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Coming Across Stocks:

People often ask my specific approach for finding stocks that qualify for my Value Portfolio. Although each stock has my list of rules applied to it before being purchased, I do utilize screens and a watch-list. Yet, the majority of the time my initial interest comes from curiosity & observations in my daily life. I’ll encounter something that sparks my interest regarding a specific company or industry and then begin my research from this point.

It’s no secret that I place more emphasis on fundamentals than technical analysis to determine an appropriate valuation, but I can’t say that I ever apply just one method to any stock that I’m interested in. I tend to stick to the industries, companies & business models I understand best, but I’m also very keen to acquire new knowledge if an attractive opportunity arises.

What I ultimately try to do is look at companies that make sense to me. I like a business that doesn’t have a complex business model and I look for a product/service that’s easy to forecast with respect to revenues, gross margins, expenses and regular activities. Book smarts may help you analyze all the numbers you can accumulate on a stock, but the street smarts are the skills you develop through experience and what I call your “business intuition” or “business instincts.” Sometimes you have to trust your instincts, just as in life, and they can provide great insight into something that just doesn’t “feel” right.

But recognizing that a good business is more than just numbers is essential. As with my post on management – shareholder value is important, but that should never be the sole focus of the business. It’s important to realize they have a job to do, a product or service to supply and stakeholders to satisfy. But you also want to focus on relationships, good business, what makes sense and most importantly logic.

So what do I look for specifically when I come across an industry, company or idea? I apply my value rules, my general business rules & simple things such as:

– Do they make a good product?
– Are they an industry leader?
– Do they hold any competitive advantage?
– Are they reasonably under-valued with respect to their opportunities to succeed?

Seems simple right? The problem is there are hundreds of stocks in the North American markets that aren’t even followed by analysts. Why? A simple numbers game. Analysts get paid to follow a stock, so if a brokerage is going to pay one of their employees to follow a company – the risk vs. return has to be present to make it affordable. A brokerage won’t be in the business of trading illiquid shares to its paying customers, so instead they tend to follow highly traded stocks as a general rule. Most of the companies I research people either don’t know about or simply don’t have the time, effort or finances to look them over. Out of all those “maybe” stocks, there are always a few that stand out as quality unknowns and have the potential to break out if given the right opportunity or right catalyst from the market.

Generally the companies I find never make the headlines because their business practices are really that boring – they just go about their business. Examples of this are KCLI, CINF, DAC and PTNX. Nothing flashy, fancy or companies that attract tons of media attention – yet they each do a job very effectively and at times their fundamentals & valuation will coincide in a buying opportunity.

I spend a lot of time reading over financial statements looking for clues that might have been missed by others. I research a company’s products or services to see how they hold up against competition, their price point, costs, stability, fundamental analysis, etc. I do screens to narrow down a group of maybe 100 stocks and look for the ones that draw my attention or maybe are out of wack with industry peers and I try to find out why that might be.

It’s important to realize this takes time – a lot of time. Even at first I wasn’t sure what I was looking for and now with a few years experience I have a much easier time scanning through information to find what I need to see.During a decline or correction in the market I also look for what stocks got clobbered and which ones stayed unscathed? This doesn’t prove that a certain group of stocks are under valued, but it gives me a good idea of how volatile the company is with respect to the rest of the market.I still read lots of market comments, investor insights or anything in the news, yet make sure that I put those comments or opinions into context with my own experience & knowledge. I especially like falling into the contrarian side of the market from time to time. Some stocks will get beaten down to levels that are attractive regardless of a larger competitor or market leader. I’m not one to follow the “herd” mentality of the generalized market, generally I find value where the market isn’t looking or has thought to look.

An example I’ve used in the past:

One day I was on my way home from the gym and noticed a truck hauling something ahead of my car. The trailer was made by Wabash (WNC)…and I remember reading something a while ago about the shortage of operators within the next 5-10 years in the rig transportation industry. So I went back, found the report and came of the opinion that as demand increases for more products as economies grow…you essentially need to move more of those products efficiently & safely from point A to B. Now, you can always invest in the specific transport companies or the manufacturers of the big rig that move those products, but who might think to just invest in the companies who make the trailers?

Think about it: You can only have as many trucks as there are drivers…but any company or trucking fleet has more trailers than trucks simply because as you load one trailer, another truck takes a full one away to market. This always causes you to have idle trailers – why would you make a driver wait 2-3 hour for a load to be filled if he could be on the road driving a full trailer to market during that time frame? Most of these trailer companies are private corporations, but WNC is public.

Yet, remember that a huge rule for me, right near the top, is DEBT. Very few companies perform well with high debt-loads. Regardless of how much you can borrow, cash is essentially how the economy works. Cash flow is huge – it allows you to do better business by not utilizing debt, so make sure you understand their cash flow model of any company you want to invest in.A SWOT & PEST analysis are also something you’ll want to take the time to do. Its important to realize you DON’T need any business background for either of these – they’re just a simple tool to help you think about what factors affect the business environment for any specific company or industry. Remember back to my TRIAGE mentality of investing.

As important as a SWOT & PEST are, you also want to do a full competitive analysis. Know the company, the industry, the competition. More than a few times I’ve been researching a company and found that the competitor was an even better candidate for my value portfolio (how I found DRYS).

Understand management, their tendencies, likes and predictability. If something happens to change the business environment, can you make a good assumption on what managements’ next move might be?

Remember that although any or all of this seems like “over-kill”, you are essentially helping to limit your portfolio to risk or a decision of investing in a poor business. The market may still price the company unfavourably over the short-term, but if you stick to your guns, your investing strategy & objectives, then you’ll see the hard work and patience pay off for you in the future.

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