My (developing) Investment Philosophy

**teenvestor2** Fri Jan 20, 2006 9:03 pm

My (developing) Investment Philosophy
Hi! My name is Mike Price, and I'm new here. I'm a 15 years old and have been learning about investing for about 2 1/2 years my website is http://rightpriceinvesting.com

This is my investment allocation philosophy. Thanks.

Value, of course

I was first introduced to the concept of value investing in the summer of 2004, I knew a little bit about it from Hidden Gem article that were published on the website, but now TMF was creating yet another newsletter “Inside Value”

At that point the only boards I read were Ask a Foolish Question, Investing Beginners and the Teen Board, none of those boards had anything to do with Value Investing, then because of this new newsletter TMF did a special hot topics that only had things from posts about value investing, about 75% of them were from the Foolish Collective board, so I started reading that board – actually just skimming the threads ;) – and I bought “The Warren Buffet Way” from a second hand book store and I was on my way.

I still depend 100% on value investing – no growth speculation or “TA” here -- but I've shied away from depending on the DCF 100%. Why?

I think Warren Buffet said if you have to do a DCF it's too close. I've been reading a lot lately about “Private Market Value” which is buying shares of a company for less than you think a competitor would pay for it. I don't know much else about how to find that, but I'll look into it.

Basically right now I'm not going to buy anything without a margin of safety.

Different ways of Investing

I believe that owning more than twenty companies at once is just asking for average returns, I will never own 50 or 100 companies, and strongly advise against it for anyone looking to beat the market.

I've been thinking about it and have found four categories that I am currently looking for opportunities in:

- Blue Chips
- Small Companies
- Cigar Butts
- Special Situations

Blue Chips

I may have poorly titled this; by blue chips I just mean companies I'll hold for longer than five years.

Large Caps, and The BMW Method

I hope to own at least three or four large cap stalwarts that may have relative returns to the market over the next one – three years, but over periods longer than that will outperform the market.

I'll try to apply a Rule Maker – post Bill Mann – analysis to these big companies; another big aspect will be the BMW Method.

Just in case you didn't know – I'm still kind of confused :-) – The BMW method uses CAGR lines to find undervalued companies based on how their stock price has performed over long period in the past – not less than 16 years – for more on that go <<http://invest.kleinnet.com/bmw1/intro.html>> here .

Mid-Caps

These companies usually have already proved themselves enough to not have a market cap below 2 Billion, but also have room to grow.

I'll be OK if there's a point when I don't own any of these companies, but I hope to usually own one or two.

I'll analyze these companies like I did in the K-Swiss report.

Options

In the future I'll attempt to use options to magnify risk-adjusted returns.

I'm not sure how I'll do it, but it'll probably be something like the stuff in “You Can Be a Stock Market Genius” using LEAPS.

Small Companies

This portion – 20-35% of the portfolio – will be the growth part.

Small Caps

These are the Hidden Gems, small companies that are being ignored by Wall St. and are trading below what they're potential growth will provide cash flow.

Small Caps are risky and volatile; I'm going to attempt to douse that risk by knowing any small cap I buy in and out, so I can take advantage of volatility.

I convinced my Dad to buy Select Comfort – actually he convinced me to look at it :-). Select Comfort makes the Sleep Number beds. Select Comfort wasn't doing very well, My dad bought it at ~$19 and it was down under $16, he asked me why so I searched Select Comfort and found that one of the beds had fungus or something on it, I watched the video and read an article on how heinous the fungus was, by Rex Moore, I was convinced it was not going to damage the fundamentals of SCSS, so my dad bought more at ~$16, SCSS now trades at $19, and has been as high $24.

Micro Caps

Companies with market caps below 100 million.

This is where most of the speculation will be. Like small caps micro caps are extremely volatile, and must be watched closely, also you'd have to know the company in and out.

Sometimes these companies don't trade on any of the major stock exchanges, so risk is extremely high.

Cigar Butts

Companies trading below Net, Net Working Capital*, cash, real estate they own, etc are cigar butts, that is you hold them for one puff then sell.

I won't own a lot of these; a lot of the time I may not own any. I want to focus on holding companies for a long time, and cigar butts don't let you do that.

Special Situations

Although there are a lot of special situations I will only invest in a few.

Companies Going Private, Reverse Splits

When companies no longer want to make periodic filings to the SEC they can do a reverse split to make less than 300 shareholders. When they do this the set a price they will pay for all fractional shares; you try buying the maximum amount of potential fractional share under the price the company is paying for those fractional shares.

When companies go private they also set a price they will pay for shares, if it looks like shareholders will vote in favor – Board owns >50% -- of the company going private, you try to buy shares for less than that set price, however if the company decides not to go private, you could lose a lot of money.

Spin-offs, Merger Securities, Bankruptcies

Sometimes a company will decide they'll do better, or a part of them will do better, without one part, so they spin-off that part to shareholders. Doesn't sound that exciting, but most institutions aren't aloud to own that spin-off – too small, no research, etc – so the mass selling of these shares creates a buying opportunity.

Similar things happen with:

Merger Securities, although it's way to risky to buy a company that is about to be bought out, sometimes when one companies buys another they issue merger securities – bonds or other things – institutions may not be able to hold bonds, but for whatever reason they usually sell these immediately, giving us another buying opportunity.

When a company comes out of bankruptcy – and only when it has come out – it usually pays the old shareholders with new shares or bonds, whatever they pay them with, once again institutions sell these immediately, the volume sends the share price down, and gives us a buying opportunity.It's not that long, I kind of over simplified it, but in order to maintain a concentrated portfolio this is all I'm going to look at.

-Mike

* Current Assets – Total Liabilities

**blast_investor** Sat Jan 21, 2006 1:44 pm

Mike, wonderful write up!

DCF is rarely that useful for value investing purpose, just like Warren said, too close. But DCF modeling certainly is most popular method for Wall Street analysts. No wonder that Wall Street analysts get it wrong frequently in stock market!

Correct me if I am wrong. Just a thought, Rule Maker is method from motley fool. My impression is that this method is more of growth stock picking method rather than value based. They used to have portfolio called Rule Maker or Rule Breaker portfolio.

**blast_investor** Sat Jan 21, 2006 2:07 pm

Just put DCF definition below for those who are not familiar with this:

Discounted Cash Flow - DCF

A valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them to arrive at a present value, which is used to evaluate the potential for investment. Most often discounted by the weighted average cost of capital.

If the value arrived at through DCF analysis is lower then the current cost of the investment, the opportunity may be a good one.

Basic Formula:

DCF = CF1/(1+r)1 + CF2/(1+r)2 + .... + CFn/(1+r)n

CF = Cash Flow
r = Discount Rate

Notes:
DCF models are powerful but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company.

Instead of trying to project the cash flows to infinity, a terminal value approach is taken in the valuation. A simple annuity is used to estimate the terminal value past 10 years for example. This is done because as time goes on, it is harder to come to a realistic estimate of the cash flows.

**teenvestor2** Sat Jan 21, 2006 4:27 pm

Thanks ;D.

Rule Maker was a TMF thing and didn't care about value much, until Bill Mann took over, he instituted a value investing strategy into the rule maker portfolio.

I use a DCF only as a part of valuing companies; I use other models as well. I also don't use Terminal value as much, instead I assume the company will be acquired in ten years (Like Mohnish Pabrai in his book: Mosaic) and add the current Tangible Book Value to the ten years of discounted cash flow.

Thanks for your reply!

-Mike

**nodoodahs** Mon Jan 23, 2006 9:24 am

I enjoyed the writeup, excellent job! Just a few comments ...

DCF is one tool in a toolbox - not everything is a nail and not everything needs hammering. Discarding DCF assumes your screwdriver will work on nails .... or that you're OK with missing some nails that are sticking up.

The same above applies to value investing and TA, momentum and swing trading, etc. Again, if you're OK leaving the nails sticking out, no problem - and many fortunes have been made using only one or two tools.

When I use DCF I use a very conservative discount factor, and I only project out 5 years. For the remainder (infinite holding period) I use S&P 500 historical average earnings growth of 6%, so essentially I do a two-stage model.

Predominantly I value invest, and I limit myself to about 20 positions, usually just over a dozen. But that doesn't mean that if I find a good technical trade or short, I won't indulge it if I think the risk is less than the reward.

FWIW the only positions that I don't fret over on a daily basis are the value longs that I think will pay off over a year or more. All the others, I'm as nervous as a cat in a room full of rocking chairs.

**blast_investor** Mon Jan 23, 2006 3:25 pm

That similar assumption actually is used extensively by Wall Street analysts. This essentially is terminal value after 5 years.

That is very aggressive assumption, not every company can achieve that. Lots of business, I would say almost all of smaller business is cyclical, which can under-perform that assumption after 5 years. That assumption may work for very stable companies such as Coke or Mcdonalds.

Because of cyclical nature of most business, after 5 years, many stock earning can go down 10% a year or to a loss.

Here is my favorite quote from Joel Greenblatt:

Everything is cyclical. Values can always be found somewhere.

nodoodahs wrote:
When I use DCF I use a very conservative discount factor, and I only project out 5 years. For the remainder (infinite holding period) I use S&P 500 historical average earnings growth of 6%, so essentially I do a two-stage model..

**jianyunli** Mon Jan 23, 2006 9:06 pm

Re: My (developing) Investment Philosophy
Got to hand it to you, bravo. I am almost twice your age and just started to embrace value investing.

Keep up the good work.