Our Philosophy

It is very easy to regurgitate a list of behavioral deviance practiced by investors. One can achieve this by searching for the appropriate terms on the Internet. The challenging task for an investor is to put this knowledge to practical use, and towards this end we try to create the holy grail of any investment process - a template that can be used for stock selection. An investor devises this template and then puts the characteristics of a stock into the template and then the results churn out indicating a buy or sell. We wish it were as easy as that, but as a start we pose a serious of questions that when answered correctly can provide a framework for picking stocks within this discipline.

Questions

1. Is the stock undervalued compared to historical valuation measures or on an asset value basis?

2. Is the market valuing the stock incorrectly based on our investment horizon?

3. Will the stock trade back up to its historical valuation range?

4. Does risk/reward justify purchase?

Is the stock undervalued compared to historical measures or on an asset value basis?

It is fairly easy to tell if a stock is undervalued relative to its history by examining readily available valuation measures.  These measures are usually industry specific and are outside the scope of this document, but five popular ones are price to earnings, price to book, price to sales, price to cash flow and price to ebitda.  While none of these are perfect, the measures are a good starting place, and can be used as an initial screen. 

It is more difficult to determine if a stock is selling at a discount to asset value as the balance sheet can either under or overstate asset values due to accounting rules regarding historical cost, treatment of inventories, and off balance sheet items.  There are some industries where book value can be used as a proxy, such as insurance, but those situations are rare.

Is the market valuing the stock incorrectly using our time frame?

An affirmative answer to the first question will only tell us that the stock is cheap, and nothing else.  If you run a screen on stocks using the metrics discussed in question one, you will find hundreds of stocks selling below historical valuation.  Since the investment community is usually short term oriented, this is where significant value can be added.  The price of a stock reflects immediate events that are occurring and seldom discounts an upcoming turn in business. Answering this question by incorporating a slightly longer time frame can be a sound strategy.  A “no’ answer to this question would put the stock into the classic “value trap” category: a cheap stock that is going to stay cheap.

Will stock trade back up to its historical valuation range?

This is where the fundamental research process comes into play.  It is our belief that all industries are cyclical in nature, and that this cyclicality is usually caused by the actions of industry participants.  It is critical when doing fundamental research prior to investing in a stock, that the forces that cause this cyclicality be understood.  All industries have a self-correcting mechanism that helps it manage the cyclical environment that it inhabits.  Every year, participants must assess existing capacity within that industry, product inventories, the activities of their competitors, pricing, and weigh whether it makes sense to spend capital to add more capacity.  When business is good and companies are getting high prices for their product, or when cheap capital is available from Wall Street, large amounts of capacity will be added.  This will cause too much supply, which leads to a fall in prices, an increase in inventories and lower profitability or earnings – and the resulting fall in stock prices.

Does risk/reward justify purchase?

Here one must determine the upside vs. the downside.  A stock that has made it this far into the process is already selling at below its normal valuation so the downside is usually limited.  Historical multiples of standard valuation metrics can be used.