I have completed my review of Issue 1 of Value Line and have added a number of stocks to my watch list. I will begin to selectively add valuations as time permits. I will generally focus on those companies that are either near new lows or that have a high earnings yield.
You will see that my valuations take the form of the total return (capital gains plus dividends) that is discounted in the current stock price based on today’s closing price. Please note that these are simplistic valuations based on the extrapolation into the future of the companies’ past performance, including net profit, return on equity, rate of reinvestment, share repurchases and average dividend yield, which may not be indicative of future performance. You should always do your own research.
You will notice that the majority of the stocks on the watch list are categorized as a “Good Business”. That is intentional as the fourth tenet of my investing blueprint is Buy Good Businesses. I want to have an active dashboard where I can easily track all these good businesses and zero in on the ones that Mr. Market is making available at a cheap price. The basic screen for Good Businesses was inspired by Buffett in his 1987 letter to shareholders.
Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.
The Fortune study I mentioned earlier supports our view. Only 25 of the 1,000 companies met two tests of economic excellence – an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15% [emphasis added]. These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P 500.
To be categorized as a “Good Business”, I am looking for businesses that pass these Fortune tests. Given the severity of the recession, I might include a company that is close but not quite there. As you can see from the study, not many companies pass these stringent tests. If you are fishing in this pond, at least from a quantitative standpoint, you have eliminated many sub-par companies. Note that 24 out of 25 of the stocks that passed the Fortune screen outperformed the S&P over the decade preceding the study.
This approach for the watch list was also inspired by Mason Hawkins who said at a 2005 lecture at the Ben Graham Centre for Value Investing at the University of Western Ontario that he and his team revalue the top 200 businesses in the world every week to see if they are available for less than 60% of value.
By way of review, the other categories are as follows. The categories may be added to or evolve over time.
- Special Situation – restructuring, spin-off, bankruptcy, divestitures, etc.
- Book Value Aristocrat – exceptional book value growth over the past decade
- Strong Moat – evident durable competitive advantage
- Guru Purchase – recent purchase by a notable investor
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