The following guidelines are based on advice from a large-cap value fund managers.
Don't spend your time and energy trying to predict the economy, interest rates, inflation, or the current market flow; focus on finding stocks of great businesses whose prices have been beaten down. If you want companies that will deliver the highest possible returns with the least amount of risk, but also provide great growth, you should be looking for companies which meet the following criteria:
- High return on tangible assets. These are the numbers on the left side of a balance sheet. Compare them with the company's cash flow minus depreciation. There is a strong relationship between assets and profitability - the more assets it takes to earn one additional dollar of revenue, the more difficult it is to improve your earnings. Make sense? For this reason, you should also avoid companies that are in capital-intensive industries, such as railroads, airlines, utilities, and industrial commodities like paper and steel.
- Unique professional services: tax preparation, advertising, money management, etc...
- Development, manufacture, or distribution of vitally important, inexpensive, or widely used products: pharmaceuticals, retail, etc...
- Media outlets with few, if any, competitors: tricky in this digital age, but think about Amazon's app store and Apple's iTunes to get your brain kicking...
- Government-guaranteed franchises: mortgage and student-loan packagers (if their numbers, and contracts, are good after all the bailouts and bubbles of late, then they are definitely worth looking into)...
- Shareholder-oriented management. Defined as management that has demonstrated an ability to recycle cash flow in a strategically effective manner. Management has a number of choices about how it can allocate capital. The most important is reinvesting cash in research and development, improving marketing, or implementing cost-reduction programs.
- Low purchase price. Don't think of this in a "penny stocks" mindset. Think of it in relative terms, and I don't mean your uncle Joey's inside tip. Look for a company's stock price to be substantially below its "private market value," which is what an intelligent businessperson would pay for the stock.
- Stock market decline
- Perceived external threat to the company's cash flow, even though the company is doing well
- Overreaction of the market to a short-term problem with the company that can be easily corrected
Other ways include: acquiring other businesses, liquidating less-profitable sections, buying back company stock and paying down debt, or paying dividends. There should be evidence, over time, that management will actually use capital in the best strategic way.
Clearly, the way management allocates capital is a good test of its regard for shareholders and the company's future growth, however, this is a subjective conclusion, which is usually reached by conducting interviews with top executives.
As you can probably imagine, you don't have to look far to find companies that match the above criteria. Simply summarized, we want slightly above-average quality companies in a discounted state. Consider a good discount to be 60 to 70 percent of "true" value. Consider selling when your purchase reaches 80 to 90% of that value. Consider that this could take years, and remember we are discussing shrewd safe investing here. This keeps you from being swept up in short-term market and economic trends and limits your portfolio's risk.
- Look at a company's "free cash flow." - This should be considered instead of its price-to-earnings and price-to-book ratios (the traditional tools of value investors). Technically, free cash flow is a company's net income plus depreciation and amortization, minus maintenance and a portion of capital expenditures. Basically, this tells us what kind of earnings a business really is capable of generating for its shareholders.
- Invest in a few well-chosen companies. - Concentration (Confucius would be proud) on the big hitters is just the way good teams win - like it or not. This doesn't mean you have to limit yourself, but make sure you know where your loyalties lie. Consider your top five stocks holding around 30% of your total portfolio value, and your top 20 accounting for around 65% overall.
- Invest for the long term, and trade as little as possible. - On average, expect to hold stocks for five years.
- Think independently. - Don't get caught up in the market mentality, and don't buy stocks based on firm ratings. Use the standards, follow the considerations, and remember the rules. This is not the be all to end all, but it will get you started on the right track. Once you've developed your own trustworthy instincts, feel free to make your own rules.