Use technical evaluation to choose stocks

Running a company is in Bruce Campbell’s genes.

A third-generation business owner, he founded StoneCastle Investment Management in 2008. Based in Kelowna, B.C., Campbell is the firm’s principal and portfolio manager.

“I grew up in a family where business has always been forefront,” he says. His grandparents ran flower shops, and his father owned pharmacies.

Campbell says he’s been investing in the stock market since high school, when his portfolio consisted mostly of blue chip and penny stocks. He remembers watching the Black Monday crisis of 1987 unfold as a teenager. “It was just another ho-hum day for everybody else at school, but I was concerned about what the markets were doing.”

Now, Campbell has 28 more years of investment experience. His firm sub-advises two funds for Redwood Asset Management. The Redwood Equity Growth Class has had an 11.34% return since its inception in August 2009, compared to 7.8% for its benchmark. StoneCastle also advises pension plans with less than $25 million in AUM, charities and an endowment.

Q: Why seek risk-adjusted, instead of absolute, returns?

A: We want to generate absolute returns, but we’re trying to accomplish that with the least amount of risk. We’re looking for companies with lower beta to the market, such as Premium Brand Holdings, Alaris Royalty and Boralex. Those have about half the beta of the market. As a result, in a rapidly rising market we tend to get left behind. In a steady rising market we tend to perform in line with our benchmark, and in a falling market, we tend to outperform by a little.

What do you look for in stocks?

A: We’re looking for a catalyst that’s really going to change a business’s earnings profile. Maybe someone has a new product, or the industry is changing. That’s when we’ll buy. A higher earnings growth rate will attract other investors, pushing up the company’s price-to-earnings ratio. But higher earnings provide stability if the earnings multiple gets too high. The company will grow into its earnings multiple. Generally, a company we’ve invested in will go from being cheap to really expensive, but the whole time the earnings profile looks great.

Q: Do you prefer a particular company size?

A: We’ll have a company in the income fund with a $160-million market cap at an equal weighting to a company with a $40-billion market cap, and we’re happy to own both. That said, looking for accelerated earning growth tends to put us in the mid-cap range of $1 billion to $5 billion. For example, it’s difficult for a large business to grow earnings at a [high] rate—though it might be able to do 7% or 8% a year, and there may be times it goes higher. Whereas, if you have a small company with a smaller earnings profile, it’s easier for it to generate 20% or 30% earnings growth for several quarters, which we prefer.

Patient Home Monitoring is a good example of a company we’ve owned and that has seen earnings ramp up. They sell in-home monitoring kits for people with a number of different ailments.

Its growth rate has been phenomenal in the last year because it started executing an acquisition strategy in 2013. When we started to see the ramp-up in growth, we purchased. Typically, acquisition strategies are great for a while, but then they peter out because there’s no organic growth. But, Patient Home Monitoring bought small monitoring businesses. That gives it a database of new clients to work off of, and it’s able to cross-sell its products to those same people. It’s seeing organic growth of about 20%, so its earnings numbers have really been up. They’ve grown their EBITDA by about 500% this year, but most of that’s acquisitions. Next year, the consensus projection is that they’re expected to grow their EBITDA about 200%.

Q: What’s your process?

A:1. Top-down: We’re always trying to figure out whether we’re on offence, neutral or defence. What typically moves us from offence into neutral would be negative short- and intermediate- term indicators. What moves us from neutral into defence would be negative intermediate- and long-term indicators. If we were in offence and we had a company that broke down from a bottom- up or a technical standpoint, we would sell it and then replace it. If we were in neutral, we would sell but we wouldn’t replace it; we’d let that cash build up. We went into neutral in June: at the time we had around 10% cash, and now we’re at about 35%.

If we were in defence and a company broke down, we would trim back all our existing positions. So, if we equal-weighted all positions at 2.5%, we would cut back to 2% or 1.75% and we’d raise cash. We’re also able to take short positions to buffer some of the downdraft in the market.

In the short term, we look at standard technical analysis such as Moving Average Convergence Divergence momentum indicators or stochastic models (see “TSX Weekly MACD,”). They look at where prices are versus where they’ve been. We use the models to look at individual stocks. Do we hold the position? Or do we cut it back or sell it? We also look at sectors and markets. If we see the momentum has slowed in a sector, then we can cut back the sector. Then if the market’s momentum has slowed, we go into neutral or defensive. That will also dictate what happens with our individual stocks. We also look at institutional money flow: are institutions increasing or decreasing their allocations to equity or fixed-income?

We also look at some longer-term economic indicators. We never really know what’s going to cause a market correction, but bear markets typically are a result of the economy going into recession. [We have] three ways to predict a recession. First is the yield curve, and whether or not you have a normalized yield curve or an inverted yield curve. An inverted yield curve is an indicator that leads to a recession. Another indicator is the leading economic indicators, and whether or not the current levels are above the 18-month moving average. When the current number crosses below the 18-month moving average, that’s when you tend to see a recession. The third is the price of oil. If the price of oil has appreciated by more than 80% over a 12-month period, it tends to be a drag on the economy.

2. Bottom-up: We’re always screening and ranking our universe of opportunities. We look at criteria such as earnings growth, past earnings surprises, corporate guidance and valuation. Say a stock is number-one ranked, and it’s doing everything we expect. Over time, it will start getting more expensive. With all things staying the same and valuation going up, the company will drop in our ranking because there are other companies with similar growth rates and lower valuations. Eventually, we no longer want it.

A good example: at the beginning of the year, Patient Home Monitoring was trading at 80 to 90 cents. It was a reasonable valuation to their forward numbers. Then the stock price went to nearly $2. There was anticipation about deals they were going to close, but they hadn’t even announced some of them. So the stock went from trading around 10- to 12-times forward EBITDA to trading around 25-times forward EBITDA. All its other numbers were still good, but its valuation pushed it down our rankings. So, we trimmed a big portion of our holding, because it went from the top of our list to the middle. At the time, our portfolio was on offence, so we took the money from selling Patient Home Monitoring and re-invested it into another stock that ranked higher.

3. Technical: When buying a stock, we try to ensure there’s more demand and less supply. Typically, once a company has a couple of quarters of breakout earnings, the stock price starts to rise. If a stock goes from $10 to $13, we’ll still buy it, knowing that it probably has five more quarters of accelerated growth. Maybe the stock price goes to $20, and then earnings start to slow down. Now, there will be less demand for the stock and that’s our cue to sell. Maybe the stock is at $18. We haven’t got out at the exact top, but we’ve made a nice return for our investors. In general, if there’s more supply, then we’re going to consider selling. It’s not necessarily easy to do because there’s no one indicator that says, “Here’s a scale and it’s tipped in our favour.” We can look at overall markets as well. We’ll sell a position in our portfolio if a specific company looks good from a fundamentals standpoint, but doesn’t from a technical standpoint.