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Stock Selection For The Individual Investor

by Ian Prittie, P.Eng., CFA
President, Independent Insight Inc.

The latest stock market turmoil, in the fourth quarter of 2008 when stocks declined significantly, has left retail investors with a larger challenge than ever before. Many feel let down by their advisors, mutual funds, and the financial industry structure that is supposed to help them.

Is it possible for an individual managing his or her own money to make their own stock selection decisions, when they likely don’t have the interest, time, or expertise of a professional industry analyst? We believe the answer is yes, and in this article hope to offer some guidance as to how an individual might approach this task. Below are the stock characteristics we believe investors should be looking for.

The best combination is fast growth and a cheap valuation.

Several years ago I read an excellent book by James P. O’Shaughnessy called “What Works on Wall Street : A Guide to the Best-Performing Investment Strategies of All Time“. In it, he took various investment strategies and used 50 years of back-test data, to see which strategies worked best. One of the main conclusions was that buying cheaply valued, rapidly-growing companies was an excellent strategy. I believe this is the formula that investors should be focused on. You could begin with a screening tool, such as marketgrader.com or one of the free screens that are available on many financial websites such as Yahoo, and look for rapid growth and cheap valuation. Risk is not proportional to return, they are inversely related. If the stock of an excellent company falls significantly, the potential reward (price appreciation) rises, and the risk (of total capital loss) has diminished significantly.

Forget earnings and focus on cash flow.

The problem with a lot of stock screens is that they focus on earnings measures, usually P/E, to identify a “cheap” valuation. We are going to get into a small discussion about accounting, but we will keep it as painless as possible. You want to focus on cash flow, because it is the true measure of a firm’s performance and the best way of valuing a business. It is far less easily manipulated than earnings or a P/E ratio. Go to SEDAR or EDGAR and get the latest 12 months of data on the company you are looking at, and look at the cash flow statement. It is divided into three sections, operations, investing, and financing. Concentrate on the ‘operations’ section, and find the total. Divide this by the number of shares outstanding to find the cash flow per share. Take the stock price and divide it by this figure, it should be in the single digits, which tells you that you are on to a good candidate.

Cash flow from operations should be higher than net income.

This again involves accounting reasons that are beyond the scope of this article, but a simple check is to get the cash flow from operations figure as described above, and compare it to the net income found on the income statement. If it’s larger, this usually is a good sign that the company is a healthy, functional business and has
conservative accounting.

You want recurring revenue.

If you’re in the business of making airplanes, it might be many years before a customer needs to order a replacement. So to show investors growth, you not only would have to find a new customer to replace the sale you just had, but also additional orders. This is a tough battle. It is far better to find companies where the customer uses the product in a very short time frame. What do I mean? Think about Coca Cola. A drinker of their product finishes each can or bottle in minutes. During a year, that customer is likely to consume the same amount of the product as they did the previous year, so all Coca Cola has to do is keep their existing customers, and then go to emerging markets such as China or India and find new customers to show growth. People who are already customers keep coming back year after year.
This is exactly the kind of situation you should be looking for. The best businesses have their customers making recurring payments every year.

I believe that recurring revenue should not be thought of as a binary characteristic, ie “does a company have recurring revenue or not”, but rather as a scale. At the one (excellent) end of the scale, you have the case we just mentioned, along with food and confection companies, and software firms that license their product on a monthly or annual basis so that customers keep paying. At the other (problematic) end of the scale would be the large, capital intensive businesses such as airplanes and cars, where the products last for years. These are difficult business models and you should avoid investing in them. In between are companies with a blend of these characteristics, for example a software firm that engages in one-time sales (non-recurring), but also has a service (recurring) component to its revenue, so the company has a blend of good and bad characteristics. A firm like this may still well be workable as a possible investment for you.

Invest in smaller companies.

There are so many good reasons for doing so. One reason is simple geometric math. If you invest in a company whose market capitalisation (the whole value of the company) is $10 million, and the stock appreciates so that the company is worth $100 million, and you have made 10x your money (the magical ‘ten-bagger’), it only required other investors to pour $90 million into the stock value to make this happen. If you buy stock in a company that is valued at $1 billion, to get that same ten-bagger, investors need to pour an additional $9 billion into the value to get you there. The second good reason is that smaller companies have a much easier time growing rapidly. The same geometric math applies as investing in the stock. Think of how much easier it is for a company to grow its revenue from $1 mln to $10 mln, as opposed to from $1 billion to $10 billion. Management of scale is much easier at smaller money amounts. Thirdly, and this is probably the least well understood reason, but may be the most important, the smaller a company is, the fewer analysts that cover it, and the greater the chance of a (favourable) valuation mis-pricing. There are so many ways to prove that the idea of an “efficient market” is nonsense, but this is probably the best. Let’s say you find a firm that has a market capitalisation of $20 mln, has revenue of $25 mln, and $7 mln in operating cash flow, and is growing at 80%. It’s trading at approximately 3 x cash flow, and with 80% growth, is a super candidate for you to buy. Because of its small size and lack of analyst coverage, the market hasn’t “noticed” that the valuation is incredibly attractive. As a company grows in size (of both stock value and revenue) more and more analysts tend to cover the name, and there is more attention and therefore “efficiency” brought to the valuation. Find good, cheap, rapidly growing small companies before this process happens. Let others (especially industry professionals who have more influence) figure out the stock is cheap after you are already an owner of it, and very, very good things will happen.

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