The Oak Harvest Stock Selection Process

 

Which stocks are right for you? In this video, Troy Sharpe, Founder and CEO, and Charles Scavone, Director of Investments here at Oak Harvest Financial Group, go in-depth about how they decide which stocks, bonds, and investments they choose to go into your portfolio to help you reach your retirement goals.

Introduction to Oak Harvest’s Investment Management Approach

Troy: Charles, you’ve had quite the extensive career throughout the investment management world on the institutional side and also the retail side, but many different market environments, many different economic cycles, and a lot of experience with different asset classes, stocks, bonds, et cetera. One of the unique things here at Oak Harvests Financial Group is we have multiple institutional managers that have had quite the amount of success.

Four-star, five-star ranked Morningstar funds, number one, number two, ranked Lipper funds over long periods of time. One of the unique things here at Oak Harvest as an RIA, registered investment advisor, most firms like ours outsource the wealth management to third-party firms. It creates a series of layered fees. The extensive experience that you and Chris Paris and also James McFarland bring to the table here really does help clients have a one-on-one connection if they have questions through their advisor or even speaking directly to the investment team.

How Our Process Benefits You

What we want to talk about today is the actual process of stock selection. Charles, from your experience, what is the direct benefit to the consumer or the potential benefit to the consumer from having a structured process in place for stock selection, and maybe in your career some examples of if there isn’t a process in place, what can go awry?

Charles: Well, the second part of your question is the best part of it because, from our standpoint, any investment program that [00:02:00] does not involve some thoughtful systematic process to allow you to identify these investment opportunities lead you to this random outcome. You have a handful of randomly selected stocks. It’s going to your barber or your hairdresser and getting stock tips.

Our perspective and what Chris and I bring to the table is institutional framework investors, is that we want to employ some thoughtful, systematic process that allows us to identify what we believe to be are the most important attributes that a company can possess. Those are the ones that affect corporate profitability. Our experience is that it is sales margins and return on invested capital. To oversimplify it a bit, if we have a good product or service and we sell a lot of it, we generate a lot of sales.

If it’s really good, we’re able to charge more for it and we generate high margins and then we can take the proceeds of that and reinvest it back in the company and generate this wonderful flywheel effect that creates the great growth companies that we’ve seen across various market cycles, across various types of economic conditions and economic cycles. It creates this thoughtful framework that gives us a confident platform to operate from that we believe gives us the best chance of creating repeatable returns over time.

Troy: It’s something that there’s quite an established precedent in capital markets for as well. There’s not many companies out there that have increasing sales, that are expanding the margins or the amount of money that they make on that increasing amount of sales then redeploying that capital from those sales and increased margins, profitability, redeploying that capital into more successful projects.

That’s how we create an expansion of multiple, that’s how we create [00:04:00] compounding profitability, which then translates into compounding stock returns or at least theoretically. That’s the first part of the process. Think SMR, sales margin increasing or margins and then return on invested capital, SMR. When we talk about investing in today’s environment, it’s not just maybe what we call that bottom-up analysis or fundamental analysis.

The Quantumental Process

You’ve brought a term to Oak Harvest called Quantumental. Charles, you brought this term to Oak Harvest Financial Group and you’re going to hear a lot about this moving forward, or at least it will be frequent in our writings and our communication with you, and our appointments with you. Quantumental, so how does quantumental, when we’re talking about the quantitative analysis, that’s obviously looking, like we said, the bottom up the fundamentals SMR, but how does it now tie into what the economy is doing and what’s going on maybe with the Federal Reserve with monetary policy?

Charles: Sure. Well, it’s important to take one quick step back and say, “Okay, what is this quantitative process?” We have the tools in-house that allow us to look at a universe of about 28,000 stocks and say, “Okay, where can we identify those trends that we talked about?” It’ll take that universe of 28,000 stocks and boil it down to a much smaller group that we have the highest level of interest in.

That’s the quantitative process. Then you have to ask yourself, given everything that’s going on with the economy, with interest rates and such how do you determine if those factors are repeatable? Are they durable, and what are they worth? That’s when we put on our fundamental research analyst hats on, and we do a deeper dive into that more.

Troy: Just the baseline information that we’ve whittled down from the characteristics that we’re looking for.

Charles: Yes. We’ve reduced our focus to the smaller universe of companies that we want to then [00:06:00]examine to see if those financial traits we’ve identified are durable, repeatable, and hopefully, carries across an economic cycle. Then we begin our process as fundamental true, fundamental analysts and begin to do a deep dive in looking into what are the drivers of the financial performance of these companies.

That’s the fundamental aspect of it. We meld this quantitative process to bring our focus into what’s most important. Then we really add a lot of value, I think, in bringing our experience as research analysts. I’d really dig into these companies and identify the choices we want to use. That’s what’s completely different from what we do versus an index fund that just allocates the client’s capital in a formulated basis across a litany of stocks, regardless of the investment, merit those positions.

Troy: That’s a really good point. When you buy an index fund, you are essentially buying just an off-the-shelf product where there is no thought, there is no fundamental analysis, there’s no quantitative calculation of these individual performance attributes that history has shown us over time tend to perform quite well on the market.

To recap what we’ve said so far, so process is extremely important and part of the Oak Harvest process is creating this layered structure where we’re trying to identify whittling down, so to speak, from the universe of stocks out there, certain performance characteristics or companies that have attributes that we feel, and history also shows tend to put us in the best position for good performance over time.

Then we’re going to make those decisions over which equities that we purchased with a consideration given to monetary policy, such as the Federal Reserve, raising interest rates or economic cycles, and having the experience of managing you and Chris Paris managing [00:08:00] money over multiple different market environments. It’s not just something that you read in a textbook, it’s something that you’ve lived and successfully navigated over many decades in this industry. That Quantamental approach, but let’s not forget the SMR.

How This Process is Different From Others

This is very important in the stock selection process, sales margin expansion, and return of that invested capital. How is this process then built into the different portfolio models that we have, let’s say the dividend model or the blue-chip growth model? How does this process, does it differ when we’re looking at those two different portfolio models, for example? Is it the same and what’s some insight you can provide there?

Charles: Yes, it’s a great question. When you take a step back and think about it, the attributes that drive what would be viewed as this growth profile of a company, the ability of this company to take excess profits and reinvest them in the business also provides them the opportunity to pay out a portion of that in the form of dividends.

We’re not looking for anything different, particularly within the financial profile of the companies. We’re differentiating is a capital allocation decision that the company is made in terms of whether it has sufficient funding to both reinvest in the business and pay out a portion of those profits in dividends. Then for us, we’re also take that even a level further, particularly in the dividend income model.

We’re looking for companies that have the ability and the willingness to pay a growing dividend. We’re looking for a pretty specialized company. For us, the process is the same and that’s what drives what we do from a research standpoint. We then let the company show us where it needs to be placed within our different equity model so that we can create, differentiate a [00:10:00] product for our client. The foundational element is all this process-driven research approach that we have.

Measuring Stock Results to Improve Your Portfolio

Troy: We’re big believers in what gets measured shows results. If we don’t measure performance, if we don’t and I’m talking about here, not just how much has the stock increased, but just big believers in if you don’t measure and if you’re not benchmarking, you really have no idea where you are versus where you should be. One of the things that I think was very, very important there is when we’re talking about dividend growth, and we’re trying to identify attributes of companies that, whether they go into the growth portfolio or this dividend growth model, and just as a refresher here, dividend growth is when companies pay out a dividend.

They have a long history of paying a dividend, but that dividend that they pay out increases over time. We expect it to continue to increase. When we’re measuring the sales of a company, the margin expansion is our profits increasing or is our profit margins decreasing? If a company has increasing sales, increasing margins, and they have a good track record of reinvesting that capital to create more sales and more margin expansion, it’s a great growth company.

Guess what? We can also, now, if the company has paid a dividend for 15 years and increase that dividend from prior years, increasing sales, expanding margins, reinvestment or reallocation of capital to decisions that continue to increase sales, we feel pretty good as an investment team that that dividend has a good probability continue to be paid out, but also to increase.

That’s one of the ways that we tend to structure portfolios when we’re doing the financial planning. If someone is concerned about inflation and they have the dividend growth portfolio dividends are not guaranteed and dividend growth is not guaranteed. That process for identifying companies that [00:12:00] have those characteristics of SMR really lends itself well to both the growth portfolio but also the dividend and dividend growth portfolio.

Charles: Agreed. That’s why you’ll see a little bit of common ownership across both of the portfolios as a result of that. Then as we look at these names, we see what is the price that the market is asking for them for these particular attributes. We size it up and based upon our level of conviction in our outlook, then that determines the position sizing within each of these models.

That helps us. That’s an inherent form of one embedding active management as opposed to just passively allocating it regardless of its merit as an index fund would do. It also allows us to best position things from a risk management standpoint. The names that have the highest level of conviction have a higher weighting within the model portfolio. Then it allows us to build this bottoms-up portfolio one stock at a time.

To a point that you were making earlier, we do then come back and say, “Okay, does our top-down view of the world, our forecast, our economic forecast, interest rate forecast and such, does that view match what this bottoms-up portfolio construction has created? If it doesn’t match, we adjust it and we make sure that everything meshes up. As things change, then we can change the allocation to these individual names within the portfolio.

Position Sizing in Risk Management

Troy: Something really, really important that Charles said there, and its position sizing. One of the tools we use to manage risk is position sizing throughout the portfolio. Position sizing, if you invest, say $100,000 and you have $1,000 in one company, that’s a 1% position size. Now most people probably aren’t aware that the S&P 500, if [00:14:00] you buy an index fund, it’s a market cap-weighted index.

There’s no strategy to which companies are allocated to what percentages in that index other than how big is what we call the market capitalization. It’s overweighted towards Google and the big technology companies, but there’s no quarntermental analysis there to really say, “You know what? These are the best companies to own right now given their fundamentals, but also the economic environment that we’re in.”

Position sizing is very important for one risk management. What we’re able to do in these portfolios is to identify companies that we feel fit the characteristics that we’re looking for in a company. Then when we start to position size across, whether it’s the blue chip growth portfolio or the dividend portfolio, we can say, “You know what? We like this set of companies and this particular environment much better so we’re going to allocate a bit higher position sizing to them.”

I call it tilting the portfolio and this isn’t a concept that I invented but if you think of an ice tray before the ice has frozen, and you tilt that corner down, more water is going to go to that corner, less water in these upper squares here or upper cubes. That’s like tilting the portfolio based on this quantamental process of identifying stocks that fit the characteristics that we’re looking for SMR but also, we feel we’ll operate in the type of economic environment that we’re in.

We can adjust. Charles, SMR is obviously very important but when we’re looking at the full dashboard of attributes that we look for in a company, it’s much greater than that. It’s much deeper than that and it’s much more involved than that, but SMR very, very good summary for the primary characteristics, I’d say that we’re looking for in stock selection. What happens [00:16:00] when we identify a company that’s in the portfolio that has decreasing sales or maybe margins aren’t expanding margins are contracting? What is the Oak Harvest sell discipline?

Charles: Well, you’ve just asked the most important question you could possibly ask and we’re all guilty of spending so much time on why do you a stock or why do you invest in a stock. Really, the fault that I see in most investment programs is they don’t have a disciplined cell program in place. It becomes an emotional thing and for us, it’s never emotional. It’s very much driven by the simple fact that, to the extent that any of the criteria that we used as part of the buy decision on a particular name is no longer valid.

That stock is candidate for sell and we put our fundamental hats on and say, okay, this looks like it’s going to be some enduring condition, something’s changed with the business model, it’s gone. We’ll take that proceeds from selling that particular name, and look to reinvest it into the next higher-earning name within the portfolio. There’s always a process of portfolio upgrade going on and there’s always a process of risk management going on.

We don’t put something in a portfolio and then just forget about it. You’d be surprised, we see that a lot of time when we look at portfolios that come in-house. It’s part of the risk management program, and a very important part of what we do.

The Importance of Visibility

Troy: What’s important for you to understand watching this video, is when you go into the investment department, and we start to look at the type of visibility that we have, we’re pulling data from all of the important metrics that we’re following, SMR is a very good summary of those, but there’s many more. We have visibility of all the companies inside the portfolio in the key characteristics with real-time data that’s being updated.

Think of it as a performance dashboard, or a measurement dashboard, where we can measure the current profitability, [00:18:00] past profitability, margins, all of the key factors that go into the stock selection process. We have visibility of all those attributes and we can use that data to dictate our decisions and if some of the fundamentals or even maybe from that top-down approach, the economic environment is no longer conducive to that particular industry or company, we can make portfolio decisions, reallocate capital as warranted on this real-time basis.

Charles: Agreed and you highlight another interesting point. We’re not just looking at just the companies that we own, we tend to focus a lot on their customers, their competitors, and their suppliers. If there becomes issues in either of those, we think through and determine if there’s going to be a problem at the company itself, trying to just stay one step ahead of the street.

Troy: You couldn’t have a better example than COVID with all the supply chain breakdowns, which leads to lack of inventory, which then leads to a lack of sales, then companies overbuy and they have excess inventory and then margins start to get compressed because they have to discount inventory to get it off the shelves. That’s actually more than probably we were planning on getting into as far as the stock selection process and in the characteristics and really how deep we’re going in this process.

One thing just also to point out there is adjusting the position sizing inside the portfolio compared to index funds. When all of this stuff happens inside a company, and its fundamentals are deteriorating or improving with your index funds, like the S&P 500, there is no tilting, because economic conditions or fundamentals are more favorable for that particular company. It’s just a static, how big is this company, and that’s the weighting that it gets inside the particular S&P 500 index fund. The [00:20:00] DOW Jones is a price-weighted index where it’s the only determinant of the position size. Inside that index is the price component.

Charles: How does that make any sense?

Troy: It doesn’t.

Tying in to Retirement Financial Planning For Our Clients

Charles: Troy, we’ve covered a lot of ground on the investment side and process there. Can you give us some color on, what does this mean for financial planning clients or the clients overall for Oak Harvest?

Troy: The investment side is very important but I’ve stressed for years that investments are just one part of an overall retirement plan, but the way we invest our capital and retirement, does determine our returns. Those returns are important for projecting out how much income we’ll have, how long the money lasts, how much we’ll pay in tax. When I started Oak Harvests, the recommendation across the industry was, “Troy, don’t bring it in-house. It’s too expensive.

The regulatory burdens are too great. It’s too much of a hassle. Just simply outsource the investment management. Probably 90% of companies like ours do.” I didn’t like that concept because it created a layered fee structure for our clients and I didn’t feel comfortable charging a particular fee for investment management if weren’t the ones actually investing the money. The first way I think from a financial planning perspective is having the investment team and this discipline process that we’ve discussed today.

One, it helps to reduce costs for clients. Two, it gives our advisors a direct line to the investment team to communicate to the clients and that is a huge benefit because when you want to understand, why we’re making particular decisions inside of a portfolio or how it impacts your retirement plan, we go directly to the source. As opposed to we just had a bunch of mutual funds that have their expense ratios, which most of you’re aware of but I still think a lot of consumers today don’t quite understand that an expense ratio is just one cost inside of a mutual fund. You have trading commissions, sometimes you have 12b-1 fees. [00:22:00]

You have other expenses that come out of the mutual fund value towards the end of the year and most people don’t see it. This is not an itemized fee that’s given to you and it’s not included as part of the expense ratio. If that was the way we were going, I couldn’t go to the mutual fund manager at American Funds and say, “Hey, Jim, what’s going on here?

Why’d you sell these positions? What are we thinking with these allocations?” [unintelligible 00:22:27]investment process into the financial planning process, it puts the consumer into what I believe is a lower cost structure because it’s not being outsourced and all the planning is inclusive of that investment management fee as well as the investment management and the buying and selling of individual stocks.

When we craft retirement plans, if someone has an expectation of a lower volatility portfolio and they’re looking for modest growth with the potential for increasing income, well, the advisors know, hey, we can use the dividend growth portfolio, and then it’s a matter of the advisor having a conversation with you the client to determine the appropriate amount of risk to put in the market, versus how much of the portfolio we want secure.

The investment portfolios that we operate and manage here at Oak Harvests Financial Group have specific intentions and specific goals but we’re able to customize, then the plan for someone’s individual retirement needs objectives, and goals around the portfolio models themselves or use the models to incorporate into a more strategic and thoughtful retirement plan that melds those two together.

Charles: Makes sense to me, and that just highlights again the risk management element of it too, and the work that the financial advisor does in helping a client assess, how much of these elements to have within their plan.

Troy: I hope you understand now a little bit more about the stock selection process here at Oak Harvests Financial Group. [00:24:00] This is just step one of the retirement success planning process which is risk management to achieve a certain expected growth or rate of return. Now that you have a greater understanding of how that operates here at Oak Harvests Financial Group, can tie that into what we do on an income planning side, a tax planning side, and of course, the healthcare and estate planning.

It’s what makes us different for you and your retirement. We’re going to have more of these videos so stay tuned. We thank you very much for watching this one and if you have questions reach out to myself, reach out to your advisor and we look forward to seeing you soon on your next review.

Do you need a Retirement Success Plan that goes beyond allocating funds to truly fit your needs? We can help you create a retirement life plan customized for your retirement vision and legacy. Call us at (877) 404-0177 or click here fill out this form for a free consultation.

Disclaimer: This video discusses fixed-income investing and utilizes the 10-year U.S. treasury as a general representative fixed-income investment. Conclusions reached, opinions stated, and downside risks and potential returns presented should not be construed as applying to other types of bonds or fixed-income assets. Other types of fixed-income products carry different levels of risk and return potential and should be evaluated as an element of a diversified portfolio with your specific risk tolerance, investment objectives, and timeline in mind. Nothing in this video is investment advice, an investment recommendation, or an offer to buy or sell any security. Investing involves risk.