In our ongoing exploration of rules-based money management, we have embarked on a journey that spans tiered allocation strategies, diversification philosophies and periodic rebalancing. Now, we reach the fourth port of call—Security Ranking Measures. This part is all about making smart, rules-based decisions about individual financial securities within the context of an overall investment portfolio, underscoring the importance of the nuanced art of ranking.
Security ranking is a key step in portfolio construction. The idea is to sort a group of potential investment opportunities according to specific metrics to help discern their comparative attractiveness. Rankings are aimed at indicating which investments to buy or sell, when to buy or sell, and how much to invest in each. These measures are critically important to rules-based portfolio management, offering a disciplined approach to investing that is less likely to be impacted by emotional decision-making.
There are many different measures frequently used to rank securities. Let’s delve deeper into some of them:
1. Price/Earnings (P/E) Ratios: This is one of the most common valuation metrics used by both individual and institutional investors. It compares a company’s current share price to its earnings per share (EPS), acting as a measure of how much investors are willing to pay for a company’s earnings. Generally, a high P/E ratio could mean that a company’s stock is over-valued, or else that investors are expecting high growth rates in the future.
2. Dividend Yield: Some investors rank based on the dividends a company returns to its investors. The dividend yield is calculated as annual dividends per share divided by price per share. A high dividend yield may indicate an undervalued stock, but it could also mean the company is in trouble and is returning profits to shareholders instead of reinvesting in growth.
3. Debt/Equity Ratio: This measure compares a company’s total liabilities to its shareholder equity and can be used to evaluate how much leverage a company is using to finance its assets. A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt, and this can result in volatile earnings.
4. Return on Equity (ROE): ROE is a measure of a corporation’s profitability, revealing the profit a company generates with the money shareholders have invested. High ROE is often a good signal, indicating efficient use of investments to generate earnings growth.
5. Price/Sales Ratio (P/S): This tool compares a company’s stock price to its revenues, reflecting the value placed on each dollar of a company’s sales or revenues. When a company has no earnings, P/S could be the lung through which it breathes in the stock market.
6. Beta: Beta measures a stock’s volatility in comparison to the market as a whole. A Beta of 1.0 implies that a security’s price will move with the market. A Beta less than 1.0 suggests lower volatility, while a Beta greater than 1.0 indicates greater volatility.
These are just a few examples of the many measures investors can use in security ranking systems. The key to making any ranking system work for you is to understand exactly what each measure is telling you about a particular security, and then applying consistently over time.
Remember that investment involves risk, and the performance of any security is subject to numerous factors. It’s important to keep in mind that high rankings based on the above measures do not guarantee future returns. But when integrated into a systematic, rules-based investment strategy, these measures can provide investors with valuable discipline and direction.
The ever-evolving world of investment is complex and filled with both risk and opportunity. By digging deep into the weeds of security ranking measures, you’ll find that you are better equipped to navigate these waters, adjusting your course as needed, while keeping a steady eye on your long-term financial goals. Be sure to consider these insights as you continue along your journey of exploring rules-based money management.
