We’re launching The Bow Tie Index, it’s an official market index hosted by IndexOne and in partnership with Stockcard to help you pick the best of the best stocks in the market.
In each video, I’ll show you the best stocks in each sector, why I think they will outperform all others and how you can get early updates whenever I add a stock to the list.
This week, we’re looking at internet stocks…OK, really the Communication Services sector which is internet, media and telecom but two of the three stocks in the index are internet and have the potential for the strongest returns of the sector.
And it could be the perfect time to invest in the sector. Among analysts surveyed by FactSet, Communication Services stocks have the highest potential upside over the next year with price targets that are 38% higher on average.
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To find all the stocks in the index, you can use the link in the video description or go to Stockcard and to the Idea Center, click on Indexes and you’ll find the Bow Tie Index. From there you’ll see the methodology we’re using to pick stocks, the videos detailing it, some great ways to contribute your own ideas and the stocks in the index and their percentage.
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Don’t forget to follow the index to get early access to videos and be the first to see when I add a stock to the group.
I want to jump right into those best internet stocks so I’ll show you later how the index is set up to beat the market and the exact process I’m using to pick these stocks!
Best Internet Stocks to Invest
Picking just three stocks in the sector meant tough decisions but this one was easy with shares of Alphabet, ticker GOOGL.
Alphabet dominates the online search market with 80% market share and that extends to a network effect across YouTube and its Android ecosystem of apps. Add in growth from cloud services and it’s hard denying the company’s leadership on the internet.
Even on an apocalypse in advertising, revenue grew 13% last quarter and is expected to keep that pace to sales of $413 billion through 2025. It’s profitability that’s really impressive though. The operating margin has grown to 30% from just 22% in 2019, that puts it well above profitability versus competitors. So, while growth may have slowed down from the peak years, the company is expected to make up for it in profitability to increase earnings per share by 16% over the next three years.
And with Google, besides just that profitability and growth, I think there is a lot of unlocked value here. Buying the shares, you’re paying for the main search, cloud and YouTube business but I don’t think the market has priced in anything from the ride-hailing service or a lot of the special projects Google owns. So, you’re getting all the “Other” businesses like Waymo, DeepMind and Calico, it’s life-extension project, these are all like lottery-ticket bonuses on top of the return on search and YouTube.
Shares are down 28% in the crash this year but trading for a multi-year low in valuation. Google trades for 4.7-times on a price-to-sales basis, its lowest since 2014 and analysts have an average target price of $151 per share over the next year, an upside of 54% on a great long-term stock.
I want to take a minute to show you the index, what it is and how it could outperform the broader market. Right now, you can see all the stocks in the index and in the future, we may have a way to invest directly in the group so be watching for that.
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What is an Index and How It Could Outperform the Market
The Bow Tie Index is the top 10% of the large cap stock market, the best one-in-ten stocks among the 500 largest companies based in the United States. You can see in back-tested results over the last five years, investing in these best of breed stocks would have outperformed the SPY fund by more than 50% so there is definitely something here.
But I’m not just picking the top stocks across the market, we’re going through this is a way that will track the market very closely while still allowing the index to get that extra outperformance, basically an index fund that gives you the market return plus something extra.
I’m starting with the percentage of each sector in that group of 500 largest companies in the market. Remember, the 11 sectors are groupings of companies that all serve a common need like Financial Services, Consumer Staples or Technology.
And why this is important is because the returns on stocks in each sector follow very closely together, all influenced on the big picture economic forces that drive the whole sector.
For example, looking at the performance of stocks in each sector so far this year, you see Energy stocks have surged on the higher price of oil and gas and it’s really been all the stocks in that sector. Nine of the top 10 stocks in the largest 500 companies have been from the energy sector.
Why a lot of portfolio managers fail to beat their index or the market is because they try to pick stocks without any respect to the sectors. They might have picked the best stock among Tech stocks but their portfolio still sank because that entire sector plunged and they had no exposure to stronger groups like Energy, Utilities or Consumer Staples.
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I’m constructing the Bow Tie Index in a totally unique way that gives you the benefits of that big picture sector investing but also the potential to find the best stocks in each.
Here you see the sector graph again but this shows the percentage of each sector in the overall stock market along with how many stocks of the 500 largest stocks is in that group. For example, tech stocks make up 28% of the broad stock market index and 140 stocks of the 500 are from that sector.
So, in the Bow Tie Index, since we’re targeting the best 10% of the stocks…the top 50 stock picks from that 500-stock market index, we’re keeping those sector weights the same. Here you see the approximate number of stocks from each sector in the BOWT index. The percentage of those 50 stocks from each sector is the same so we benefit no matter which sector jumps in any given year.
In effect, we’re targeting the market return on each sector but then an additional return on picking the best stocks within each sector. It’s an innovative approach to investing that no other index is using and I’m excited about what it means for how you invest.
Let’s get back to our list of stocks in the index but stick around because next I’ll show you the factors, I’m using to find those stocks, the best of the best.
Comcast, ticker CMCSA, is not an internet company like the other two on the list but has just as much upside.
Comcast has solidified its dominance in broadband internet with an estimated 67% market share according to Morningstar, up from 52% just 10 years ago. That’s control of two-thirds of the market, far above its next largest competitor, and that side of the business provides cash flow to the cable and streaming segment for growth.
Now 1.3% sales growth expected over the next three years definitely isn’t a growth stock but the company is expected to leverage that into 10% annual earnings growth for strong profitability improvements and pricing power.
Where I like Comcast is, besides that best-in-class market share of its industry, the shares are trading for a rock-bottom 1.1-times price-to-sales and under 10-times price-to-earnings. That’s the lowest valuation for the stock in more than a decade and a 44% discount to the five-year average.
This isn’t a stock that is going to make you rich but it is one with a commanding lead in its industry and that makes it one you can’t ignore. Shares are down 42% this year with an average analyst target of $46 per share or a 58% upside.
I’ll reveal that last internet stock next and it’s one I know a lot of you will disagree with me but I think it’s one of the best upsides in the market.
How to Find the Best Stocks in the Market for the Index
Now I want to show you how I’m picking these stocks, how we’re finding the best stocks in the market for the index. I’ll walk you through the quantitative factors in this video and then cover the qualitative factors next week so be sure to tap the subscribe button and watch for that.
You can see all the factors on the index page on Stockcard. Quantitative factors are those we can measure numerically, things like sales growth and profit margin rates. I’m using these as an initial pass to find the top 100 or so stocks in the market then using the qualitative factors to narrow the list down to the best stocks to own.
This first factor, that the company must have a growth rate in sales above the sector median for the last three years. We want companies with competitive advantages in their sector, advantages that help them grow revenue and take market share away from rivals and this is how we’re finding it.
Next, we’re filtering for companies where last year’s sales growth was higher than its own three-year average. Not only do we want growth companies but we want to find those companies that are growing sales faster than they have in the past…building that momentum.
We’re doing the same with profitability, filtering for companies with an operating margin that is higher than the sector median over the last three years. What good is a fast growing company if it can’t turn those sales into profits? With this, we’re not only investing in the fastest growing but also those with some kind of advantage that helps them drive better profitability versus peers.
Here we’re filtering for companies improving profitability, where the last year’s operating margin is above the three-year average. We’re not looking for companies’ content to be the best but those on top and still reaching for more.
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Now the first two factors are classic growth stock filters, finding those companies growing above and beyond peers. But growth stocks can be expensive and sometimes not worth the price, so I also wanted to add a valuation filter into the index, using the price-to-earnings-to-growth or PEG ratio. This helps us find the growth stocks also trading at great valuations, discounts that produce returns.
Along with the qualitative factors I’ll show you next week, these are going to help us find the best stocks in the market, the top ten percent of stocks in each sector for the index.
This next stock is going to be controversial but Meta Platforms, ticker META, the old Facebook.
And you can laugh all you want but the numbers don’t lie. Between Facebook, WhatsApp, Instagram and Messenger…the company has a reach that is unrivaled by any other platform. That’s over seven billion active users and while there’s a lot of overlap there, I’d bet it’s far beyond the next largest competitor.
The Apple privacy changes was a jab that rang Zuckerberg’s bell, then recession fears brought a drop in ad spending that was a right hook out of nowhere.
But these are both temporary problems. Facebook will find a way around the targeting problem in ads and ad spending will eventually boom with the economy. Shares are down 61% and for the first time, people are asking existential questions about the platform, whether it can survive but…really?
Are you using Facebook any less than you used to? I know I’m not and even if there are a few that move to other platforms…three billion monthly users is a market position the company can leverage to transform itself out of these challenges. No other social media company has the breadth of platforms like Meta, including Facebook, Instagram, WhatsApp and Messenger.
Sales are expected flat this year but then to post 11% annual growth to $163 billion over the next three years. Profits are expected to grow even faster at a 19% annual pace to $16.86 per share through 2025.
Besides that, market dominance, the growth that I think is underestimating what the company can do, the shares here are trading for just 3.1-times sales…the lowest in the company’s history and a 65% discount to the five-year average.
Despite all the negativity, analysts still have a target of $244 per share or an 88% upside over the next year.
