A Guide to Security Selection

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Securities selection is the process of determining which financial securities are included in a specific portfolio. Proper security selection can generate profits during market upswings and weather losses during market downturns. The process of security selection can be administered on a scheduled basis or when market conditions warrant a change. Security selection is vital for financial advisors who wish to maintain and grow their client bases throughout all market climates. Here is a quick guide of factors to consider for proper security selection.

Risk

Risk applies on both sides when selecting stocks. The risk tolerance on the side of the investor must be first be considered. Younger investors tend to handle more risk, as downside can be tempered with time. However, older investors nearing or at retirement age should ratchet down the risk, as they may rely more on the income generated from their portfolios. Risk tolerance should be adjusted down as the investor gets older, and allocations should lean more toward more stable fixed-income vehicles.

The second form of risk comes from the actual underlying stock or financial instrument. Sectors that are considered to carry the most risk include biotechnology, information technology, financials and consumer discretionary. Less risky sectors rely more on dividend income, such as utilities, energy, consumer goods and real estate investment trusts (REITS), which pay out most of the income in dividends. Investors can use the stock beta to gauge how volatile an individual stock may perform compared to the benchmark indexes.

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Diversification

Is the portfolio meant to be diversified or specific to a sector or theme? Theme-focused portfolios carry more risk but offer higher reward as opposed to a general market-tracking diversified portfolio. Younger investors are more tolerant of higher risk portfolios that may specialize in particular themes or sectors. Experienced investors who own multiple portfolios may consider theme portfolios as long as they are offset with conservative portfolios with the proper fund allocations.

Sector Fundamental Metrics

Every sector has an exchange-traded fund (ETF) that allows investors and traders to track and trade it. By looking up the ETF symbol for the particular sector, investors can see the average fundamental metrics, such as price-earnings (P/E), price-book (P/B), price-cash flow (P/C), price-sales (P/S), and revenue and earnings growth. A prudent investor can also peruse the ETF holdings to gauge the specific stocks that are held, from the heaviest allocations to the lightest, in order to get ideas. Well-established names tend to carry higher premiums due to the predictability of the performance and established track record.

Companies growing at 20% or more quarterly also carry high premiums, despite weaker fundamental metrics, such as exorbitant P/E ratios. Value investors prefer to pay as little premium as possible without sacrificing high-quality fundamental metrics. This can be a tough task, as the market doesn’t like to keep windows of opportunity open for extended periods of time.

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Industries

To find the hidden gems, investors can look to investigate the individual industries that compose the overall sector. Investors can delve deeper into select industries by searching for industry-specific ETFs. Evaluating the ETF holdings is a quick way to spot viable stocks for selection and assess a quick peer comparison. Usually, the top-tier, best-of-breed stocks carry the heaviest weightings and most expensive premiums. The more speculative cheaper stocks carry more risk, as well as more upside. However, there are situations when a stock may be outperforming a sector but still trading at a discount. These stocks may be flying under the radar but can be found with the use of a good stock screener.

Using a Screener

A solid method of finding stocks that are undervalued compared to the average metrics is to use a free stock scanner, such as FinViz.com, and plug in the specific financial metrics in a stock scan. For example, the Technology Select Sector SPDR Fund (NYSEARCA: XLK) shows a forward P/E of 17.48, P/C 12.18, P/B of 4.05 and 11.13% estimated three- to five-year earnings growth, as of Aug. 10, 2016. An investor can take these average sector stats and plug them into the scanner at FinViz.com to find candidates that meet or beat the average metrics and may be undervalued as a result.

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