Stepped Investment Process
Stocks are screened using several basic criteria such as free cash flow, rising earnings estimates, quality of earnings, relative strength and stock valuation.
A. Quantitative Analysis
Free cash flow yield (FCF/ Market Cap) is a strong factor in stock performance. Also, if a company’s free cash flow exceeds its net income significantly, it indicates a good quality of earnings … ie: there is actual cash, rather than accruals behind the earnings.
Rising earnings estimates are an indicator of superior performance : by comparing current estimates to past estimates, we can focus our search on stocks that show increases.
Relative strength allows us to select stocks in a more timely fashion because it identifies stocks that are starting to rise faster than the market.
Stock valuation is always important, so by comparing price-to-earnings ratios and ranking our sectors accordingly, we eliminate companies with deteriorating performance factors.
This quantitative step culminates in a smaller universe of stocks with characteristics associated with outperforming the market.
B. Fundamental Analysis
This analysis focuses on the competitive position of the company within its industry.
Extraordinary returns should not be expected from ordinary companies, so we seek out companies which have a demonstrated franchise value. This could include a technological edge relative to competitors, better
management, brand recognition, and companies for whom the threat of new competition or product substitutes is relatively low. In general, companies with these characteristics tend to earn superior returns on
capital and pay handsome rewards to patient investors.
C. Portfolio Formation
At this stage, we usually still have more candidates for purchase than places available in the portfolio. Quantitative risk analysis is the final stage in the construction of a portfolio, the relative risk of which is precisely measured and found to be within acceptable risk tolerances. Our process generates enough candidates for entry into the portfolio whilst ensuring that alternate stock choices are available.
D. Sell Discipline
If a stock is down 30% relative to the market and fails our quantitative tests, we look to liquidate it to allow for opportunistic trading.