The more we attend conferences across North America one of the many questions we continually entertain is that of our particular “investment philosophy.” Essentially, investors like to know what approach or style we use to uncover the stocks we recommend to our clients.
GARP (Growth at a Reasonable Price)
A significant portion of our strategy involves the search for GARP or Growth at a Reasonable Price. This means that we will recommend a stock because we believe the company to be a strong business that will grow over time and because we believe we are buying this company at a price that is significantly below its real or ‘intrinsic’ value (undervalued). The paragraphs below provide descriptions of a few of the attributes to which we pay very close attention.
Resilient Business Model
One thing we look at very closely is the resilience of a company’s business model. The business model is the plan that a company uses to convert whatever it does (product or service) into positive cash flow. There are a multitude of different types of business models out there, some of which are highly risky and some of which don’t make sense at all
(a common criticism of technology companies during the dot com boom). We look for business models that make sense and provide their respective companies with a great chance of growing during strong markets and at the very least, surviving during challenging markets. A resilient business model provides a unique or even essential product or service to customers that can easily afford to pay for it. An example would be a company that provides linen cleaning services under contract to hospitals. Another would be a company that owns and operates ATMs (automated teller machines) in strategic locations across the country. Yet another would be a company that processes and packages food products for distribution to international markets.
Profitability and Earnings Growth
As fundamental investors, first and foremost, we require that a company we research already be profitable and at the very least, provide strong potential for earnings growth. The earnings growth is what will drive the stock over the long term and provide the company with flexibility to grow their dividends. There are numerous companies in the market that are not profitable (may never have been profitable), but will attract themselves to investors under the promise of future profitability. The problem is that until these companies have achieved profitability, they will be entirely dependent on the market for raising funds to finance their survival (pay wages, pay bills, and invest in the business). If the markets, or that company’s particular industry, encounter any kind of danger, the very survival of the unprofitable company will be in serious jeopardy, as they will be unable to raise money or will be forced to raise money at terms injurious to the current shareholders. So for us, the unprofitable companies present too much risk.
Acceptable Level of Financial Risk – Healthy Balance Sheet
Financial risk refers primarily to the level of debt a company has incurred. All things equal, more debt means more financial risk and a higher likelihood of financial distress. A good deal of this risk is captured in the company’s balance sheet, which lists assets and liabilities. Ideally, we are looking for companies with large cash balances and little or no debt. Some companies that we research do maintain a debt balance; however, we believe this balance to reasonable respective to the company’s financial position. We look at the total debt balance, the regular interest payments, and the required principle payments and ascertain whether or not the company will have problems meeting its obligations. If debt is too high, the company is at high risk of suffering financial distress should the market enter a downturn. We therefore look for companies with acceptable levels of financial risk.
Strong Management Teams
Everyone has heard that they should invest in companies with strong management teams, but what exactly does that mean? What constitutes a strong management team? Analyzing management can be one of the more difficult steps in the research process. It means more than just getting along with the CEO. For us, we look not at what management is saying but what they are doing and what they have done. Analyzing management involves looking back as far as you can and tracking the correlation of what they have said they were going to do with what they have actually done. Have they made targets and met them? Have they managed the company prudently? Do they have a demonstrated track record of providing value to shareholders? Perhaps most importantly, do they hold significant shares in their own company – aligning their interests with shareholders.
Value – What We Pay For is What We Get
Value is the final ingredient in our investment equation. Understanding the value is important because “a good company is not necessarily a good stock.” What makes a good company a good stock is the price you pay for it. As a rule, we are looking for companies that we can buy at a significant discount. To ascertain this, we use a variety of tools including: ratios such as dividend yield, price-to-earnings, price-to-cash flow, and price-to-tangible book value. If our research tells us that we are getting a great deal on a stock then we may buy it. Conversely, if we own the stock and our research tells us that it is becoming overpriced, we may sell it.
For more insight on our philosophy in reference to our two key areas of research, click on the links below.
KeyStone’s Latest Reports Section