Six Stock-Picking Secrets From a Hedge Fund CEO

Alpesh Patel|August 13, 2021

Note: It’s an exciting day for Manward. Today, we’re sending you the very first column from our newest contributor, Alpesh Patel. In it, he reveals what he looks for in the perfect stock. These are the tools he uses with his high net worth clients… and now he’s sharing them with you.

Check it all out below and let us know your thoughts and what questions you have for Alpesh. Send an email to mailbag@manwardpress.com.

– Amanda Heckman, Editorial Director

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After 20-plus years in the markets… winning prestigious investing competitions… becoming a Dealmaker to bring businesses to the U.K… I can say my investing philosophy boils down to this phrase…

I want to invest in companies that I never have to worry about.

Sounds simple, doesn’t it? Isn’t that what everyone wants? To build a portfolio of robust companies that grows your wealth while at the same time lets you enjoy life?

Well, today, I’m going to show you how I make that simple phrase possible.

Making the Grade

I’ve developed a set of stringent criteria for finding stocks to invest in. It’s how I pick stocks for my own portfolio and those of my high net worth clients. Every day, I scan the markets – that’s more than 9,000 tickers – to find the best stocks that make the grade.

I will invest my capital only in the companies that check off all these boxes…

Valuation. I’m looking for valuations that have historically correlated to superior share performance over the next 12 months. We know valuation is important, but we also know it cannot be the only metric. Some companies are undervalued for good reason (they’re not good), and valuations vary by sector too. My formula allows for these metrics.

Growth. Revenue growth is key for me. While this excludes many companies, it allows me to sleep easier. We may miss some companies whose revenue growth stinks yet shoot up on, say, Reddit excitement. But that is speculative, and I like to remove speculation.

Income. I don’t buy companies for their dividends. I prefer companies that don’t provide dividends and instead reinvest all the profits. But I know major funds will pick up companies if their yields rise – for instance, by their prices falling – so I know this metric can provide a base. My role is to work out what others will be thinking – it’s something I learned and lectured on at Oxford University when looking at the field of game theory in economics.

Cash Return on Capital Invested. This is one of the most important factors for me. There is a strong correlation between stock performance and this cash flow measure. It provides companies with resilience. I discovered this formula at a meeting with Goldman Sachs Asset Management’s chairman (Jim O’Neill at the time) at a presentation by its quantum division. (I still keep the slides next to my desk – pure art!)

Momentum. I want companies in the recent past to have thrived in whatever the current market conditions are. I am not going to guess when the market likes value or momentum companies. Instead, for me they have to meet both.

And finally, Sortino. It’s a measure of the reward (average return) versus risk (how consistently it hits this). But it allows for the fact that upside (outperformance volatility) is good, not bad. I added this metric to my strategy after I set up my hedge fund in 2004. I quickly came to realize its importance as all the high net worth clients, pension funds and family offices would ask us for it.

I’ve seen many a newsworthy stock pop up, and I would note how poor its Sortino was… only to see the public plow in and the stock revert to its poorer performance. I know to keep out in the first place as these stocks always fall after that initial euphoria.

Once a stock fits all my strategic categories – and only about 1% to 2% do out of a possible 9,000 – then I look at a few other factors, including analyst forecasts, sector, geography, volatility, market cap and even news stories. But these are far less important to my overall strategy.

Here’s the other crucial part to my strategy. Once I have my investments, I hold them for a year and use a 25% trailing stop. This allows me to enjoy life without needing to check on my portfolio. After a year, I check in to see whether the stocks are still worthy of my money.

The result? This strategy has led to my outperforming the market by more than 500% over the past five years.

So what stock is meeting my criteria right now?

Picture Perfect

Shutterstock (SSTK) is a popular online provider of stock photography, stock footage, stock music and editing tools.

The stock made my list because when I weighed its valuation (I use share price and earnings, revenue growth year over year, and dividend yield) according to my formula, it scored an 8 out of 10.

But just as important for me were the other factors.

First, cash return on capital invested. I got a figure of 32%. This makes the company one of the most cash-generative in the U.S. It assures me it will be strong in any market turbulence and could be a flight to safety should the broader markets get headwinds.

I like that the stock is up over the past six months (around 60%). While of course I’d prefer it rise 60% after I buy it, I still see upside. I also expect the hedge fund Gotham Asset Management adding to its position has not harmed the share price!

Critical for me is the Sortino. This company on a “volatility to average return” basis has a good Sortino. In other words, its historic downside risk is worth the upside reward. While it’s true history is no guide to the future… I think history is important. This measure shows me the consistency of returns. And we all like consistency.

The company generates a whopping 8% alpha on my metrics. Alpha is the ability to outperform the market. It’s the secret sauce for big hedge funds – the “edge” to outperform.

And the stock’s 18% volatility is not excessive. Some investors like higher volatility (higher risk) stocks as they think risk and reward go hand in hand, but I want to look for outliers of reward at the lowest possible risk. I don’t want to take on risk just for the sake of it.

This is just an example of how I apply my metrics to find good stocks. I’ll be sharing plenty more with you in the weeks and months ahead.

These metrics have led me and my clients to great success. With them as a guide, I never worry about the stocks I invest in. I’m able to leave my portfolio alone… content I’ve picked up solid companies that will work hard for my money.

Note: If you have any questions about the metrics I use, send them to mailbag@manwardpress.com.