Selection Criteria

Wallstraits 8 Portfolio Stock Selection Process: The 8 Steps

Wallstraits has decided to 'walk our talk', and therefore we invest the vast majority of our company's cashflow each year into a portfolio of common stocks in the local market. Our portfolio is concentrated into just 8 core holdings, although from time to time we may own additional stocks, usually smaller positions that are under evaluation. Our focused approach forces us to make very careful decisions only after extensive investigation. Here's what we look for as we search for new stocks to add to our portfolio: Note: we didn't invent any of this stuff, but only stand on the shoulders of wiser investors who were kind enough to publish their thoughts, especially Benjamin Graham and Warren Buffett...

Step #1: Strong consistent sales & earnings growth that looks predictable into the future...
We much prefer a chart that looks like the one on the left, compared to the one on the right...
Osim's sales & profit chart is encouraging because since 1995, despite a severe regional economic and currency crisis in 1997 and 1998 and a global tech market crash that depressed global stock markets in 2001, Osim's growth just kept marching forward. We are confident in projecting future growth for Osim based on their solid performance in challenging times since 1995 (in fact, since long before 1995). This predictability of future earnings growth is absolutely essential as we move through our other screens... most essential when we arrive at our 8th and final screen, which is a valuation method that requires us to make growth assumptions 10-years forward. Without passing this first screen, we will be left with no dependable way to value the business in the end.

Step #2: Conservative Financing with total debt less than a single year's net earnings...
Warren Buffett has focused on low debt businesses with great long-term success. His benchmark has been total debt less than one times current net earnings. Warren favorites like Wrigley, UST, Coca-Cola and Gillette meet this criteria. It is not uncommon to find good businesses that use debt to finance the acquisition of another business. This can be acceptable if the acquired business is a consumer monopoly that scores as high on these 8 screens as the acquiring business, but if not, the overall score is destined to fall, often precipitously. Conservative financing may reduce short-term profits in good times, but it also ensures survival, and maybe even growth in tough times.
The debt measure is very easy to perform, but its ramifications to other screens are critical. For example, a company can 'finance' a high return on equity (our next screen) by using borrowed money. Likewise, high borrowings could produce a consistent EPS growth (first screen). Imagine if a company could borrow endless amounts of money at 10% interest to invest in a business that produced 8% net returns. The more it borrowed, the higher it could drive EPS each year. And the more it borrowed, the more it destroyed shareholder value. You will find that many of these 8 screens work together, in this case low debt combined with consistent EPS growth and high ROE makes a beautiful combination. Any of these first three screens in isolation can't possibly lead to a useful conclusion.

Step #3: Consistently High ROE, above 15% each year...
Shareholder's equity is defined as a company's total assets less the company's total liabilities... thus it is the last line in the annual balance sheet of the annual report. It's like the equity in your house. Let's say that you bought a condo as a rental property and paid $200,000 for it. To close the deal you invested $50,000 of your money and borrowed $150,000 from the bank. The $50,000 you invested is your equity in the property. When you rent your condo, the rental income minus expenses, mortgage and taxes, would be your return on equity.
If you rented the condo for $15,000 a year and has $10,000 total expenditures, then you would be earning $5,000 a year on your $50,000 in equity, or 10% ROE ($5,000/$50,000 = 10%). Likewise, if you owned a business that had $10 million in assets and $4 million in liabilities, the business would have shareholders' equity of $6 million. If the company earned, after taxes, $1.98 million, we could calculate the business's return of shareholders' equity as being 33% ($1.98m/$6m = 33% ROE).

Over the last several decades, American businesses have averaged about 12% ROE. Anything above 12% is thus considered above average ROE. Our minimum standard of 15% is significantly above average. I like to think of ROE as a business efficiency measure. Old locomotive steam engines could only go faster if more coal is shoveled into the boilers. Some companies are like that, only able to expand with massive capital injections. Others are like a modern Honda hybrid engine, which can run almost effortlessly on stored solar power at cruising speed, only needing to step on the gas an instant to ramp up to higher speeds.

Step #4: Intelligent Capital Allocation, where retained earnings are used for growth not maintenance...

The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite-- that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such businesses usually benefit if it pays out most of its earnings in dividends or makes stock repurchases.

Businesses that can grow rapidly while remaining asset-light are attractive. These businesses are often found in the area of services or branded consumer products. If a business must retain a great deal of capital just to repair equipment to maintain status quo, it is not very attractive. Likewise, retained earnings (or worse, debt) used for acquisitions of unrelated to or less economically viable than the core business usually destroy value.

We also take a quick snapshot look at a company's ability to manage internal cash flow at this point, a metric we refer to as the Cash Flow Ratio. This ratio is taken from the annual balance sheet, and we look for a ratio below 1.5 but the lower the ratio the better. A low cash flow ratio indicates a company is effectively using other people's money to run their business by collecting their debts very quickly, but paying their bills very slowly (unless those bills charge an interest or penalty). Current assets are bad in this case, because they represent uncollected invoices for goods already produced and shipped. Current liabilities are good, because they represent money owned to others that is still in your bank.

Cash Flow Ratio = (current assets - cash) / (current liabilities - interest bearing short term loans) = <1.5

Step #5: The Business is easy to understand, and Management is open, honest and competent...

Over the last several years investing in Singapore, we have found that quite often small-cap businesses score higher on our screens than larger corporations, and they are certainly easier to understand and analyze. Because small-cap businesses are typically dependent on the skills and motivation of one or a small team of Directors and Managers-- it is absolutely critical these few leaders be of impeccable integrity, skillful capital allocators, open with minority shareholders, and focused on growing the business long-term. We have been badly burned by managers who inherited the business from Mommy or Daddy, take it public, and then funnel the profits to other family-owned private businesses (often property development businesses).

We prefer simple businesses that do one thing very very well. The business must be very well understood. As Buffett says, "Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word 'selected': You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital."

The simplest business I have ever analyzed was Unisteel Technology (luckily the word 'technology' didn't frighten me off right away). Unisteel has a factory full of nearly identical automated machines. Hardly a person around. Each machine pulls a steel wire from a spool, two loud 'boom' bang' sounds are emitted, then a screw pops out the other side and is run across a threader. The screws are sent next door to be conveyed through a series of automated treatments (electropolishing) to make the surface ultra smooth. These screws are then sold at a huge premium to the hard disk drive industry, with each HDD needing about 20 screws to hold components securely. Today, Unisteel controls about half the global market for HDD fasteners, the dominant player on the planet! They have no consumer brand, but they have a tight grip on a growing niche market, and they keep it very simple!

Osim International is the best example we have found of a consumer monopoly with a strong brand name in Singapore. Osim markets, they don't manufacture. They market healthy lifestyle products, led by a flagship luxury massage chair, but the brand has been extended across hundreds of lower-cost products marketed to more than a dozen countries. When you think OSIM... you think about how to relax after a hard day's work, about how to filter clean pure water from your home faucet, about how to exercise and stay fit at home, about how to vacuum your home in the most sanitary allergy-free way, and about how to live and enjoy a healthier lifestyle.

Warren Buffett looks for three qualities in a manager of a public company: (1) they run their business as if they own 100% of it, (2) they run it as if they couldn't sell it or merge it for at least a century, and (3) it is the only asset their family will ever have. An excellent manager should run the business without being affected by accounting considerations-- focused more on what counts, not how it will be counted (this fiscal year). Good small-cap managers are patient in growing the business, always looking to undersell and overdeliver. Over time they look for strategic investors to diversify ownership, and continually communicate their plans to minority investors.

The economics of a business are more important than management talent. Jack Welch or Bill Gates are not going to compare well if they managed coal mines versus an average manager behind a consumer monopoly like Coke. Nevertheless, our results have been best when we invested in both the economics of the business and the quality of the management. The best example to date would have to be the economics of OSIM combined with the pleasure of working with and observing Ron Sim, Osim's founder and driver, and an open communicator. Ron Sim is the only CEO I know in Singapore who has laid out a growth target (sales and number of outlets) more than 5 years in advance (in 2001, he laid out a plan through 2008).

Step #6: 2x5y = Business/Industry Prospects indicate Earnings could Double in 5 Years...
If a business is in a growing industry, or even dominates a growth industry, it should be able to achieve a minimum net earnings growth of 15%, which will result in EPS doubling in just under 5 years. Fifteen percent net earnings growth consistently year in and year out offers investors a nice compounding effect. Warren Buffett has managed to compound the growth of his investment portfolio at nearly 24% for the last 4 decades, thus doubling its value nearly every 3 years.

People's Food is probably the best example we've come across of a company with a tremendous opportunity to grow within a simple but promising industry. People's Food slaughters pigs in China and markets end-products including: fresh pork, frozen pork, pork sausage, hams, sandwich meats, pig organs, pig skin leather, and even pig hair artist brushes. Pork meat is a massive industry in China, by far the largest pork market in the world. While People's Food is one of the largest and most advanced pork processors in China, and processed more than 4 million pigs to create over S$1 billion of revenue last year-- they still have yet to achieve a one percent market share. China appears to be in the early phases of a major consumer spending revolution that will create increasing demand for high quality branded meat products, especially pork.

Step #7: Sustainable Competitive Advantages are in place...

A business can have different types of competitive advantages, and some are more sustainable over time than others. The simplest type of advantage is a patent on a product or process innovation. Drug manufacturers are protected by patents to produce and sell blockbuster drugs for about 17 years before generics are allowed to cut into their market share. Sometimes government owned or linked companies are protected from outside competition for as long as the country feels the industry is strategic. Sometimes size is an advantage as large economies of scale can be achieved.

At the top of the competitive advantage food chain is a consumer monopoly. This term was popularized by Warren Buffett as he used it to describe a company with superior economics and predictable future results. Throughout his investment career, Buffett has been able to find several such companies that had what he called toll bridge economics. If you, the consumer, want to cross a river without swimming or renting a boat, you have to use a bridge and pay the owner a toll for convenient and dependable passage.

Examples of Buffett's toll generating consumer monopoly investments: the only newspaper in a large town, the secret refreshing formula of Coca-Cola, the chewy texture of Wrigley chewing gum, the sweetness of a Hershey's chocolate bar, or the addictive nature of Marlboro cigarettes. A consumer monopoly is a brand that creates a positive perception in the minds of consumers, some distinctive attributes that are particularly attractive to buyers, who then form an attachment to a company and the products it sells, even if they are premium priced.

Consumer monopoly brands produce superior company results-- which equate to higher returns on equity, superior earnings growth, and improved stock performance in good economies or bad. If you ask 100 top corporate managers if they would accept unlimited low-cost capital to compete with the given brand, and they all say NO-- then you have identified a consumer monopoly. A consumer monopoly must operate in an unregulated industry. If it is the only water company in town, but water is regulated, than the water monopoly can't sustain superior results because the government wants consumers to have low-cost water.

The ultimate consumer monopoly is General Electric, a company founded more than a century
ago (the only remaining original 1896 Dow component stock) by the inventor of the electric light bulb--Thomas Edison. GE sold the world the know-how to make electricity and the products to wire up and then just kept introducing more products that required electricity-- light bulbs, power tools, refrigerators, air conditioners, etc. A century later GE is still the world's largest corporation and one of the world's most respected and admired brands... and one of the best performing stocks throughout the history of organized markets.

Step #8: Attractive Valuation

The Theory of Investment Value, written more than 50 years ago by John Burr Williams described an equation for valuing a business based on assessment of cash flow: "The value of any stock, bond or business today is determined by the cash inflows and outflows-- discounted at an appropriate interest rate-- that can be expected to occur during the remaining life of an asset."

While the typical discounted cash flow equation is rather complex, including projected cash 15 years into the future, extrapolation of a terminal value from the 16th year to perpetuity, and discounting all future earnings projections by both a risk-free rate of return and an equity risk premium that considers systemic and unsystemic risk factory... We heed Buffett's advice that, "it is better to be approximately right than precisely wrong".

We distill our Intrinsic Value formula to simply looking at the projected earnings per share during the next 10 years, and discount these earnings by a risk-free rate equal to US Treasury bonds. We take a careful look at the company's financial statements to make sure net earnings approximate cash flows (no unusual depreciation or amortization charges). The risk-free rate discount is used to decrease each year's earnings by the amount an investor could have made had he placed his money in US Treasuries, a nearly risk-free investment, instead of buying the particular stock and waiting year after year for the earnings to be produced. We do not add an equity risk premium beyond the risk free rate because we believe the few businesses that can survive our first 7 screens are not subject to significant additional risks. We don't add a terminal value because a 10-year forecast is already foggy enough, and the goal is to be conservative, not precise.

Here's how this process works. Suppose we are looking at a company like People's Food in mid-2002. We have only confirmed half of the current (2002) earnings, so we use 2002 as our first projection/discounted year, and project out ten years to 2011. After thorough investigation and high scores on the first 7 screens (especially screen #1), we decide to assume a 20% EPS growth rate each year from 2002 through 2011, and the risk-free rate is about 5%.
People's Food Intrinsic Value
Year
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
EPS (20%)
15.4
18.5
22.2
26.6
31.9
38.3
46.0
55.2
66.2
79.5
Discount, 5%
.9525
.9070
.8638
.8227
.7835
.7462
.7107
.6768
.6446
.6139
Discount EPS
14.7
16.8
19.2
21.9
25.0
28.6
32.7
37.4
42.7
48.8

Total Discounted EPS for 2002 to 2011 = $2.88

The EPS row is filled in by simply estimating EPS in the current year (2002) and then multiplying by 1.2 (20% growth) each year into the future. The Discount factor is calculated by dividing 1 by the discount rate, or 1/1.05 for 2002, which is .9525. Then for 2003, you divide .9525 by 1.05 again to get .9070, and so on until by year 2011 every dollar of earnings is only worth 61 cents today. The discounted EPS is the EPS from the first row multiplied by the discount factor, thus in 2002, the EPS of 15.4 cents/share is multiplied by (discounted) .9525 (15.4 X .9525 = 14.7). Then the total Discounted EPS is simply the sum of the Discounted EPS for all ten years across the bottom row, which in this 14.7 + 16.8 + 19.2 + ... + 48.8 = 288, or $2.88.

Our approximate discounted value of People's Food's EPS to be produced over the next decade is $2.88. The current July 2002 market share price of People's Food stock is about $1.25. This the market price today is a discount of 57% from the intrinsic value of the business. A discount of 50% or more offers a large margin of safety to investors buying the stock today with a long-term appreciation view.

Forward Projected PE: We also do a reality check by looking at what the stock price would have to be to achieve a reasonable PE ratio within the specific industry 5-years into our projection. In this case, People's Food would be expected to achieve a PE of about 10-times earnings in the basic foods/meat industry. Our Intrinsic value table tells us the forecast EPS in 2006 is 31.9 cents, thus to achieve a PE of 10 the share has to reach $3.19 (31.9 X 10 = 319). A share price of $3.19 is an annual compounded appreciation (from $1.25 in 2002) of over 20%, and a total return of over 150% before considering dividend income.

Dividend Income: Today most investors are focused on capital gains, looking to buy a stock at a low price and sell it at a higher price, especially in a capital-gain tax-free environment like Singapore. However, for the long-term investor dividend income is very important. Do you realize the United States DOW index, founded by Charles Dow in 1896 with a value of 40 and growing to over 10,000 by 2000, would have grown to about 700,000 if it would have reinvested all dividends along the way. Dividends do matter!

For our People's Food example above, here's a quick projection of dividend income over our 10-year forecast, with the assumption that PFood is able to pay-out 40% of net EPS each year as a dividend.
People's Food Dividend Projection
Year
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Dividend
6.2
7.4
8.9
10.7
12.8
15.4
18.4
22.1
26.5
31.8

Total Dividends collected 2002 to 2011 = $1.60

The simple dividend projection table above tells you, as a patient investor in People's Food over the next decade, if it achieves 20% EPS growth each year and pay out 40% of net earnings as a dividend each year-- you will collect total dividend income over the 10 years of $1.60, which is more than the entire initial investment of $1.25/share! It is important for long-term investors to consider the effects of both efficiently utilized retained earnings (which drives capital gains) as well as dividend payouts. Of course, you can choose to reinvest your dividend each year to purchase additional shares of People's Food stock and achieve the compounding effect we saw in the Dow.

We keep screening local stocks to assess their performance based on the first 7 screens, and the highest scoring businesses are valued using step 8. None of the screens can stand alone, but in combination, they are pretty powerful. Our results have been good to date. After selecting fine businesses, we try to be very slow to sell them, even after a sharp and significant price rise. We believe we will come out ahead by achieving long-term compounding of dividend income and high-ROE retained earnings, as opposed to short-term capital gains. Our ultimate goal is to find eight businesses we can purchase at attractive prices and hold them for a decade as they achieve total returns in excess of 1000%.