Combing through a list of stocks to pick potential winners can be an arduous task for even the keenest investor, however valuable time can be saved by taking a data-driven approach to stock selection.

Management consultancy firm McKinsey & Co has gone down the data analysis route to come up with five simple lessons to guide investors in choosing the right businesses to invest in.

McKinsey researchers ploughed through the financial results of more than 1,000 of the world’s public companies from 2007 to 2017 and boiled down the top qualities of the most successful firms.

A key finding from the McKinsey research is that companies need to regularly refresh their business to keep up with changes in their sector, or else they can get left behind. The same principle can be applied to the make-up of a stocks portfolio.

“Our research makes the clear business case for dynamic portfolio management,”  McKinsey says.

“We analysed hundreds of companies, worldwide, across a decade-long business cycle. The conclusion? Winners change their business mix, year after year.

“Laggards sit still.”

Here’s the five key takeaways from the McKinsey research:


#1 Keep the portfolio moving

McKinsey found that leading companies tend to rotate their business portfolios at a steady rate – a ‘Goldilocks’ pace that is not too fast, and not too slow.

A turnover rate of about 10 to 30 per cent of a portfolio was found to be the optimal level.

This group outperformed the rest of the study group, delivering a 5.2 per cent annual excess total return to shareholders.

About half of the companies studied kept their business portfolios mostly unchanged, refreshing them fewer than 10 per cent over a 10-year period.

“This group barely moved the needle in average annual excess total returns to shareholders,” McKinsey said.

One-quarter of the companies studied turned over their portfolios by more than 30 per cent over the decade and produced slightly negative shareholder returns.


#2 Move with the market

The best companies identify where the winds of change are shifting to and deploy resources to new areas of value creation.

Companies that stayed in the fast lane and kept up with market trends — about one-third of the study group — delivered an annual excess total shareholder return of 4.4 per cent.

Other companies that switched lanes from slow to fast had an excess total shareholder return of 1.7 per cent, and the laggards stuck in the slow lane had negative returns.


#3 Use transactions

Leading companies account for a higher share of merger and acquisition (M&A) activity in their market sector, and they use M&A and divestitures to speed up their journey to their desired destination.

Mergers and acquisitions are important in positioning a company for growth.

McKinsey  found that firms that relied on organic growth alone underperformed their more active peers.

Programmatic M&A activity was found to be the best way for a company to grow, as it produced a 6.2 per cent excess annual total shareholder return.

This is when a company makes two mid-size deals a year, acquiring 15 per cent of its market capitalisation over a 10-year period.

“A steady stream of deals gives a company access to the latest market intelligence and improves its transaction and integration capabilities,” it said.


#4 Focus M&A ‘on the edges’

Importantly, fast-growing companies use mergers and acquisitions to accelerate a move toward new market opportunities in secondary businesses just outside their core activity.

The researchers found there is an optimal transaction radius, not too far from a company’s core business, where winning firms expanded to.

Companies that made acquisitions to shore up existing but secondary businesses had the best returns, an average 1.6 per cent in excess annual total shareholder return.


#5 Go hard when in a tough spot

Lastly, a key determining factor in competition is how hard companies pulled their internal levers to improve company performance.

McKinsey researchers found that even laggard companies could improve their business performance when they participate in M&A activity, or step on the gas.

“And step-out M&A, which is usually higher risk than acquisitions closer to the core, is a better option than modest portfolio shifts when the companies that do them are at the back of the pack,” said the researchers.