreneurism is one of the four main sources of wealth creation, which consists of: (1) stocks; (2) real estate; (3) entrepreneurship; and (4) multiple sources of income.
The Intrinsic Value Wealth Creation PyramidTM also discusses the notion of multiple sources of income. This notion is discussed more fully in the book, The Intrinsic Value Wealth Creation Pyramid and the Pillars of WealthTM.
- Asset Allocation
As a starting point for determining your asset allocation, I recommend that you use the American Association of Individual Investors (AAII) Asset Allocation Models to help you determine an appropriate asset allocation for your particular needs and circumstances. Remember, though, that there is a lot of subjective judgement that goes into the asset allocation decision. You will have to use your best judgement when making this determination.
- Investing in Stocks – Start with the Cassandra Stock Selection Model
You can find the most current Cassandra Stock Selection ModelTM in the Intrinsic Value Wealth ReportTM. Click here to access the Cassandra Stock Selection ModelTM. You must be a registered user to access the model; but registration is free due to the generous support of our sponsors. You can register for free by clicking, sign up. The Cassandra Stock Selection ModelTM is updated on a periodic basis.
- Read these instructions
- Begin investing in your portfolio
Your goal is to have 20 to 30 stocks in your portfolio after about 18 to 24 months of periodically investing. Having 20 to 30 stocks in your portfolio gives you an important measure of diversification that should reduce the risk in your portfolio.
As shown in the chart below, one way of measuring investment risk is by the measuring the volatility of your portfolio, which can be represented by a statistical measure known as standard deviation. The higher the standard deviation of the portfolio, the higher is the volatility, and therefore the higher the risk of the portfolio.
Volatility, or risk, is reduced by adding more stocks to the portfolio. But, most of the diversification benefit of adding more stocks to the portfolio is achieved at around 20 to 30 stocks. After that point, very little benefit is achieved.
You should invest roughly equal dollar amounts in each stock, instead of equal numbers of shares. That will keep the higher priced stocks from dominating the lower priced stocks in your portfolio.
- Dollar cost average
Invest in the 20 to 30 stocks over an 18 to 24 month period of time. This means, if you are investing over 24 months, you will be buying a new stock about every month. In some months you might buy a couple of stocks; and other months you might not buy any.
- Dividend Stocks
You should begin your stock investing program by considering dividend paying stocks you like on the Cassandra Stock Selection ModelTM candidate list. The dividend yield (the amount, expressed as a percentage of the price of the stock, paid out by the company as a dividend) is listed on the candidate list for your reference. Don’t pick a stock just because it pays a dividend. But given two stocks that you like equally well, choosing the one that pays a dividend might be the better choice. The reason is that a significant portion of the returns you get by investing in the stock market comes from reinvesting dividends. This phenomenon is explained below in a little more detail in the section entitled, Reinvesting.
After considering some dividend paying stocks for potential investment, you should look at other stocks on the Cassandra Stock Selection ModelTM candidate list for possible investment. The two alternatives for selecting stocks that are discussed in the next section are applicable for selecting both dividend and non-dividend paying stocks.
- Two Alternatives for selecting stocks
Alternative #1 – Just pick stocks from the list
- Pick stocks from the market cap range in the Cassandra Stock Selection Model that you feel the most comfortable with. Generally speaking, the smaller the market cap, the more risk there is. Risk is defined as the volatility of the portfolio, as we discussed above. It should be noted, however, that the more risk there is, generally speaking, the more there is a potential for investment gain. So the general rule is – more gain, more risk. In this case, you cannot have your cake, and eat it too!
- You can pick stocks from only one, or from multiple market caps. So, you can tailor your portfolio for the amount of risk and gain potential that you want to have.
- Within each market cap, the stocks are ranked by their Multi-Factor Score. The lower the score, the better the combination of value, financial health, and growth factors for each company. See the Cassandra Stock Selection Model Notes for a further discussion of the Multi-Factor Score.
- When investing for the dividend portion of your stock portfolio, look for stocks that pay a higher dividend rate. The dividend rate is shown in the Cassandra Stock Selection Model list.
- In Alternative #1, you typically won’t do a lot of further analysis. Accordingly, it is very important to avoid the stocks from the Cassandra Stock Selection Model with the higher Multi-Factor Scores, as these would require more analysis to ascertain their desirability for investment.
Alternative #2 – Pick stocks from the list and perform more in-depth analysis
- In Alternative #2, you will need to do much more analysis of the stocks you select. Therefore, it is highly recommended that you subscribe to the American Association of Individual Investors (AAII) Stock Investor Pro database or a similar database to help you perform your analysis.
- The steps in Alternative #2 are the same as in Alternative #1, except that you will be doing a lot more of your own analysis.
- See Steps to Investing in Enterprise Value for guidance on how to do the fundamental and other analysis needed in Alternative #2.
- Because you are doing more in depth analysis, you can choose stocks with higher Multi-Factor Scores. But still be careful with high Multi-Factor Scores, as they have less desirable combinations of value, financial health, and growth on a prospective basis (i.e., look-ahead basis). However, you can find some good stocks to buy from these higher Multi-Factor Score candidates with careful analysis.
- When to sell
In the Intrinsic Value Style of Investment Management, you won’t be selling often. This approach is more of a buy and hold approach, with an expected holding period of 3 to 5 years for most of the stocks in the portfolio. You will typically sell a particular stock for one of two reasons: (1) the stock has performed well and has become fairly valued or overvalued; or (2) the fundamentals on the company have deteriorated to the point where it is no longer a good business or investment.
The following are some general guidelines for determining which stocks to sell and when to sell them. These guidelines don’t take the place of rigorous analysis of your stock holdings, but can be used effectively as a quick screen of what stocks to focus on for more rigorous analysis. They can also be used by those not familiar with the tools used in more in-depth analysis. In this latter case, while not the preferred approach, it can still be used effectively to help in the selling decision.
Here are some guidelines:
The table below provides several ratios that can be used in the relative valuation approach. These ratios can be used for both the buy and sell decisions. Stocks can be bought when they are in the lower ranges and sold when they are in the higher ranges. This is what we mean when we talk about undervalued, fairly valued, and overvalued stocks.
The ratios are easy to calculate. You simply divide the price-per-share by earnings-per-share for P/E; and the price-per-share by the sales-per-share for the P/S. In the case of the PEG ratio, you divide the price-per-share by the earnings-per-share; and divide that result by the expected growth rate of the company. A discussion of the PEG ratio can be found by clicking PEG Ratio. Click the following links to find articles on the Price-to Earnings (P/E) and Price to Sales (P/S) ratios.
When using the relative valuation approach, you should compare the ratios you calculate to the current and historical ratios for the company, its industry, and its sector.
The table below is designed to offer some general guidelines on the ratios. But again, it is emphasized that you should compare the ratios you calculate to the current and historical ratios for the company, its industry, and its sector.
|Price to Earnings (P/E)||Price to Sales (P/S)||Price to Earnings to Growth (PEG)|
|Low||10.0||Below 2.0 is good; below 1.0 is excellent||Less than 1.0 is very good to excellent|
|Medium||15.0||2.0||1.0 is good|
|High||20.0||4.0||Greater than 1.0 is pricey|
Intrinsic Value Valuation
In addition to the relative valuation approach, if you know how to calculate the intrinsic value of a company, do this calculation and compare it to the market price of the stock to see if the stock is undervalued, fairly valued, and overvalued. If you don’t know how to do this calculation, and want to learn, I highly recommend that you read following book: Damodaran, A. (2011). The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit. Hoboken, New Jersey: John Wiley & Sons.
You should always perform as much analysis on your companies as you can. You don’t have to know all of the tools of financial analysis to be effective. Common sense goes a long way in investment analysis. Here are some tools and general guidelines that should help you in this common sense analysis step:
- Use SWOT Analysis to help you understand the strengths, weaknesses, opportunities, and threats that pertain to your company. Click here to learn more about SWOT Analysis.
- Think about the main value drivers (positive and negative) impacting the company. See the handbook on creating and analyzing value, Think Strategically, Think ValueTM for ideas on how to analyze value drivers.
- Be patient and look at the long-term prospects for the company. Remember that many of the companies that were selected by the Cassandra Stock Selection Model TM are, or have been, experiencing short-term problems. But, these companies were chosen by the model because they are good companies and have had strong performance in the past; and appear to the model to have good future prospects. So, carefully consider whether they should be sold or held. Again, there is no substitute for using good common sense here.
- Use reliable outside resources when available. A good outside resource that covers many of the stocks chosen by the Cassandra Stock Selection Model TM is the Value Line Investment Survey, which can be found at most public libraries (ask the reference desk to help you find it in the library). You can use outside resources such as these to help you do your research.
- Time Horizon
As discussed, the expected holding period for most of the stocks in the portfolio is 3 to 5 years. Accordingly, the expected holding period for the entire portfolio is 3 to 5 years. You should plan on a time frame that is at least this long – and it could take longer. If you don’t plan on and commit to a 3 to 5 year holding period, the Intrinsic Value Style of Investment Management probably won’t work for you. But in our experience, and in the many studies on value investing, the 3 to 5 year holding period works and it has been shown that this is a reasonable holding period. Patience is the key!
If you want to continue investing your portfolio beyond the 3 to 5 year holding period, simply keep investing using the buy and sell guidelines discussed above. And always keep around 20 to 30 stocks in your portfolio at any given time.
A significant portion of the returns you get by investing in the stock market comes from reinvesting dividends. According to Dimson, Marsh, and Staunton in their book, Triumph of the Optimists: 101 Years of Global Investment Returns, as paraphrased in Gardner and Gardner (2009), “…a portfolio in which we reinvest dividends – using the dividend to then buy more shares of stock – generates almost 85 times the value of a portfolio that relies solely on stock appreciation (p. 52). Many other studies have confirmed this finding as well.
When You Sell a Stock
The goal of the Intrinsic Value Style of Investment Management approach using the Cassandra Stock Selection Model TM is to always have 20 to 30 stocks in the portfolio once you have become fully invested (i.e., after the 18 to 24 month initial investment period). Accordingly, when you sell a portfolio holding, you should replace it with a new stock position. As the value of your portfolio grows, you can increase the size of the new positions on a proportionate basis; always maintaining approximately 20 to 30 holdings.
- Track Record – The best part of all!
How have we done with this investment process? The Intrinsic Value Style of Investment ManagementTM and the use of the Cassandra Stock Selection Model TM have produced excellent performance results for us. Please see our Track Record, which shows the results of a three-year track record study that we compiled on our actual stock recommendations.
Bodie, Z., Kane, A., & Marcus, A., (2013), Essentials of Investments. New York: McGraw- Hill Irwin.
Damodaran, A. (2011). The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit. Hoboken, New Jersey: John Wiley & Sons.
Gardner, D. & Gardner, T. (2009). The Motley Fool million dollar portfolio. New York: HarperCollins.
Meir Statman, “How Many Stocks Make a Diversified Portfolio?” Journal of Financial and Quantitative Analysis 22, September 1987