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This is a yahoo bulletin board response I posted earlier today to a fellow investor on how I pick stocks. The original poster is a student of buffett, hence the references.


Hi Shawn,

1. USG is interesting. It is on my watchlist to buy at $46. This is the max price which Buffett has been accumulating USG at. Of course, I missed out at the recent buy at 46.50, as if a 1% difference would have mattered over the long term :)

2. For me right now, the top filter before I start doing some serious due diligence would be: track record. Track record of revenues, earnings and free cash flow. This is a simple and yet often ignored metric. You see, it is ignored often because, the present and future is probably more important than the past, and most investors often buy based on an optimistic forecast rather than a consistent performance. Since you are a student of Buffett, check out the following book exerpt,

"Watch that track record. The best judgment we can make about managerial competence
does not depend on what people say, but simply what the record shows. At Berkshire Hathaway, when we buy a business we usually keep whoever has been running it, so we already have a batting average. Take the case of Mrs. B, who ran our Furniture Mart. Over a 50-year period, we'd seen her take $500 and turn it into a business that made $18 million pretax. So we knew she was competent. She's also 97 years old. In fact, now she's competing with us; she started a new business two years ago. Who would think you'd have to get a noncompete agreement with a 95-year-old"

Consistency of performance leaves you certain clues about the company as Buffett alludes to in the previous paragraph, firstly, it is probably run by a sane management team not doing anything rash, it probably has a good business model earning decent return on equity above 12%.

3. Once this filter is satisfied, I would usually put it in my to-do-more-due-diligence pile, and probably the next exercise would be to check out if it is currently "cheap" to own ? I like to use historic 10 year ratios to compare with the current. This is no guarantee that the stock that is 10 year cheap won't get cheaper or even zoom to zero. Again, companies do not become magically cheap without a reason, and if I can ascertain that the cheapness is caused by temporary problems, then perhaps it is worth taking a deeper look. What is temporarily cheapness ? Well, let me give you an example on one of my oldest holdings, KO. After peaking in the late 90s, KO went into a funk and move sideways and lower for the next 6 years. Different CEOs came and went, and analysts started being cautious about KO's business, how it could not compete with PEP, and the Carbonated Soft Drink moat was being breached.

When the then new CEO Isdell said that the earnings would take a hit because of a new expensive marketing campaign, and the stock sold off. Having a temporary hit on earnings (and share price) to build a better tomorrow doesn't sound too terrible a deal, no ? I started buying at around $40 in 2004. The primary indicator I used was the P/E ratio,

P/E Ratio 1997--> 40.7 47.2 59.4 69.3 29.5 27.4 28.7 20.8 19.8 22.3 <-- 2006

Of course I couldn't tell if the price would continue to go side-ways for the next ten years, but I knew that (a) I got in at a historical cheap, (b) the dividends were assuring (c) KO wasn't going to fall off a cliff anytime soon. In retrospect, I was lucky with KO since I only started investing in Oct 2003. (I have since made a lot of silly mistakesm like the time I double-down on KKD after it crippled 50% of my initial investment, and it proceeded with another 70% swoon... but I'll reserve that for another post)

So, how does one go about comparing historical 10 year metrics? There are several tools around, the popular ones are MSN moneycentral and Morningstar. Both can be gotten free and easy to use if you spend some time on the user interface.

4. These days, I try not to be too sophisticated in my investing, like trying to tease a Discounted Cash Flow into making an investment cheap. Simply put, an investment has to be obviously cheap to make it attractive to me. What is a cheap stock in plain sight ? Well, MSFT at $25 last year was a good price. Apollo Group was also an inflection point in 2006, ( you can read my write-up here: ). In the last 6 months, Citibank looked attractive to me, ( ). I own small positions in APOL, C and MSFT.

To quote buffett again,

"Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results."- 1974 Letter to Shareholders

5. For me, into my 3rd year of investing, I am tweaking some of my methods and putting some discipline into my stock selection. For example, I maintain a Want-To-Buy list, and a Do-More-Due-Diligence list. The WTB List essentially is a list of stocks that I will buy once the price of the stocks gyrates down to the buy price. The DMDD list is basically a list of stocks which I need to do more homework on, whether the business is sound, or too good to be true, (like PLB before it announced the books were cooked).

The other thing I am toying with in the past 6 months is the concept of holding cash, and buying my purchases in thirds. Ie. I buy 1/3 now, if it moves against me, say -15%, I'd buy another 1/3. The last 1/3 I will use sparingly, knowing that if after the last 1/3 the share price doesn't appreciate after a time period, then I'd have to check my assumptions and thesis again.

Hope this post helps

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