The number 20 is pure coincidence, I'm sure, but 20 stocks is a good starting point for a portfolio; each stock represents about 5% of your holdings. At 5%, no individual stock should get you into serious trouble if trouble is brewing. The challenge is diversifying so that not all of them go in the same direction at the same time. We'll address the diversity issue later in this article.

As noted, these 20 stocks rate 5-Stars in the GuruFocus predictability rankings. GuruFocus reports, "We have found strong correlations between the Predictability of Businesses and the long-term return of stocks as shown in this table."

The higher the predictability, the more likely a stock is to deliver higher returns over 10 years. And, the higher the predictability, the less likely it is that share price will be below the buying price after 10 years. Simply put, high quality means the highest probability a stock will earn above-average capital gains and lowest probability of being under water after a decade.

Here's a table showing the 20 High Quality stocks along with some key data:

Diversification

What we've got here is a cross section of high quality stocks trading on American stock exchanges. And they come from a range of different industries, giving us a head start in building a diverse portfolio. However, we could do some trimming to get rid of duplicates:

• AutoZone (AZO) and O'Reilly (ORLY) both sell auto parts so one of them could come off the list.

• The duplicate call cannot be made so easily with Novo Nordisk A/S (NVO) and Biogen (BIIB), which are both biotech stocks but working in different areas of the industry. Here's a hint if you want to keep just one: Novo Nordisk is not only one of Simons' Top 25 holdings but his second-biggest holding among the more than 3,000 stocks he owns (according to Simons' gurufolio).

• Heico Corp. appears on the list twice, once as HEI and once as HEI.A; the company explains the difference on its website, "HEICO Class A Common Stock (NYSE:HEI.A) and HEICO Common Stock (HEI) are virtually identical in all respects except for voting. HEICO Class A Common Stock carries one-tenth of a vote per share while HEICO Common Stock carries one vote per share." So we could eliminate one of them.

• Turning to the two Airports & Air Services companies, "Air Methods Corp. [AIRM] is a provider of air medical emergency transport services and systems" while "Grupo Aeroportuario del Sureste SAB de CV [ASR] is engaged in operating, maintaining and developing nine airports in the southeast region of Mexico." (Quotations are from GuruFocus' company pages). Again, two companies in the same industry doing different work.

• Turning to Diversified Industrials, "Ametek Inc. [AME] is a manufacturer of electronic instruments and electromechanical devices" and "Danaher Corp. [DHR] designs, manufactures and markets professional, medical, industrial and commercial products." Potential investors might shed one of these to seek greater diversification.

We might eliminate up to five of these 20 stocks to achieve greater diversification.

Looking at the following table, we likely should change more than five stocks since the current group overrepresents some sectors and misses others altogether. The sectors come from Standard and Poor's:

Valuations

Excluding one outlier (Tyler Technologies [TYL]), the stocks in this group have reasonable P/Es, ranging from 12.37 for Air Methods to 32.45 for Costco Wholesale (COST). The average for the group of 20 is 26.01 which is 8% higher than the P/E of the S&P 500 at the close of trading on July 1 when it sat at 23.74.

This table highlights the P/E ratio for these stocks:

Moving over one column, we see the PEG ratios, PEG referring to the P/E ratio divided by the average five-year growth of EBITDA. Stocks with a PEG value of less than 1 are considered undervalued, those between 1 and 2 are considered fairly valued and those over 2 are considered overvalued.

According to this standard interpretation of PEG valuations, two stocks come in as undervalued, 13 would be classed as fairly valued and five are considered overvalued. Overall, the average PEG is 1.73, at the higher end of fair value.

Earnings per share (EPS) growth

As a group, these stocks display strong growth with an average at 15.74%.

This number would build in share buybacks but not include dividends.

Fourteen of the 20 stocks in this collection offer double-digit growth rates, and the other six offer at least respectable growth within a predictable earnings context.

Dividends

Twelve stocks pay dividends, but with the exception of Westwood Holdings (WHG), the cash and the yields are on the low side:

Conclusion

Do the stocks in this collection, Simons' High Quality stocks, constitute a reasonable equity portfolio?

Perhaps. As we saw, this group of stocks overweights a couple of sectors, and particularly Health Care, so it does not provide out-of-the-box diversification. And we haven't looked at capitalization, another area where diversification can help protect prudent investors.

Overall, the valuations seem reasonable. The notable exception would be the P/E and PEG ratios of Tyler Technologies, but that stock also has displayed hot growth rates in the past few years.

If you want an income portfolio, you need to look elsewhere. This group is more oriented toward growth than distributing income. Again, there's an exception in the group: Westwood Holdings Group, a company I profiled when it was a triple screen winner. Between its dividend and EPS growth, it offers a total annual return of more than 30%, if it stays on the same track.

That a group of high predictability stocks should be overwhelmingly weighted to growth rather than dividends is interesting. Normally we associate predictability with established dividend payers, and particularly those that have consistently paid and raised dividends for at least five years.

All in all, I like this group of 20 stocks from Simons' High Quality list. They are, by definition, predictable earners. That means not only capital gains but also lower downside risk. Valuations overall are reasonable, and they are consistently growing their earnings year after year. If I were creating a new portfolio today, I might well start here.

Disclosure: I do not own any of the stocks listed in this article and do not expect to buy any in the foreseeable future.

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This article first appeared on GuruFocus.

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