Editor's Note: These are extracts from the Oct. 5 and Oct. 12 TheStreet.com Value Investor newsletters from Jon Markman.
You may find that my style of value investing differs somewhat from those of other managers, but that should not come as much of a surprise. There are as many kinds of value investing as there are shades of gray.
At the end of the day, however, all value investors focus on a simple concept: We try to buy shares of companies when they are relatively cheap and their stories misunderstood, and try to sell them when they grow to be relatively expensive and their stories widely appreciated.
Very often, the shares of those relatively cheap and misunderstood companies are trading near one-year or multiyear lows. But sometimes they are trading near all-time highs.
In the former case, we may take on some risk to assert that we know something that the rest of the market doesn't know. We buy into negativism, distaste, anger and regret, and wait patiently for the mood to turn apathetic, then hopeful, happy and finally optimistic.
In the latter case we may take on somewhat less risk to assert that while a few early investors understand the company's potential value, we believe that in the future many more currently sidelined, skeptical or unknowledgeable market players will be persuaded to become holders.
In both cases, we develop an intellectually advantaged variant perception of a company's prospects after an analysis of its fundamental financial structure and executive culture. This means combing through its balance sheet, income statement, cash-flow statement, proxy filings, public comments, insider buying and board governance. But we'll also study the world in which the company operates: talking to customers of its products or services or trying them ourselves, studying the major owners of the shares, and observing the recent history of its trading pattern. In addition to cheapness, we are looking for a catalyst that will drive prices higher.
Finding the Diamonds
There are about 3,000 tradeable stocks (market capitalization over $100 million, average daily trading volume more than 30,000, price over $2) to choose from. How do I sort through them all for the ones with the right stuff, and then distinguish myself from other value investors to make a final decision on the deployment of our precious capital?
First, I use a proprietary, multifactor, nonlinear model to help me assess and weigh the key, quantifiable decision-making inputs. This model, which has been tested both historically and in real time, helps me determine whether, for instance, a company with strong cash flow and low valuation but high debt, a modest dividend yield and a lousy chart deserves an investment as a surprise "turnaround" play. My model removes some, but not all, of the fear, doubt, excitement and personal bias that creeps into pure, seat-of-the-pants value stock-picking.
But numbers are only part of the story because these days, plenty of other investors have great quantitative models. Although each modeler believes he or she has a unique set of inputs and weights, at the end of the day the dirty little industry secret is that they are all pretty similar. And that similarity has put a lot of investors in a world of hurt in recent years, as many have put on the same trades, depressing potential returns.
For my final choices, I will depend on my experience and intuition -- two human attributes that pure quantitative investors shun. I try to peer into the back-story behind the numbers to observe moments when investor sentiment may have begun to shift in ways that don't show up well statistically. In this way I attempt to combine methodologies that are often kept separate by warring camps of investment ideologues -- fundamental analysis, technical analysis, quantitative analysis and sentiment analysis -- to generate valid value ideas.
Managing Value Picks
Buying stocks, however, is only part of the story, and in some ways it is not even the most important part. A smart person and facile writer can make a strong case for almost any investment. But position management and selling discipline are even more important factors in effective portfolio management.
If you'll permit me the analogy, most golfers spend the majority of their practice time hitting long balls off the driving range even though only 18, or 25%, of the shots on a par 72 course are off a tee. The folly of this is that successful golf is all about the short game ? chips and puts, shots that are the least fun to practice. And likewise, buying is only about a quarter of the battle in investing. The rest is knowing what to do with a stock once it's in your portfolio.
To be sure, I earnestly wish to become a long-term holder of every company I buy. Very often the best thing to do with a stock is nothing. It's great to buy a misunderstood stock at $10 one day, and then note with satisfaction five years later that it is at $50. But the kind of foresight and perseverance required for that sort of hold is more common in anecdote than in real life. Maybe we'll get lucky, but we won't count on it. As the speed of information accelerates and the globalization of business advances, it is increasingly difficult for companies to establish and maintain the sort of credible and lasting edge that makes long-term investment possible.
My approach is to average up as prices rise rather than to average down as prices fall. But when my target is reached, I will take profits and redeploy them into new ideas. Sometimes an appropriate level of profits will be unlocked in a couple of months; more often it will be many months, or years.
Sometimes, however, profits don't come at all. In this case, I tend not to wait around, turning a prayer wheel, hoping that the market comes to my point of view soon. I will exit losing positions sooner than many other value investors. Small losses are good losses: They teach you something. Big losses just sap your confidence and capital, and they often make you too gun-shy to take the next opportunity.
I will attempt to earn your confidence a week at a time and will depend on your feedback, as well as the market's, to let me know if I'm on the right track. This service is not just about my point of view and investment recommendations, but about a partnership of trust and discovery. Every great investor that I know depends on a network of sources. We can be a profitable team if we share ideas and work together, rather than maintain the straitjacketed roles of writer and reader, or coach and player.
I will share a lot more about my investment philosophy as we go forward. So enough talk, let's take some action. Because this report is already lengthy, let me get right to the core of my new trade idea. I will follow up next week with more background and analysis, and another idea or two.
Don't Forget the Small-Caps
My work has led in the past couple of years to small- and mid-cap value, rather than large-cap value, which are the types of stocks that dominate the Value Investor portfolio now. This can, and will, change over time. Smaller companies are attractive at various times in the economic cycle, such as now, because they are less subject to the whims of the global economy.
Smaller stocks also represent the potential for a greater information disequilibrium. As an example, there are 20-plus brokerage analysts and hundreds of portfolio managers who are on top of the
situation with Vioxx. It's relatively hard to get an information or analytical advantage on them. The market for these shares is fairly efficient.
In contrast, there is relatively scant analyst coverage of many of the stocks to which I'll draw your attention, and much lighter -- though never nonexistent -- institutional ownership. This means we can learn something about these stocks that most other market players don't know now, but which we expect they will want to know.
A few of the stocks I will recommend will also tend to be less liquid -- which is to say they will have fewer shares outstanding and trade fewer per day. This just means that it may take you longer to acquire a full position in some of my suggestions. If you consider a stock that I add to the model portfolio trades only 50,000 shares per day, then you may discover that it might take a week or more to get to a sizable position.
If you typically think of yourself as mostly a large-cap player but want to try these kinds of names, you will find that you can't simply drop a 10,000-share order in the market and have it filled right away near the market price. You may have to work it more. This is obviously what the large funds do.
As my Value Investor stock candidates become increasingly popular, as I think they will, then with any luck, by the time you are ready to sell they will be trading a lot more shares and it will be much easier to exit than it was to enter. For example, when I first suggested
to readers of my growth-oriented research service in January, it was trading only around 10,000 shares a day. By the time I recommended a sale in February, it was trading 100,000 shares a day. When the stock peaked four months later, it was trading 500,000 to 3 million shares a day.
The point is, don't get freaked out by low trading volume. Consider the idea, then if you like it, trade into it slowly but steadily over time, just as the large funds do.
And finally, rest assured that I will focus on large-cap value, too, opportunistically from time to time, and perhaps more programmatically as the economic cycle rolls on.
Jon D. Markman is publisher of
StockTactics Advisor, an independent weekly investment research service, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. At the time of publication, he held no positions in stocks mentioned. He also writes a weekly column for
CNBC on MSN Money. While Markman cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at
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