Model Portfolio mkoza:TGF

I am a value investor. I search for stocks with low EV/EBIT or price/book ratios. I will invest in distressed companies at the right price, but only if I think they will not go bankrupt. In addition to these traditional value situations, I also invest in fast-growing emerging markets companies, if they trade at reasonable valuations relative to their growth prospects. A purely value-driven approach requires that I be able to identify and avoid companies with oppressive debt loads, dubious business models, or suspicious accounting. Generally, I am able to find suitable stocks with forward PEs under 6 for slow-growth companies, and under 10 for fast growing companies. I prefer that stocks selected for purchase have short-term headwinds that are depressing the stock price.

One of the first steps in evaluating a stock for purchase is to compute its intrinsic value, or the value a prospective purchaser of the entire company would assign to its stock (in a normally functioning market). The ratio of intrinsic value to current share price will, in a large part, determine what percentage of the portfolio is allocated to that stock.

How I Compute Intrinsic Value

For most stocks, intrinsic value is calculated by adding the excess free cash position to an appropriate multiple of adjusted earnings. Excess free cash is that portion of cash, in excess of debt, that is not neccessary to run the business. The cash position may be discounted if it is being used improperly. Adjusted earnings are equal to EBIT plus acquisition-related intangibles amortization, less taxes. Tax credits/NOLs and nonoperating assets such as real estate, if they exist, also contribute to intrinsic value.

For financial companies, intrinsic value is based on expected trough book value ex goodwill, appropriately discounted for the time required to return to a normal ROE (generally in the 10% range).

Special Situations

I have a rather broad definition of special situations. Basically, special situations are short-term disconnects in the market. We like these very much. Index fund rebalancing, warrant expiration/forced redemption, misunderstanding of news events, stock issuance/dilution, convertible debt issuance, easily debunked allegations, all can cause stocks to over-react to the downside. I also like to see gross undervaluation relative to peers, for no reason other than popularity or neglect. These special situations add a degree of safety to the intrinsic value approach, as there is an easily definable short term factor accounting for the discounted stock price. Even if I am somewhat incorrect in my valuation, the special situation may still cause the stock price to rebound.

Due Diligence

After computing intrinsic value and reviewing special situational factors, I review the stock's recent news flow and price performance. The price performance is evaluated against the news flow to understand any substantial price changes - this helps me understand how the market views the stock. For example, a stock may decline rapidly due to fear/news of a dilution event. All company-specific, sector-specific and economy-specific risks are evaluated. Evaluation of these risks may result in an adjustment to the intrinsic value. SEC financial filings for the past year are read, although for the more complex issues a complete reading may not occur until accumulation beyond a small position occurs.

How I Find Stocks To Buy

20% - Peer companies of stocks that I already own or am evaluating
15% - Stocks I have owned before and continue to follow
15% - Online networking (message boards, news flow)
10% - Public print media (newspapers, magazines)
15% - Lists of top daily gainers/losers (print or online)
10% - Direct exposure (local companies, consumption)
15% - Stock newsletters, money shows
0% - Stock screeners
0% - Technical analysis

How I Allocate Funds Among Stocks

Buy limit for any single stock is about 12% of the portfolio. Thus, a stock could double and remain well within the 25% fund holding restriction. Stocks allocated more than 10% of the portfolio should have intrinsic values at least triple their current share price at time of purchase (or at least double if the stock is low-risk or has near-term triggers). Stocks with only 100% upside (as measured by intrinsic values) are allocated less than 10% of the portfolio. Stocks with only 50% upside are allocated less than 5% of the portfolio.

Sell Discipline

Sell stocks as the ratio of intrinsic value to share price decreases (due either to price increase or value decrease),such that stock is completely sold off after the ratio falls below 1.25. Discovering a peer company that also trades at a discount may result in a partial sale of a stock to reallocate funds among the best prospects in a sector. Tax considerations apply in some instances, especially when the holding period is approaching 1 year.

Posted by Mark Taguchi at 8:34 PM | Permalink