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We employ both quantitative and qualitative resources to
generate investment ideas. Our quantitative process involves
computer screening for companies selling at below-market
price/earnings ratios and trading below the midpoint of the
stock's 52-week high-low. Our qualitative resources include
trade press, corporate reports and financial publications. We
find that the trade press, such as Oil & Gas Journal,
Public Utilities Fortnightly and
Best's Review (Insurance), addresses
critical issues long before they appear in mainstream
publications. Together our qualitative and quantitative sources
generate 200-300 investment candidates worthy of further
analysis.
Our fundamental analysis seeks to understand the basis of the
investment candidate's profitability. We evaluate potential
catalysts which can rejuvenate companies: new products, new
technologies or new management. We analyze a candidate's
fundamental strength; we prefer companies with solid or improving
balance sheets, positive cash flows, low cost structures, product
differentiation, defensible franchises and effective management
with an equity stake. Based on this analysis, we estimate the 3-5
year earnings growth rate potential for each candidate.
The next phase of the investment process focuses on valuation.
We look for stocks trading at a low price/earnings ratio, low
price/book, low price/cash flow, low price/sales or discount to
private market value. Using the valuation parameter relevant to
each company, we determine a target valuation range. From this
range, we derive an upside price target as well as a downside
price target. The result is a reward/risk ratio for each stock.
The Reward/Risk Ratio depicted below is the
stock's upside from its current price divided by the downside.
This ratio is a tool we use to compare the attractiveness of
different stocks within industry groups and across economic
sectors. For example, it allows us to compare the attractiveness
of a drug company to an electric utility. In a sense it allows us
to compare "apples to oranges" as well as "apples
to apples" in an effective manner.
We build portfolios in a bottom-up manner according to the
attractiveness of each company's reward/risk ratio. We maintain
diversification by usually having 20 to 50 stocks in the
portfolio. Individual positions generally range in size from 1%
to 5.0% at cost. Stocks with higher reward/risk ratios receive
larger initial positions. Our discipline often leads us to average
down while accumulating shares. In the course of our fundamental
and valuation analyses, we often discover that many individual
stocks in a given industry or sector are attractive. We think the
market frequently misperceives entire industries and sectors,
producing a cluster of investment opportunities. Consequently, our
portfolios will often be overweighted or underweighted in certain
sectors relative to our benchmark.
We attempt to control risk in the portfolio by normally
limiting sector weightings to +/- 25% vs. the index. For example,
if a sector is 10% of the index, we could have a weighting from 0%
to 35%.
Our sell discipline is triggered under three different
scenarios:
TARGET PRICE ACHIEVED -- A company's fundamentals recover as
expected, the valuation rises and our price target is achieved. As
there is no reason to modify our upside target, we sell the stock.
FUNDAMENTAL ACCELERATION -- A company's fundamentals improve
beyond our original expectations. We reevaluate our upside and
downside price targets, and trim accordingly.
FUNDAMENTAL COLLAPSE -- A company's fundamentals collapse
unexpectedly, and our revised reward/risk ratio is unattractive.
We eliminate the position.
The portfolio is continually renewed as stocks with low
reward/risk ratios are replaced by candidates with high
reward/risk ratios.
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