Acknowledgments
Guru Acknowledgments
I want to thank each of these professionals for sharing their time and insights with me. The strategies described in this book were inspired by their comments and strategies. As you read the book, you'll recognize their ideas in every chapter. Our conversations were quite lengthy and each could fill a chapter. Here is a very condensed abstract. These are in no way a complete representation of their strategies, they're merely interesting tidbits that came out of the conversations.
John Buckingham
Al Frank Asset Management
Laguna Beach, California
John Buckingham is president and chief portfolio manager of money manger Al Frank Asset Management, and editor of the Prudent Speculator newsletter. Buckingham follows classic investment strategies, buying underpriced firms with long-term track records and holding them as long as it takes. Buckingham views everything in terms of cycles, and likens value investing to farming in that “you plant the seeds, and then wait for them to blossom.” Buckingham relies on a firm's historical performance as a guide to the future. He prefers firms with plenty of cash in the bank, strong cash flow, and low debt. Buckingham favors the price/sales ratio to measure value.
Jim Chanos
Kynikos Associates
New York, New York
Jim Chanos is the famous short seller who was the first to blow the whistle on Enron in January 2001. Short sellers are ardent fundamental analysts and Chanos ranks among the best. Chanos spends most of his efforts analyzing the balance sheet instead of the income statement. He compares capital expenditures to depreciation charges to see if a company is adequately replenishing its assets. He sees receivables and/or inventories growing faster than sales a red flag. Chanos considers the frequent occurrence of nonrecurring charges an indicator of poor management quality.
Michelle Clayman
New Amsterdam Partners
New York, New York
Michelle Clayman founded and runs private money management firm New Amsterdam Partners. Clayman has a strong quantitative bent—she derives her analysis criteria by studying historical data. Clayman considers multiple instances of nonrecurring charges, and receivables or inventories increasing faster than sales as red flags. She requires high return on equity of her candidates.
Jim Collins
Insight Capital Management
Walnut Creek, California
Jim Collins runs investment management firm Insight Capital Management and publishes OTC Insight, a top-rated investment newsletter.
Collins employs a quantitative screen comparing stock performance to volatility to define an initial list of candidates, and then picks the fundamentally strongest from that group. Collins emphasized that sales, not earnings, are the best measure of growth. Collins looks to the stock charts, specifically weakening relative strength, for his sell signals. He also considers high valuations compared to the company's own historical values as a red flag.
David Edwards
Heron Capital Management
New York, New York
David Edwards is president and primary portfolio manager of private money management firm Heron Capital Management. Edwards, a growth investor, relies mostly on fundamental analysis, but also watches the price charts to help with the timing of his buy and sell decisions. Edwards emphasized the importance of picking the leading companies in growing market sectors, and his thoughts on how to do that inspired much of what you'll find in Tool #4, Industry Analysis. Edwards looks to a firm's own historical ratios to establish valuation, rather than to the overall market or to its industry. Edwards prefers firms with strong operating cash flow, and high return on equity. He believes that for proper diversification, portfolios should contain a least 32 stocks, with no more than 25 percent in any one sector. Edwards follows a strict selling discipline and my “when to sell” sections reflect many of his ideas.
Nicholas Gerber
Ameristock Funds
Moraga, California
Nicholas Gerber is manager and founder of the Ameristock Fund. Gerber is primarily a large-cap investor with a bent toward value. Gerber introduced two important concepts to me. One, the Porter Five Factor Model, was the inspiration for Tool #5, Business Plan Analysis. Gerber's concept of gauging the growth rate inferred by a stock's valuation inspired the implied growth analysis strategy featured in Tool #2, Valuation. Gerber uses return on equity to measure profitability, but double checks it by requiring book value to grow at the same rate.
Louis Navellier
Navellier Associates
Reno, Nevada
Louis Navellier, founder and president of the firm bearing his name, publishes several newsletters, runs mutual funds, and manages money. Navellier selects stocks by first running a screen that compares stock performance to volatility, and then picks the fundamentally strongest from that list. Navellier bases his fundamental analysis on computer run analysis of his database to determine the factors that are the best stock selectors in the current market. He shared his recent research with me, and that information helped to form the strategies described in this book.
Paul Rabbitt
Rabbitt Analytics
Hermosa Beach, California
Paul Rabbitt is president of stock analysis firm Rabbitt Analytics. Rabbitt uses a computerized database to rank companies, giving them what he terms a Q-Rank. The highest scoring Q-Rank companies show strong relative strength, recent positive earnings surprises, and strong and accelerating earnings growth. Rabbitt was one of the only market experts that I interviewed who doesn't use return of equity as a selection criterion. In fact, Rabbitt mentioned that he had recently removed ROE from his criteria list because he found that it didn't help.
Peter Schliemann
Rutabaga Capital Management
Boston, Massachusetts
Peter Schliemann founded private money manager Rutabaga Capital Management. A value manager, Schliemann looks for unloved, underfollowed companies in run-of-the-mill businesses that are going through a rough patch. Schliemann believes in the regression to the mean concept, and seeks out companies with below normal profit margins. He focuses on return on capital as a profitability measure, and seeks out firms with the biggest difference between ROC and cost of capital. Schliemann looks for positive cash flow, and avoids companies that are growing by acquisition. He prefers firms where insiders are buying the company's stock with their own money. Schliemann compares a stock to its own history to gauge when it's overvalued or undervalued. He prefers low expectation stocks meaning that they have low institutional owner ship, few analysts covering the stock, and even fewer buy recommendations. He sees rising receivables, increasing provisions for bad debt, deteriorating cash flow, and increased borrowings as sell signals.
Susan Schottenfeld
TCW Asset Management Company
Los Angeles, California
Susan Schottenfeld, co-manager of the TCW Galileo Value Opportunities Fund, introduced me to the concept of “looking through the valley to the next peak,” the foundation of value investing, at least the interpretation that I've adopted for this book. Schottenfeld seeks out companies selling at low end of their historical P/E range based on normalized earnings. She attempts to discover if the company is different now, than it was two years ago; that is, is the problem temporary? She looks for catalysts such as new management, better capacity utilization, divesture of bad units, and so forth, and prefers candidates with strong free cash flow. She sells when a firm's stock price reaches fair value, or if she notices a big jump in receivables, inventories, or accounts payables. She'll also sell if a competitor is having trouble or if she notes significant insider selling.
Ken Shea
Standard & Poor's
New York, New York
Ken Shea is director of equity research at Standard & Poors. Shea, mostly growth stock oriented, believes that you have to apply different rules depending on where a firm is in its cycle. For instance, though a believer in the importance of free cash flow, he doesn't apply that requirement to fast growers. Shea also considers it important to understand a candidate's business model. Shea considers management quality an important factor and is wary of companies growing by acquisition. Shea looks for companies with low margins that can improve, and sees slowing revenue growth, as well as big nonrecurring charges, as red flags.
Nancy Tengler
Fremont Funds
San Francisco, California
Nancy Tengler is president and chief executive officer of Fremont Investment Advisors, and co-portfolio manager of Fremont's New Era Value Fund. Though a value manager, Tengler doesn't mind taking some pages out of the growth manager's playbook. For instance, she prefers stocks with analyst coverage and strong operating margins. Tengler's favored valuation ratio is price/sales ratio, not by itself, but compared to the S&P's price/sales ratio, which she calls the relative price/sales ratio. She compares her relative price/sales ratio to historical values and uses it as her primary buy/sell signal. Tengler tracks capital spending to assure that a company is replenishing its assets. Tengler's somewhat offhand comment that “when value investors sell, they sell to growth investors,” gave me tremendous insight into the relationship between the value and growth styles.
John C. Thompson
Thomson Plumb
Madison, Wisconsin
John C. Thompson, comanages the Thompson Plumb Growth Fund. Thompson mixes growth and value strategies. He believes that every company has some years that are better than others, and looks for firms currently growing slower than their historic rate. Thompson introduced me to the concept of earnings leverage, meaning that a small increase in revenues can lead to a big improvement in profits when a company is operating close to its breakeven point.
Thompson looks for firms with no debt and lots of cash. He's a big believer in what he terms free cash flow, but he defines cash flow as excluding changes in working capital, along the lines of EBITDA. Thompson places great importance on understanding a firm's business model.
Thatcher Thompson
Merrill Lynch
New York, New York
Thatcher Thompson is a Merrill Lynch analyst specializing in the business services sector. Factors he considers important are revenue visibility, a company's position vis a vis the competition, sales growth and earnings growth, margins, cash flow versus net income, and low debt. Thompson's red flags include negative earnings surprises and/or reduction in guidance, departure of the CFO, growth by acquisition combined with declining margins, or declining cash flow combined with rising receivables.
Geraldine Weiss
Investment Quality Trends
La Jolla, California
Geraldine Weiss has been publishing her Investment Quality Trends newsletter for more than 30 years. Weiss' strategy hinges on tracking blue-chip stock's dividend yields. It's an effective method and Quicken.com implemented a version her strategy in its One-Click Scorecard. I tracked the performance of Quicken's four Scorecard stock-picking models and Weiss' was the hands-down winner. In our interview, Weiss stressed the importance of strong institutional sponsorship, in fact if my notes are correct, she said that “there is never too much institutional ownership.”
Academic Acknowledgements
A brief review of academic research that contributed to the strategies in this book.
“Earnings Quality and Stock Returns: The Evidence from Accruals,” Konan Chan, Louis K.C. Chan, Narasimhan Jegadeesh and Josef Lakonishok. Working Paper, January 2001.
Accruals result from increases in inventory and accounts receivable levels and from decreases in accounts payables. The study found that firms showing an increase in earnings accompanied by a large increase in accruals underperform in the three years following the high-accrual year compared to the previous three years. The study found changes in inventory to be the most important accrual factor for predicting future returns.
The study noted that since accrual increases are accompanied by corresponding cash flow decreases, the increase in accruals could be detected by comparing cash flow to earnings. That is, earnings increase, but cash flow doesn't.
“Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers,” Joseph D. Piotroski, Journal of Accounting Research, Vol. 38, No. 3 Supplement 2000.
Piotroski found that applying simple financial health tests using financial statement data to eliminate weak companies can significantly improve the performance of value portfolios.
“Earnings Surprises, Growth Expectations, and Stock Returns, or Don't Let an Earnings Torpedo Sink Your Portfolio,” Douglas J. Skinner and Richard G. Sloan. Working paper, April 2001.
Found that growth stocks exhibit a much larger negative response to negative earnings surprises than value stocks. The study found that “it is the disappointment per se and not its magnitude that is important to stock market participants.” The authors say, “when earnings news is positive, growth stocks outperform value stocks, but that when growth stocks disappoint, they underperform value stocks by substantially more than they outperform when the news is good.”
“Characteristics of Price Informative Analyst Forecasts,” Cristi A. Gleason and Charles M. C. Lee. Working Paper, September 23, 2000
Found that stocks with analyst forecast revisions move in the direction of the revisions, but only if, in the case of positive changes, the revised forecasts are also above the consensus forecast. The study found the effect also worked the opposite; that is, negative forecast revisions sink the stock price if the revised forecasts are below the consensus. The study found that the “magnitude of the revision is relatively unimportant.”
“Cash Flow is King: Cognitive Errors by Investors,” Todd Houge and Tim Loughran, Journal of Psychology and Financial Markets, Vol. 1, No. 3 and No. 4, 2000.
Found that high cash flow firms significantly outperform low cash flow firms.
Special Acknowledgment
I would like to thank Standard & Poor's Institutional Market Services unit, particularly J.P. Tremblay, Director, Investment Products, and analyst Jerome Blanchette for providing me with historical data derived from S&P's COMPUSTAT database. S&P's data very much facilitated my research.