STOCK SELECTION

PHILOSOPHY


We seek stocks that provide both value and growth. We further wish to buy only those stocks that are currently in bull markets
Some stocks look very attractive from a classic value perspective. They have a low P/E, low debt/equity ratio, and trade near book value. Unfortunately, these companies are often at low P/E's because they have little or no growth prospects. As a result, these "value" stocks are actually very risky because competitive threats may erode their profitability.


On the other hand, some stocks look very attractive from a classic growth perspective. They have high growth rates and high ROE's. Unfortunately, many of these companies are using high quantities of debt to finance their growth. In addition, many of these companies have growth rates that are unsustainable. As a result, many of these companies have P/E's or market capitalizations that reflect not only strong growth prospects but nirvana.


Of course, there are also special situations that do not fit these criteria. An example might be a company that is just coming out with new products or doing acquisitions. Here, analyzing organic growth can be misleading and/or irrelevant.

STOCK SELECTION

 

With our stock selection process we look for stocks that provide the best elements of value and growth investment. Specifically, our stock selection involves looking for stocks with the following qualities:
· Low P/E
· Low price/book value
· Low price/cash flow
· Strong cash flow
· Low debt/equity
· Low capital expenditures and working capital needs relative to cash flow
· Strong and preferably accelerating earnings growth
· Strong and preferably accelerating cash flow growth
· Excellent management
· Insider buying or stock buybacks
· Strong competitive advantages


Obviously, there are few companies that can leap our high stock selection standards. We usually have a list of companies that meet these criteria of less than 30 stocks.


Once again, special situation stocks will not necessarily fit in these criteria and take a more artistic approach to finding.

THE QUANTITATIVE PROCESS

We constantly screen all the listed stocks in the US and the top NASDAQ stocks for certain quantitative criteria that will meet our high stock selection standards. These include:
· P/E ratio of less than the market multiple and preferably single digits.
· A P/E of at least 50% less than the expected earnings growth over the coming several years.
· Earnings growth of at 15% and preferably 20% per year for the next several years.
· An ROE of greater than 15% and preferable over 20% with using debt to boost up the return.


In addition, we use a similar concept to the "owner earnings" concept of Warren Buffet. We look at the current and expected cash flow and subtract and capital spending and increases in working capital and discount them to the present. We only buy stocks that have a valuation of at least 50% greater than their current market capitalization though we greatly prefer to buy companies with at least a 100% greater expected value than their current market cap.


We also want the stocks to be trading at the "cheap" end of their usual P/E in relation to themselves and to the market. In other words, suppose a company's P/E has been in a range of 10-20 over the last 10 years and has generally averaged at about the market's P/E. We would then prefer to buy the stock nearer to a P/E of 10 than to 20 and to buy the stock at less than the market multiple. We expect that the stocks P/E will return to its mean over time and give us an additional boost in stock performance.
This demanding stock selection screening reduces the universe of stocks down to just a few dozen. We then shift to a qualitative analytical mode to further reduce the number of stocks.


However, we are also looking out for special situations that don't necessarily follow the criteria above.

THE QUALITATIVE PROCESS

The next step in or stock selection process is to analyze the companies prospects from a qualitative perspective. This is, by necessity, subjective, but is based on many years of experience and input from other experienced observers and analysts.
We look for such key items as:


· Strong competitive position. We prefer to buy companies that have a significant edge or franchise. This may include a technological edge, such as Intel has right now. It may include a distribution edge, such as Wal-Mart throughout the 1980's. The ideal, of course, is a monopoly or near monopoly, such as newspapers or utilities or companies whose products are protected by patents.


· Strong management. We look for managers who look out for the interest of the shareholders rather than simply plunder the company for their own good. We like managers to be significant shareholders. We look for managers who have been very successful at dealing with problems.


· Strong shareholder support. By this, we mean that the company and/or its officers are showing support for the company. The ultimate way to do this is to buy the stock. We therefore look very closely at insider buying or corporate stock buybacks. Academic research shows that this gives a very strong boost to the stock's price.


· Strong acquisition path. Companies that are aggressively growing through acquisitions can be a fantastic investment, at least for a couple of years.


· Strong innovation. Innovative companies can often carve out a strong competitive position through developing new products or technology.

THE TECHNICAL PROCESS

By now, we have reduced the number of potential stock purchases down to less than 30 stocks. We believe that with our stock selection methods we have identified companies whose prospects are bright yet stock is inexpensive.


However, we also know that we can find a great company but the market will not see our bull case for years, perhaps decades. We therefore do not want to buy a company's stock until we have an indication that the market agrees with us. The best indication that the market agrees with our bullish cash is if the price of the stock begins to climb.


We therefore do not buy the stocks on our buy list until the stocks moves into a bull market. We therefore tend to buy stocks near but never at their lows.


In addition, we believe in risk management. Many stocks will drop in value before we or other members of the analytic community know why the stock is dropping. We therefore use protective stop loss orders to make sure that we do not suffer great losses in our positions. If we are stopped out prematurely and the stock begins to climb again, we buy back our position. Commissions are very cheap these days.

THE BOTTOM LINE

We believe that the Courtney Smith & Co. Stock Selection Approach combines the best of value, growth, and technical analysis. It is disciplined and rigorous. As a result, we believe that it presents superior performance with controlled risk.

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