Investment Approach

Friday, July 30, 2004 | 0 comments »

(This does not attempt to cover portfolio management which is, in my view, more important than stock selection)

Involves four steps and is focused primarily on US and UK small caps:

1. Screen looking for firms

  • that persistently produce strong free operating cash flow
  • set to continue driving revenues
  • that are comfortable leveraged
  • that are not massively capex dependent
  • enjoy current ratios well over 1
  • that have positive eps YoY growth
  • that have a positive trend of accumulated retained earnings
  • that have low price-to-sales ratios
  • where key decision-makers holding meaningful amounts of equity
2. Historical ratio analyses to gauge management and financial strength as well as specific year over year trend analysis. These typically involve some use of the Altman Z and Piotroski Score formulas (or derived versions). Particular attention is paid to free operating cash flow yield, debt levels and earnings quality.

3. Outlook: how does a company’s next financial year look according to
(forecast eps growth% + dividend yield%)*100 / (p/e ratio less extraordinaries)
Results over 2 imply a buyer is getting twice what he pays. But that is only a signal and may say more about forecasting than it does about the company.

4. Context and soft issues - what are the dominant company specific and/or macro considerations? What are its relative (to, say, the Russell 2000) alpha and volatility (using standard deviation) performances?

Above all, flexibility is key. Hitting the mechanics of a screen or ratio is one thing; assessing prospects another. Ultimately, for the rational small cap investor, the question is whether the company is weaving a business story that its house broker can sell to institutional money.

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