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STOCK SELECTION
PHILOSOPHY
We seek stocks that provide both value and growth. We further
wish to buy only those stocks that are currently in bull
markets
Some stocks look very attractive from a classic value perspective.
They have a low P/E, low debt/equity ratio, and trade near
book value. Unfortunately, these companies are often at
low P/E's because they have little or no growth prospects.
As a result, these "value" stocks are actually
very risky because competitive threats may erode their profitability.
On the other hand, some stocks look very attractive from
a classic growth perspective. They have high growth rates
and high ROE's. Unfortunately, many of these companies are
using high quantities of debt to finance their growth. In
addition, many of these companies have growth rates that
are unsustainable. As a result, many of these companies
have P/E's or market capitalizations that reflect not only
strong growth prospects but nirvana.
Of course, there are also special situations that do not
fit these criteria. An example might be a company that is
just coming out with new products or doing acquisitions.
Here, analyzing organic growth can be misleading and/or
irrelevant.
STOCK SELECTION
With our stock selection process we look for stocks that
provide the best elements of value and growth investment.
Specifically, our stock selection involves looking for stocks
with the following qualities:
· Low P/E
· Low price/book value
· Low price/cash flow
· Strong cash flow
· Low debt/equity
· Low capital expenditures and working capital needs
relative to cash flow
· Strong and preferably accelerating earnings growth
· Strong and preferably accelerating cash flow growth
· Excellent management
· Insider buying or stock buybacks
· Strong competitive advantages
Obviously, there are few companies that can leap our high
stock selection standards. We usually have a list of companies
that meet these criteria of less than 30 stocks.
Once again, special situation stocks will not necessarily
fit in these criteria and take a more artistic approach
to finding.
THE QUANTITATIVE PROCESS
We constantly screen all the listed stocks in the US and
the top NASDAQ stocks for certain quantitative criteria
that will meet our high stock selection standards. These
include:
· P/E ratio of less than the market multiple and
preferably single digits.
· A P/E of at least 50% less than the expected earnings
growth over the coming several years.
· Earnings growth of at 15% and preferably 20% per
year for the next several years.
· An ROE of greater than 15% and preferable over
20% with using debt to boost up the return.
In addition, we use a similar concept to the "owner
earnings" concept of Warren Buffet. We look at the
current and expected cash flow and subtract and capital
spending and increases in working capital and discount them
to the present. We only buy stocks that have a valuation
of at least 50% greater than their current market capitalization
though we greatly prefer to buy companies with at least
a 100% greater expected value than their current market
cap.
We also want the stocks to be trading at the "cheap"
end of their usual P/E in relation to themselves and to
the market. In other words, suppose a company's P/E has
been in a range of 10-20 over the last 10 years and has
generally averaged at about the market's P/E. We would then
prefer to buy the stock nearer to a P/E of 10 than to 20
and to buy the stock at less than the market multiple. We
expect that the stocks P/E will return to its mean over
time and give us an additional boost in stock performance.
This demanding stock selection screening reduces the universe
of stocks down to just a few dozen. We then shift to a qualitative
analytical mode to further reduce the number of stocks.
However, we are also looking out for special situations
that don't necessarily follow the criteria above.
THE QUALITATIVE PROCESS
The next step in or stock selection process is to analyze
the companies prospects from a qualitative perspective.
This is, by necessity, subjective, but is based on many
years of experience and input from other experienced observers
and analysts.
We look for such key items as:
· Strong competitive position. We prefer to buy companies
that have a significant edge or franchise. This may include
a technological edge, such as Intel has right now. It may
include a distribution edge, such as Wal-Mart throughout
the 1980's. The ideal, of course, is a monopoly or near
monopoly, such as newspapers or utilities or companies whose
products are protected by patents.
· Strong management. We look for managers who look
out for the interest of the shareholders rather than simply
plunder the company for their own good. We like managers
to be significant shareholders. We look for managers who
have been very successful at dealing with problems.
· Strong shareholder support. By this, we mean that
the company and/or its officers are showing support for
the company. The ultimate way to do this is to buy the stock.
We therefore look very closely at insider buying or corporate
stock buybacks. Academic research shows that this gives
a very strong boost to the stock's price.
· Strong acquisition path. Companies that are aggressively
growing through acquisitions can be a fantastic investment,
at least for a couple of years.
· Strong innovation. Innovative companies can often
carve out a strong competitive position through developing
new products or technology.
THE TECHNICAL PROCESS
By now, we have reduced the number of potential stock purchases
down to less than 30 stocks. We believe that with our stock
selection methods we have identified companies whose prospects
are bright yet stock is inexpensive.
However, we also know that we can find a great company but
the market will not see our bull case for years, perhaps
decades. We therefore do not want to buy a company's stock
until we have an indication that the market agrees with
us. The best indication that the market agrees with our
bullish cash is if the price of the stock begins to climb.
We therefore do not buy the stocks on our buy list until
the stocks moves into a bull market. We therefore tend to
buy stocks near but never at their lows.
In addition, we believe in risk management. Many stocks
will drop in value before we or other members of the analytic
community know why the stock is dropping. We therefore use
protective stop loss orders to make sure that we do not
suffer great losses in our positions. If we are stopped
out prematurely and the stock begins to climb again, we
buy back our position. Commissions are very cheap these
days.
THE BOTTOM LINE
We believe that the Courtney Smith & Co. Stock Selection
Approach combines the best of value, growth, and technical
analysis. It is disciplined and rigorous. As a result, we
believe that it presents superior performance with controlled
risk.
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