A company should have a sound business model that has demonstrated consistent growth in revenue and earnings over the past 3 to 5 years.  The company also should have the potential to sustain growth in revenue and earnings into the foreseeable future.  

The quality of a company, which usually reflects strong management, manifests itself in several ways, including:  (1) consistent historical growth in revenue and earnings, (2) steady or increasing pre-tax profit margins, (3) steady or increasing return on equity that is greater than the industry median and is generally greater than 15%, and (4) a strong balance sheet.  

Value Line ratings of  B++ or better for Financial Strength and 85 or better for Earnings Predictability correlate well with quality and good management.  We also compare each company’s prospects for future growth and net profit margins with other companies in the same industry.  The Manifest Investing quality rating combines these four factors into a single 100 point rating.

Superior long term returns can be assessed in two ways – (1) by calculating intrinsic value for a company using discounted cash flow or (2) estimating the projected average return using a stock selection guide or similar calculation.  Using the stock selection guide, we look for a projected average return (PAR) greater than 15%.  We also look for quality stocks that sell below their intrinsic value.  Morningstar uses a discounted cash flow analysis to determine the fair market (or intrinsic) value of a stock.  Stocks rated 4 and 5 stars sell below their intrinsic value.  It is generally easier – although not as precise – to compare stocks using their projected average return from the stock selection guide.  

We prefer companies that, if purchased, offer the possibility of price earnings (PE) ratio expansion.  We generally avoid companies with high PEs, particularly when the PEs have been contracting in recent years.  High growth stocks with high PEs are particularly vulnerable to large downward price adjustments if the growth outlook for the company slows down.

Portfolio management is as important, perhaps more important, as selecting good stocks.  Several general principles guide our portfolio management:  

• Try to stay fully invested and to keep our cash position
  below 5%.  
• Don’t try to time the market.  
• Maintain about 20 stocks in our portfolio +/- 5.  We reinvest all of our dividends in the companies paying the dividends or in the portfolio.  
• Replace a holding if the company’s fundamentals deteriorate or if the company becomes overvalued.  
• Replace an individual stock if the replacement company will improve the overall projected average return or the quality of the portfolio.  
• Consider diversification when making purchases and try to stay invested in at least five different sectors but there are no strict rules about sector weighting or company size.

If you are a member of Moose Pond Investors, current portfolio valuation and club administrative information can be found at http://www.bivio.com/moosepond/.

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