Model Portfolio athompson:TPSNX

I follow the Growth At a Reasonable Price approach to selecting stocks. That is, I buy stocks of companies whose earnings have been growing and whose earnings will, I predict, continue to grow. But I buy these stocks only if I can get them at a good price. I generally look for a price/earnings ratio (P/E) that is substantially less than the annual growth rate. For example, if a stock had an annual earnings growth rate of 20 percent, I'd be willing to buy it if it had a P/E of 13 or less. If it had a P/E of 10 or less, I'd consider it a really good buy (see the Stock Focus below for a concrete example).

When a stock has a low P/E, or a low P/E relative to its earnings growth rate, this usually means that it is unnoticed or unloved. Unloved would mean that other investors think that the strong growth won't continue. Of course, they may be right. So before I buy a stock, I examine the factors that have been responsible for the growth so far and try to make a reasonable prediction of whether those factors will continue to be in play for the next few years. This requires evaluating such factors as whether it is possible for the company to further reduce expenses, whether new competitors will emerge, the overall direction of the economy, and many other factors. These are all notoriously difficult to predict; no one gets it right all the time. However, I have found that I get it right often enough that my stock picks have generally beaten the market by a good amount.

Unnoticed stocks are even better than unloved ones. If a stock continues to increase its earnings, it almost always gets noticed eventually. It doesn't even have to get noticed by the stock market; it can be acquired by another company. Many of the stocks I have bought have been acquired, usually at a substantial premium. A great thing about unnoticed stocks is that they're not necessarily unloved. There may not even be any doubt that the earnings will continue to grow. In analyzing stocks, I look for two signs that low P/E stocks are unnoticed: low institutional ownership and few analysts covering the stock.

There are various other factors I consider in selecting stocks, factors that I consider to be additional attributes that favor one reasonably valued growth stock over another. For example, I prefer stocks that have low levels of debt. I also like to see insider buying.

I am primarily a bottom-up stock picker and don't usually intentionally target any particular industry or market capitalization. As it turns out, most of my picks have been small-cap stocks because they've tended to be more likely to be unloved or, even more likely, unnoticed. Also, I did make a decision to target petroleum stocks because I expected that increasing demand in developing countries would push up petroleum prices.

I think the emotional elements of stock picking are at least as important as the intellectual analysis. It's really difficult to refrain from acting based on emotions. It's hard not to sell when the stock price falls, which it will often do for reasons having nothing to do with the company's prospects. It's hard to pass up those flashy gee-whiz stocks that everyone else is talking about, especially when they've already gone way up in price. It's impossible not to feel strong emotions when investing, but I try not to let my emotions affect my investing decisions. I try to just let myself feel the emotions but to make the investment decisions that I know intellectually are reasonable, even when I feel like I should do something else.

Selling:

If all goes well, I buy a stock when it is undervalued. After that, it continues to increase its earnings. Then the stock's price goes up even more quickly than the earnings as more and more investors realize that earnings are growing and come to think that this growth will continue. When other investors have pushed the stock up to the point where it's substantially overvalued, I sell for several times more than I paid. Sometimes it goes this way, and it's extremely satisfying when it does. But of course, sometimes there's bad news: earnings shrink, or the company even loses money. It's very difficult to know what to do in such cases. Sometimes I sell, figuring it's best to cut my loses and put what's left of my capital to a better use. Sometimes, I hold on, figuring that the stock has already taken such a hit that it's unlikely to go down further, and the company could get eventually return to prosperity. When I've held on, I've often regretted it, as more bad news came out and the stocks just kept going down. But other times, I have been glad that I held on since the company eventually returned to earnings growth and my investment showed a positive return. At one point, I made a fairly systematic study of what I did in the case of bad news for stocks in my Marketocracy portfolio. I found that overall I did better when I held a stock after bad news than when I sold. This suggests that I should be more inclined to hold in the case of bad news. So far, I continue to try to make a case-by-case judgment.

Stock Focus: FreightCar America

FreightCar America (NASDAQ: RAIL) makes railroad cars, primarily coal-carrying railcars. The stock recently traded at $55.97 (12/27/06) and its earning per share over the last four quarters are $8.79, giving it a P/E of a little over 6. For each of the last seven quarters, earnings have increased substantially over the same quarter in the previous year. It's hard to know whether this growth will continue, but I think it probably will. Use of coal is currently on the rise; the Bush administration has relaxed environmental regulations on emissions by coal-fired power plants. I think this increased use of coal will increase demand for coal-carrying railcars, and FreightCar America will build many of them. FreightCar America recently received a large order from TXU Generation, a Texas-based utility. I think it is reasonable to assume an earnings growth rate of 20 percent for the next several years.

FreightCar America's current assets exceed its current liabilities, even when inventories are excluded from current assets. Its long-term debt, including pension costs, is about $27 million, compared to $190 million in equity, so it is not very heavily leveraged.

John Carroll, FreightCar America's President and CEO, is retiring in April 2007. However, I don't expect this to have a material impact on the stock's earnings.

Some negatives include very high institutional ownership and the fact that insiders are not buying. However, I feel that this stock's positives clearly outweigh these negatives.

Disclosure: I hold this stock in my own accounts and in most of my clients' accounts.

Posted by Adam Thompson at 11:39 PM | Permalink