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Hello to the Value Investing board. I’m a newcomer here and it looks like a pretty good place to swap ideas. A friend suggested I get a membership, and when I saw it was free, I decided to join. After some poking around I found this discussion group, which seems to fit with how I look at the market, so it sounds like a good place to me. So I guess the first thing to do is introduce myself and then say something about my value approach. I’m a retired surgeon, living well and happily off my investments. Retired a few years ago at age 53, thanks in most part to what I’m about to describe. Having spent 25 or so years in and around the markets, I’ve tried just about everything, found lots of ways to lose money, until finally developing and settling on what is most likely called a value approach. So when I saw a “Value” group here, I thought this was the right place to start. The approach I’ll describe in this posting works well for me and I like to share it with others every chance I get. I started using an earlier version of this approach in the early 1990’s, still reading, learning, and trying to see how things fit. Then in 1993 I brought it up at a lunch meeting during a conference with some other docs, and there seemed to be some interest. So a bunch of us ended up forming an investment group, and lots of what follows is not purely my own thinking but rather the result of many others’ ideas. Some of them have stayed with it, while others have not. Most recently I taught all this in a two-day seminar at a local university, for the ninth time in the past 2 years. They just keep selling tickets and sending me checks, and I keep on showing up and talking about it. And I keep telling the school that I’d gladly do it for free, but for some reason they feel the need to pay me for something I just love to do. Anyway, what follows is simple, but not easy (like most good things in life). And it works….consistently. Sure, other methods work as well, and lots work better, but I can happily say it works as well as I want it to work. Sort of like the old MGB roadster I just restored…no A/C, a little noisy, but it runs great and does just what I want it to do.

So here’s what I call “doctor Jack’s seven-step process”. The basic idea is to find high-quality companies, buy their stocks when the share prices are more than a little under-priced, and sell them when the share prices become somewhat over-priced. (Did I just hear a loud collective “duh”?) I guess that qualifies me as a value (or “contrary”) investor, but I’m not much for labels. Besides, my wife says I’m definitely contrary but of little value these days. Moving on….I’m not interested in finding high-flyers and trying to hitch a ride on the way up. Rather, I like finding good (or even better, great) companies whose stocks are beaten down price-wise and then riding them back up to a point where the stock price makes sense again. In this way, I’m betting on the company, on my analysis, and on the market’s ability to eventually recognize quality. Sure, in the short run, much of Wall Street focuses on the next 1 to 2 quarters, and my approach usually takes much longer than that to produce profits. But in the longer run, once the next 1-2 quarters have passed by, and maybe even the following 1-2 quarters, it’s amazing how often folks will suddenly wake up and “discover” a company that has been lolling around at its lows for a few months. Then the ride up is just plain fun.

One disclaimer I need to make right here: I make heavy use of the proprietary data available at Morningstar for much of my analysis. This is not an advertisement for their services – not at all. In fact, I’m sure there are better sources of information available. I used to do all the work myself, but the small handful of dollars a year it takes for their service seems (to me) to be well worth it, mostly in terms of time saved. As you’ll see, I use their data as a starting point, not for actual signals. And when I first started using them, being me, I spent months validating everything they did and said, but now that I trust them, I accept their data (well, mostly). I’ve just always been a believer of leveraging the work of others when they can do things faster or better than I can.

Step #1: Limit the universe. A search for stocks to buy starts with identifying the universe of stocks to be searched. For many investors, this step is skipped; that is, they plan to search the universe of “all” stocks. However, my goal is to find companies which I believe are large enough and strong enough to overcome temporary adversity and which I believe have a strong future potential for growth. Plus, I like to keep my attention focused on a smaller number of companies so I can go as deep as I need to go. Maybe that’s just a sign of the getting-ready-to-turn-sixty syndrome. My wife says my attention span these days is commensurate with the hair left on my head. In any case, the following are all probably valid approaches: (a) use the 30 companies in the Dow Jones Industrial Average; (b) use the companies in the S&P 100 index; (c) create a list of personal favorite companies; or (d) use one or more on-line stock screens to find companies meeting a set of criteria. My own approach involves a combination of things:
• First, I use the MSN stock screener to find all stocks in the S&P500 index which currently pay a dividend. Of course, there are plenty of other ways to get this data; I’m familiar with MSN so that’s what I use. My thinking is that these companies are big enough (in the S&P500) to be interesting, and by paying a dividend they are returning at least some of the earnings back to the shareholders, which I take as a good sign. Yes, this keeps me away from some types of companies, but I can live with that. This scan takes a few iterations, since MSN only returns 200 stocks at a time.
• Then I add in a list of my favorite companies from my favorite industries. Where did these favorites come from? They’re just companies I happen to like and believe in. We all have our favorites, right? Maybe mine are non-dividend-paying big cap techs that I just like. Or maybe they’re smaller regional utilities that aren’t in the S&P 500. But they’re my favorites, and I want them to have a chance in the race.
Taken together, this made a list of about 450-500 companies the last time through.

Step #2: Narrow down the universe to only the best companies. My next step is to eliminate any companies which don’t meet a minimal set of what I call quality requirements. There are many ways to do this, including examining annual reports, looking at 10-year earnings, sales, and cash flows, looking at profits, and studying each company’s management. You name it and I’ve probably done it. To shorten the process at this point, as well as speed up my access to information, I use the proprietary information produced and published by Morningstar (again, this is not an endorsement….just how I happen to approach the problem). Specifically, I look at the following “grades” they assign to a company:
• Stewardship grade: the quality of the company’s management
• Financial health grade: the quality of the company’s financial statements
• Profitability grade: the past and current profitability of the company’s operations
• Moat grade: the size of the company’s economic moat (competitive advantage)
There are other grades they assign, but I’ve found these four to be the best for what I do. In addition, I want to make sure the company has been in business and publicly traded for at least 15 years (don’t want any newbies), and that over that time it has had a positive stock price compounded annual growth rate (CAGR). For this analysis, I retrieve the monthly historical price data from Yahoo finance (I used to keep individual spreadsheets on company price data which I laboriously updated monthly…no more….thanks to Yahoo and other sources of historical data). So, the details of step #2 are as follows:
• Stewardship must be at least “C” (basically a passing grade for management)
• Financial health must be at least “C” (again, passing for financial health)
• Profitability must be at least “C” (ditto for profitability)
• Moat must be “Narrow” or “Wide” (the company must have some sort of competitive advantage)
• Years of data must be at least 15 (any less than that and I pass)
• 15-year CAGR must be greater than zero (don’t want a company whose stock has lost money on average over the past 15 years)
The last time I ran this analysis against a pool of companies (about 450-500) the number of those which qualified was a little over 200.

Step #3: Analyze each candidate in detail. Now that the universe has been further limited, it’s time for the detailed and time-consuming work. Just because a company has made it this far doesn’t necessarily mean I believe its future prospects are bright enough to warrant my investment. Now I want to get to know each of the companies who passed all tests in step #2 in much more detail. Again, there are several ways to do this. My approach is as follows.
• First, I ask myself if I truly believe this company and/or its industry have a strong potential over the next 3-5 years. I study what the company does and how it does it. I look at its competitors and how they operate. Believe it or not, I read the annual and quarterly reports as well as the transcripts of any recent conference calls. If I’m convinced the company has a positive future, then it warrants further analysis. If not, it goes back with the others that didn’t make it past step #2.
• Next, I read the Morningstar analyst research report in detail, paying particular attention to the “bull” and “bear” case scenarios. Since I already subscribe to Morningstar for their quality metrics, I have access to the analyst reports as well. I’ve found these reports to be unbiased, informative, and insightful. (Once again, but probably not for the last time, this is not an endorsement…). I’m not looking for a recommendation to buy – rather, I want to get a further understanding of the company in case I missed something in my reading of the annual reports, etc. If after reading the analyst report I have uneasy feelings about the company, I take it out of the pool and put it back with those that didn’t pass step #2. So they (Morningstar) can’t talk me into a company, but they may be able to talk me out of it. By the way, if I disagree with them, I drop the analyst an email and usually get an answer quickly.
• Then I read the S&P research report, and possibly others, which are available through my online brokerage firm. Also I’ll look at any information I can find at Wikinvest and maybe a few other sites. Maybe also take a look at what people on the discussion boards are saying. This gives me additional perspectives on the company. What I’m looking for in these reports, etc. is something to talk me out of liking the company, since the only companies left in the pool at this time are those which I feel have the quality I’m looking for. If I find something I don’t like, I try to find out more information to see if it is something I can overlook. Some times I’ll drop an email to the Morningstar analyst who wrote the report I read earlier and ask them about what I’ve found to see what they have to say. At this point, if I’m still not satisfied with what I read in these additional reports, the company is removed from the pool and put back with the others that didn’t make it past step #2.
• Next, I read any news and alerts about the company. These are available through my brokerage firm and just about any of the major financial sites. Once again, I’m looking for warning signs. If something crops up which goes against what is now a positive view of the company, I go back to square one, trying to either resolve the issue to my satisfaction or else the company is moved out of the pool.
• Finally, I ask myself once again if I believe in the company. If so, it makes it to the next step. If not, then it goes back with the others.
At last count, the group of 200 or so companies making it past step #2 was reduced in size to a list of finalists consisting of about 120 after step #3. I keep track of the companies I’ve analyzed and my decisions for future reference. This now constitutes what I’ll call the list of finalists.

Step #4: Regular pool maintenance. This step is just painful. What I do is go back and repeat this process monthly, making sure that the companies currently in the list of finalists still meet all required qualifications. Sure, this takes some time, but it saves trouble down the line. Something else happening here is to see about including any new companies in the list. When I have a handful of new ideas, they start with step #1.

Step #5: Buying an initial position. This is the fun part – looking for companies in the list of finalists which are current under-priced enough to be buyable. To qualify to be bought, a stock must exhibit all (I repeat, ALL) of the following qualities. But first, a bit of explanation is needed. Since I subscribe to Morningstar, I also have access to their “star” ratings and price analysis data (again, no endorsement here). Using a multi-stage discounted cash flow model, they calculate a “fair value” (or intrinsic value) price for each company they follow. Then, based on the risk of each company, they further calculate a “margin of safety” for the fair value price, which results in a “Consider Buying” price. This may be 15-30% or so below the fair value price. (All this is nothing new to value investors.) Over the years I’ve developed and used a number of DCF models of my own. Their model does a fairly good job vectoring in on a fair value price which is usually near the average of the prices I would calculate from my three best models. So I’ve stopped using mine and started using theirs, mostly as a matter of convenience. But without theirs, I’d use mine with just as much confidence. Then, they apply their “star” rating to each company, based on the current price, the “buy” price, and the fair value price. A company receiving five stars is normally priced below the “buy” price, etc. So, my first requirement to buy a company’s stock is:
• Morningstar rating = 5 stars, or 4 stars with the current stock price no more than 5% above the “consider buying” price. This is another way of saying that the current stock price is at or below the fair value price discounted down by a margin of safety.
Next, using the 15-year monthly historical price data from Yahoo, I run a couple of sets of analysis on the stock price data. First, I run a simple regression model (using excel), and plot a chart of the stock price data along with the regression mean and lines showing 0.5, 1.0, 1.5, and 2.0 standard deviations on either side of the mean. This chart shows me how the stock price has bounced around relative to the regression mean and the standard deviation envelope lines on either side. Using this chart, my next requirements for a company before I’ll buy their stock are:
• The current price must be at least -1.0 standard deviation below the regression mean, and
• The current price must have pulled back to a point where it is at an equivalent (or near equivalent) level of other pullbacks in the recent 5-10 years.
Here I’m not talking about absolute price level. Rather, I’m talking about the relative level on the chart, which takes into account the regression growth rate of the stock price. If a pullback to $50 happened 5 years ago, and if at that point the price had dropped to about -1.5 standard deviations below the mean, and if this was the most significant pullback in recent history, then the current price pullback should also be in the neighborhood of -1.5 standard deviations below the mean, even though the price itself might now be at $60 or more. This may sound a little strange, but what I’m trying to find is a price level which is at the lowest extreme level relative to the annual growth rate. The basis for this is the idea that if the company is solid and has a good future, and if its growth rate is sustainable, then a significant variation from that growth rate is worth sitting up and noticing.
There are a few other data points which I like to look at, but they are not required. If all of these following data points fail, then I might be persuaded to look a little harder before buying the stock. However, if some of them are true, then so much the better:
• The latest 1-year stock price return should be no more than 50% of the 15-year stock price CAGR. This is kind of a no-brainer, looking to make sure the most recent 12 month return is well below the average yearly return.
• The latest stock price should be no more than 75% of the 1-year high price. Don’t want to buy stocks at their highs.
• The price ratios (P/E, P/S, P/CF, P/B) should be less than 80% of their 5-year averages. Sometimes the price ratios are based on faulty data, so this one is just a “nice to look at” item. But it is great when some of these ratios are well below their averages.
The first two items are available as a result of retrieving the data from Yahoo finance. The price ratios and their historical averages are available at a number of sites. Once again, these are not required, but they certainly add some sweet icing to an already tasty cake.

Step #6: Buying a second position. After buying the initial positioning a stock, I’ll watch it closely, and buy a second position if either of the following should occur:
• The price drops by 10% or more from my initial buy price.
• The price rallies and then drops back down to a point on the regression chart equal (in relative terms) to the point at which the original buy occurred.
Note that either of these is enough to warrant a second buy. However, before I do anything, I check the latest news and alerts and reports to make sure the company hasn’t run into any severe trouble.

Step #7: Selling a stock. I keep an excel spreadsheet of all current positions, and run it regularly to look for signs a stock should be sold. There are two basic reasons why I’d sell a stock: (a) the stock has reached a point where it is overpriced, or (b) the company no longer qualifies as a “high quality” company which I believe has a good future. In either case, I’ll sell all shares. The specifics are as follows…I’ll sell a stock if any (yes, ANY) of the following occur:
• The Morningstar rating is one or two stars. This is a sign that a stock’s price has moved well above the fair value calculation.
• The price reaches a point mid-way between the Morningstar “fair value” and “consider selling” prices. I don’t want to let it run too far…there are too many other good candidates around.
• Any of the Morningstar grade requirements in step #2 are no longer true. One note here…if one of the grades just drops a little (say, Profitability drops from C to C-) that might not be enough to sell the stock out of hand, but it is enough to make me go back and see what’s going on at the company to cause this grade to drop…sometimes I’ll send an email to the analyst asking for an explanation of the drop to help my thinking along.
• The share price has reached a point where it is +1.0 standard deviation above the regression mean, and the share price has reached a point which in relative terms it is at the highest point reached in the regression chart in recent history (both must be true for a sell to occur).
Also, the following are cause for concern, but not sell signals in and of themselves:
• The one-year price return for the stock is above 150% of the 15-year CAGR
• The current price is the 1-year high price
Finally, the following rule will always cause me to sell a stock:
• I no longer believe the company has a positive future. This comes from continual reading of research reports, news and alerts, and just thinking about the company in the context of its industry and the market as a whole.

To make things simple, I’ve built a few excel spreadsheets that go out to the Web and bring down the data I need, and then the macros do most of the manual work, flag any interesting signals, draw the charts, etc..

I guess that’s it….this approach has served me well, keeping me out of the deep weeds when things turn sour in the market and providing some nice profits along the way. As I write this I see many tasty candidates out there to buy, but then that’s usually the case (didn’t someone once say there’s always a bull market running somewhere….well, I guess my corollary is that there are always bargains somewhere). When the market goes through its normal gyrations, it regularly throws out some good ones with the bad ones, and that’s where all this pays off nicely.

If you’ve made it this far you probably needed an extra cup of coffee or one of those energy drinks. But honestly, any comments are certainly welcomed…this isn’t perfect and the best way to improve it is to hear what others have to say. I love to talk about the markets and investing, and I’m more than a little bit interested in what others are doing and how they handle things. In fact, I’d much rather hear about how someone does what they do rather than find out what stock they’re buying or selling today. Good stock ideas come along all the time, but (at least for me) good ideas about investing are much more worthwhile. In any case, take it a little bit easy on this almost sixty-year-old country doc, please. Who knows, I might even have removed your gall bladder a few years ago.

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Great post!

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Well thanks, SirTas. I wondered over there earlier today and you're right.
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You seem to have a great bed-side manner; something I severely lack in my kelbon incarnation, but maybe not so much in the real world — perhaps I should work on it, but I think I'll stop short of adopting the personality of a large canine critter (anyway, that's already been done).

Welcome to the Fool, you already seem to be having a love-fest with some over at the BMW board. OK, honeymoon's over, here's a question:

I read your 'due diligence' process with interest here on the Value Investing board, but first caught glimpse of you over at BMW.

There was one step or process of yours — as this is the Value Board — that I expected to find, I didn't. I wonder if you would care to comment?

What I expected to see was a screening for price to fundamentals — indeed, you do mention this in passing. However, you rely to a large extent on Morningstar's Fair Value, Consider Buying, and Consider Selling price points to trigger a buy or sell signal — or so it would seem.

My issue with some of Morningstars valuations is that, if a company is clearly a great company they tend to ignore, or at least minimize the importance of the stock price to fundamentals, presumably relying more heavily on past valuations and stock-price performance?

Here's an example of what I mean. Fastenal (FAST) is on of Morningstar's favored stocks and they have a Consider Buying price on it of $53.70. This gives it a trailing p/e of 40 and a trailing price/cash flow of nearly 35 (calculated from Value Line data). At $45.07 a share Morningstar assigns it a p/e of 33.1

So, using a standard Value Investing calculation at $53.70 a share Fastenal would initially return you 2.46% on your purchase, with a reasonable expectation of a mid-teen increase every year going forward. It would take a four years before your return approached the 5% that is approximately equivalent to today's 100% government insured 1-year CD rate. So, essentially you are taking on some risk to initially achieve a return of about half of what can be had risk-free. (Initial yield is calculated, for those who don't know, by dividing the earnings by the share price (1.32 divided by 53.70 = 0.02458, which is 2.458%).

Even given Fastenal's price history this isn't a historically low valuation compared to fundamentals, in 1998 it could be had for a p/e of 19 at that years lows. Nothing seems to have fundamentally changed about the company since then. in fact in 1999, ROE and ROTC were actually a little higher than they are today.

So, there's an example and my reason why I probably would not buy Fastenal at these prices, though I would love to at the right price.

So, I'm curious to if you give more weight to Morningstar's Five Star stocks with lower, rather than higher price to fundamentals, or if all the other hurdles are passed (all being equal except for valuation) in your method they are equal — and if so, why?

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Hi kelbon,

The offspring and their little ones are out in back spashing away in the pool, the grilling and eating are done at least for the present, and I thought I'd pop open a cool one and take a break from the cacaphony to check in at the fool for a minute. Found your posting...thanks for a much-appreciated break from an otherwise hot and noisy afternoon. Now I don’t know about the bedside manner you mentioned…surgeons don’t get much of a chance to chat with patients while they’re seeing them. And you’re right, it’s time to get down to work and find some future winners.

In your posting you wrote: “…you rely to a large extent on Morningstar's Fair Value, Consider Buying, and Consider Selling price points to trigger a buy or sell signal — or so it would seem.” I guess I wasn’t as clear as I should have been. I don’t use M*’s data as pure buy or sell signals…just signals to make me do some detailed analysis.

Regarding price as it relates to fundamentals, that's a key issue to being able to pull some profits out of the market, and here’s how I see it…I view stock price and company fundamentals as two separate issues. The fundamentals relate to the company and its business, while the price relates to the market's current valuation of the company's stock. If the company’s fundamentals are up to my standards, and if the price is low enough, then I see the stock as a potential buy. But both of these need to be true. Since you asked about FAST, let’s use it as an example:

The company itself seems to be in pretty good shape. The folks at M* seem to like it (talk about a love-fest), with superb grades for Stewardship, Profitability, Financial Health, and Economic Moat, just about anything else they can find to grade. So far so good. Also, it has enough data (15+ years) and a positive CAGR (18+%) over that time, so it meets my minimal criteria. It’s a strong player in a somewhat limited marketplace, and even with competition in its field (fasteners and other goodies) from GWW, and possibly from HD, and maybe even from LOW, it still has a strong brand recognition that seems worthwhile, and a future that seems bright. Again, so far so good. I don't find anything in the annuals or quarterlies to raise any alarms, and other analysts seem to like them as well. In all, I kind of like FAST also, but only as a potential date…not ready to ask it to the prom quite yet.

Having satisfied myself re: fundamentals, I will then need to move on to stock price itself. M* gives it a full five stars, since the current share price is some 15% or so below their “buy price” and about 27% below the fair value. OK, now this is starting to look interesting, but I need to look further before ordering a corsage for this one. So I fire up one of my trusty spreadsheets and it runs a 15-year regression analysis on the stock price. Here I find that the current share price is +0.13 standard deviations above the regression mean. (I use the excel built-in regression analysis module). A look over at the charts available on the BMW web site shows the FAST price to be right at the regression mean. (I guess our routines calculate things a little differently, or maybe the difference is due to 15 years vs. 16 years, but the result is nearly the same and certainly close enough.) So here's the big "Oops"….even with five stars and a nice discount below the M* fair value, the price is still not nearly low enough relative to its past to warrant a further look from me. In order for me to get interested the price would have to be at least -1.0 sd below the regression line, and also at a point which is (on a relative basis using the regression CAGR) as low as the lowest price drop in recent history. This occurred back in the spring of 2003, when price dropped to between -1.75 and -2.0 sd below the regression line. At that time the price was somewhere in the $13 range. In today’s relative prices, a drop to that neighborhood in the regression chart would take it to about $27 or so. Therefore, I’d pass on this one.

Just for interest, some additional things I’d look at are the following. The current P/E is 89% of its 5-year average, which is a little high for my tastes. The current P/BV is 108% of its average, way too high. And the current P/S is 103% of average, again too high.

I have some of the same issues with M* as you noted in your posting. That’s why I do my own homework as well, and why I give the regression analysis equal importance to the DCF price analysis from M*. I think of my approach as progressively exclusive; each step along the way has the opportunity to remove a stock from further consideration. In this case, it was the regression analysis that did it. But I do agree with you…I would love to jump into FAST at the right price, which right now would be in the high 20’s or so, assuming the fundies are still in good shape. So my conclusion on FAST is that the fine folks at M* are probably right on the fundies, and they may even be right on the price analysis, but it’s too rich for my blood at these prices. There are better candidates elsewhere.

Thanks much for the though-provoking posting…now it's time to go back out and see if the number of grandkids is still five.

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Hi Doc,

I would love to jump into FAST at the right price, which right now would be in the high 20’s or so, assuming the fundies are still in good shape. So my conclusion on FAST is that the fine folks at M* are probably right on the fundies, and they may even be right on the price analysis, but it’s too rich for my blood at these prices. There are better candidates elsewhere.

My quick rule of thumb usually is if the stock doesn't initially yield the equivalent to a one-year CD, or ten-year treasury, take your pick — currently a yield of about 5% which translates to a p/e ratio of about 19, then I have to find a very, very good reason to buy at a richer valuation (next I'll look at price to cash flow and see what the spread is), I already alluded to this. Where I'm going here is that with FAST, a p/e of 19 would translate to a share price of $25.00 and as that's a trailing p/e I would start to get very interested at around $28.00. This coincidentally is the buy price you have arrived at by other means, so maybe our roads taken are different but the destination the same, this time at least.

Talking about issues with Morningstar's valuations, currently Harley Davidson has a p/e of just over 13, but would require a 10% share price drop to meet their Consider Buying price. There's a current thread on HOG and its potential as good buy at these prices on the BMW board — which I'm sure you're already aware of. Feel free to chime in if you feel inclined; the more the merrier.

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