A Simple Lesson on Selecting Winning Stocks

I love a good teaching moment...

A few weeks ago, my team and I were deciding which stock we wanted to use for an options trade in my Retirement Trader service. (For those who aren't familiar, in Retirement Trader, we sell options on high-quality stocks to collect income.)

One of my researchers sent me two stock ideas. Both ideas had solid analyses and I liked them both.

But he left out one key piece of information that I needed to know before we committed to any stock.

His pitch for both stocks was simple... A while back, consumer staple stocks were getting hammered. They were down more than 10% since the start of 2018.

Regular readers will remember that I recently wrote about consumer staples being the most hated stocks in the market.

In that essay, I made the case that there were a few stocks in the sector trading for bargain prices.

My researcher thought he found two of the most attractive stocks that would make for excellent options trades. The first stock was spice maker McCormick (MKC). The second was condiment giant Kraft Heinz (KHC).

McCormick is the type of stock you would feel confident owning your entire life. Think about it like this... When you go to the grocery store, what spices do you usually purchase? If you're like most people, you buy McCormick spices. And you usually just do it instinctively. No marketing required.

McCormick has other widely accepted brands besides its namesake spices, such as Old Bay (a kitchen staple here in Maryland), Lawry's, and Schwartz. No matter what is going on in the economy, whether we're in one of the longest bull markets of all time or we're heading toward a recession, folks are always going to purchase McCormick's products.

And when you dig into McCormick as an investment, it's a moneymaking machine. At the time of the stock pitch, McCormick's gross margins were the highest they had been since 2010. The company's free cash flow, which is the cash after a firm pays its bills and invests in capital improvements, has more than doubled since 2010. Also, McCormick has increased its annual dividend payment every year for 31 consecutive years.

All things I love to see.

With all the negativity toward consumer staples in general, McCormick's stock was trading below what we thought it was worth.

Kraft Heinz was a similar story. It is the brand for ketchup. Its Heinz mustard is one of the top mustards on the market and the company also sells a variety of other condiments and snacks that are very popular.

If folks have been buying Kraft ketchup and Heinz mustard for years, they are unlikely to ever switch to another brand. There's a lot of brand loyalty.

At the time, Kraft Heinz's stock was dirt cheap... It was down nearly 27% since January. Since the price fell so much, it was paying a dividend that yielded 4.3%, which is more than double the broader market and half a percentage higher than stalwart stocks like Coca-Cola (KO) and Kimberly-Clark (KMB).

Its price-to-earnings ratio was near a multiyear low. Kraft Heinz only traded for 16 times earnings, nearly half of its three-year average of about 29 times earnings.

Both stocks sound pretty enticing, right?

I thought so... But I needed to know one more thing before I made a decision.

My response to my researcher was short. It was a teaching moment (and I can never turn down a teaching moment).

All I said was: "I like both. But I ask... What is the top line doing?"

When I mentioned the top line, I was talking about the company's overall revenue. I wanted to know if both companies were growing their sales every year.

You see, McCormick is the poster child for top-line revenue growth. It has grown its revenues 28 out of the past 30 years, a stretch that included three recessions.

Kraft Heinz, on the other hand, has not. Over the past three years, revenue has pretty much gone nowhere. It was $26.5 billion in 2016 and $26.2 billion in 2017. Over the past twelve months the company made $26.1 billion.

Knowing this made the choice about which stock to go with easy. We bought McCormick around $103 per share back in early June and sold covered calls against its shares with a September expiration date.

McCormick is currently trading for more than $120 a share after an excellent second-quarter earnings report. In our Retirement Trader trade, we're on track to make 3.5% in only three months, which is 14% annualized. That's an excellent return for a low-risk trade.

Kraft Heinz, on the other hand, is only up around 3% over the same period. Still a solid gain, but I'm not sure how comfortable I would feel holding the stock for a year or two.

The lesson here is simple. Why would you want to own a portion of a company that has a hard time growing its sales each year... especially in today's economy – where consumer spending is robust, gross domestic product is projected to grow 3% this year, and the unemployment rate is less than 4%?

If a firm can't grow in this environment, chances are it won't do well when the economy is in a recession.

Sometimes investors can get caught up in financial metrics such as valuation ratios, leverage ratios, operating margins, profit margins... the list goes on and on.

Those metrics are useful, but sometimes it's best not to overthink things.

Remember, when you buy a stock, you're buying an ownership stake in a company. Think about the products and services it sells. And in general, stay away from companies that struggle growing their revenues each year.

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Here's to our health, wealth, and a great retirement,

Dr. David Eifrig and the Health & Wealth Bulletin Research Team
August 22, 2018