What Am I Looking For? + Fin Tech
Maybe I should have started with this post. What are the 5 most important things I am looking for in a stock to make it into my Top 25 Model Portfolio?
I wish I could give you a specific ratio, some quantitative measure, but that would be too easy. In fact, it is qualitative factors that are most important. Go back and read the first 80 pages of Graham’s “Security Analysis” text, he writes the same thing.
In general, I look for stocks that can double (or more precisely provide a 100% total return) over 5 years. When markets are elevated, like today, this rough estimate might fall to 75% total return over 5 years.
I might sketch an earnings estimate, and expected PE multiple, for 5 years out, but I never make detailed models.
In general, I look for stocks with some degree of limited downside risk. You cannot eliminate risk, but you can try to mitigate it. Years ago I might make a specific estimate of “asset value”, but again with elevated markets you have to be a little more creative. Remember we are looking for the best 25 stocks, and we ARE NOT comparing them to t-bills (give me the t-bills right now).
75-100% return over 5 years, with below average risk, is the goal. How do we achieve this goal? These are the most important factors in order:
I must be able to understand the company. This is admittedly a very qualitative factor. This factor can be very, very, frustrating to young analysts. It takes a great deal of experience and judgement. That is why young analysts have to dive in and learn lots of companies. I must understand what are the important issues that will make a stock rise or fall. That does not mean I have to see the future, but I do have to understand what the issues are. There is an important difference. I will never violate this criteria. Some ideas I can understand 90%, other around 60%, when my understanding falls below 50% I bail out and give up. Ideas I can understand at 90% do not need to be as undervalued as ideas I understand only 60%. I must be able to understand the history of the company, and who its competitors are. Generalists cannot understand every company. Sometimes Seeking Alpha has a great report, often they do not. Sometimes a company has a very clear presentation, or investor day, often they do not. Sometimes you can buy a stock for “macro” reasons, but I would rather find companies that are beating their competition. That is why you have to understand individual company strengths and weaknesses.
I must think the stock in undervalued. I look for companies with average prospects, selling at below average valuation multiples. Or in some cases, I look for companies with above average growth prospects, selling at average valuation multiples. Very roughly the average company growth rate is 5-7%, and 8-10% is above average. I seldom look at companies expected to grow at 15%. I do not use discounted cash flow, or other complex models. Since I often look at companies with highly variable earnings streams, I often use price/book, and/or EV/sales, in addition to average earnings power. Dividend yield is “nice to have”, but never “must have”. I might do some asset value calculations. It would be easier if I could point you to one specific ratio, but who said this was going to be easy.
I look for companies that are out of favor with other investors. Often this is best measured by a stock underperforming the market for 1, 5, or 10 years. Sometimes “out of favor” can be estimated by looking at Wall Street recommendations. In general, an average company with 10 analysts covering the company, will have 7 buys and 3 hold/sells. If I can find a stock with only 50% buy ratings, I am mildly interested. If that ratio falls to 30%, I am very excited. I will often violate this Wall Street opinion factor if an idea meets the first two criteria.
I would prefer that at least one other value manager that I respect owns the stock. There are about 20 value managers I respect, some more than others. Especially when my understanding falls below 75%, this ownership factor becomes more important.
In general I prefer companies with above average balance sheets. 5x interest coverage is best, but I can live with lower if the maturities are extended. Again, if the first four factors are strong, I can live with an average balance sheet.
90% of my opinion about a stock can be explained by these 5 factors. There will always be special situations.
Ten years ago market capitalization might have factor #6. I used to be more comfortable with companies with market caps below $5 billion, and $1 billion dollar stocks were best of all. As I age rapidly I am putting more emphasis on understanding companies, and some smaller companies are often just not giving enough disclosure. I cannot take a month to understand a company. If I cannot explain the important issues in a week, I drop back and punt.
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Fin Tech stocks are a classic example of stocks I cannot understand. I tried to investigate WEX Inc. - WEX - $158, but after a few days I just gave up. Even though the company is tied to the trucking business (which I like), I could not really figure out who the competitors were in payment systems. This company used to be called CUC International, but it has made many acquisitions. They are headquartered in Maine, and run by a rather quirky (borderline hostile) woman. I will pass for now, WEX is still more than 2x EV/sales.
As required by law, when I looked at WEX I also looked at the other Fin Tech stocks that have been underperforming. Paypal gave me another headache, I do not want to compete with Apple under any circumstances. Fidelity National and Jack Henry were also difficult to understand. Flywire was very interesting, but is too tied to foreign student payments. I am glad I have stayed away from Western Union (the NVIDIA of the 1880’s, look it up).