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How We Manage Stocks
Research
WALT ST research consists of a diverse variety of evaluative tools and databases that are internally developed and purchased from external sources.
WALT ST focuses on stocks of companies with attractive businesses and attractive valuations. Characteristics of favored stocks include established management, industry leadership, growing revenues, highly visible earnings and free cash flow, return on capital that exceed cost of capital and the sustainability of competitive advantages.
WALT ST utilizes a Research Universe that consists of its 100 best common stock ideas. Quarterly, stocks are added and subtracted from the universe. While some stocks are in the universe for short durations other stocks that have been selected have remained in the universe since inception.
The Research Universe is then used to select stocks for private portfolios. The Research Universe is not a buy-list; it is a disciplined process to identify "world-class" companies with favored characteristics for potential investment. The number of stocks in the Research Universe that are found attractive for investment varies but typically averages 12 to 30 stocks out of the 100.
All stocks in the Research Universe, and all stocks held in private portfolios, are constantly evaluated using four primary tools: (1) discounted cash flow model, (2) comparable valuation analysis, (3) the fundamental story ("big-picture") of each stock and (4) technical trends analysis.
Discounted cash flow (DCF) or "intrinsic valuation" is defined as the value of any stock as a function of the cash flow it generates, the life of the stock, the expected growth in the cash flows and the riskiness associated with the cash flows. Computers and proprietary models are used to help calculate and estimate "intrinsic value."
Comparative analysis is a logical process that can be applied to many tangibles and intangibles, and is also helpful when valuing the attractiveness of stocks. In comparable valuation analysis, WALT ST compares the value of a stock to values assessed by the market for similar or comparable stocks. Some of the most often used comparables are Price/Book Ratio, Price/Sales Ratio, Price/Cash Flow, Price/Earnings.
WALT ST also feels that understanding the fundamental story (or "big-picture") of each stock as it is conveyed by the specific company and interpreted by WALL STREET is important. Understanding the fundamental story of each stock helps assess realistic assumptions regarding growth rates, margins, capital investment requirements, effective tax rates and the efficiency in using working capital. WALT ST may examine company reports, financial statements and research from various analysts following the company to make judgments regarding attractiveness.
WALT ST also uses Point and Figure charting to determine the technical trends of supply versus demand relating to each stock.
The four primary tools are used to assign letter grades to each stock, with "A" being the best grade and "F" being the lowest grade. This simple system allows for easy communication and decision-making regarding portfolio management and optimization.
Portfolio Construction (i.e. number of securities in the portfolio, average annual turnover, sector security weighting constraints, etc.):
The size and number of holdings in the portfolio is based on the expected return potential, contribution to the overall portfolio risk and liquidity. Portfolios are typically concentrated and focused using 12 to 30 individual holdings.
WALT ST uses focused, concentrated portfolios representing its best ideas rather than closet index as many equity managers do. For example, we concentrate in approximately 20% of the industries in the S&P 500.
WALT ST strongly believes that 12 to 30 securities is plenty to achieve diversification for a portfolio and agrees with Philip Fisher who in 1958 authored Common Stocks and Uncommon Profits and wrote "Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all. It never seems to occur to them that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification."
WALT ST believes that long-term results will be more a function of the economic reality of each individual stock as measured by "intrinsic value." WALT ST subscribes to the definition of "intrinsic value" as defined by Benjamin Graham in Security Analysis as the "value which is justified by the facts- e.g., assets, earnings, dividends, and definite prospects. Usually, the most important single factor determining value is now held to be the indicated average future earning power."
WALT ST imposes no market capitalization or industry concentration restrictions on itself although in most cases stocks followed will have market capitalization greater than $1 billion.
WALT ST has an investment philosophy of letting the winners run as long as the majority of the tools indicate reason to hold. WALT ST will more likely re-balance a portfolio to adhere to the client's preferences, constraints or portfolio guidelines.
Sell Discipline:
There are four primary reasons that we would sell a security.
(1)We sell when a stock demonstrates fundamental weakness or a general breakdown in it's "big-picture" fundamental story. (2) We sell when we have found a "better idea." (3) We sell when we have made a mistake and the company has failed to execute as we had thought. (4) We sell when a stock demonstrates excessive valuation based on discounted cash flow or comparable valuation to other relative stocks.
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