We frequently write about our investment criteria and its importance on stock selection. As long term investors we are constantly searching for companies that meet these criteria. Today I wanted to briefly outline these and list several companies we are currently invested in, or interested in, investing but there is an insufficient margin of safety.
Generous Free Cash Flow
Typically, we look for companies that generate at least 15% of revenue into free cash flow. We also seek companies with at least a 10 year history of meeting this goal. This is important for several reasons:
Free cash flow is a very difficult measurement to distort or fictionalize.
Free cash can be utilized to reduce general ownership or pay dividends. We generally like to see slightly above average dividend yields and substantial share re-purchases.
Free cash flow allows companies the flexibility to take advantage of new business opportunities.
Pristine Balance Sheets
By our nature, we are a risk adverse investment team. It’s difficult for a company to go bankrupt when it doesn’t have any debt. In addition, the ability to access capital markets is generally (but not always) easier when debt levels are low or non-existent.
Solid Management
We look to do business with people we trust and admire. While it’s impossible to sit with each company’s CEO, we like to get to know them through their actions and their words. Three critical pieces to ascertaining the quality of management are:
High Returns on Invested Capital (ROIC): We believe management must create a long term and sustainable business model where return on capital exceeds cost of capital. Solid management identifies ways to improve product, beat competitors, and achieve pricing control to meet this goal. Great managers (and companies) do this year after year.
Clear and Concise Communications : We like to read and hear corporate communications where management is clear about the current business environment, choices facing the business, and a clear path forward. We don’t invest in companies where CEO’s use acronyms, consulting buzzwords, or can’t answer at least one question a quarter without a simple “yes” or “no”.
Pay Structure and Incentives : We like to invest in companies where management’s and shareholders incentives/rewards are aligned. We look for these measurements to focus on the creation of long-term, sustainable value to the company.
Margin of Safety
Without a doubt, we recognize the short comings of our evaluation and valuation tools. To that effect we look to utilize Ben Graham’s concept of “margin of safety”. Simply put, we look to purchase companies at a significant discount to our valuation. The amount of discount differs by size, financial condition, industry, etc.
Utilizing these criteria, look at the following companies as tremendous investment opportunities. Some are at a level to purchase today, while others currently do not offer an adequate margin of safety. Over the next several weeks I will evaluate each of these and offer our specific thoughts on each company.
As always, we look forward to your comments on our writings.
List of Recommended Stocks
FactSet Research Systems (FDS, Financial)
Expeditors International of Washington (EXPD, Financial)
Corporate Executive Board (EXBD, Financial)
Graco (GGG, Financial)
3M (MMM, Financial)
Franklin Resources (BEN)
Strayer Education (STRA)
Coach (COH, Financial)
The author is currently long FDS, EXPD, FAST, EXBD, GGG, MMM, and COH.
_____________
Mr. Macpherson is a partner at Macpherson Consulting Group. He specializes in corporate strategy and financial modeling. He received his undergraduate and graduate degrees from Harvard University.
Generous Free Cash Flow
Typically, we look for companies that generate at least 15% of revenue into free cash flow. We also seek companies with at least a 10 year history of meeting this goal. This is important for several reasons:
Free cash flow is a very difficult measurement to distort or fictionalize.
Free cash can be utilized to reduce general ownership or pay dividends. We generally like to see slightly above average dividend yields and substantial share re-purchases.
Free cash flow allows companies the flexibility to take advantage of new business opportunities.
Pristine Balance Sheets
By our nature, we are a risk adverse investment team. It’s difficult for a company to go bankrupt when it doesn’t have any debt. In addition, the ability to access capital markets is generally (but not always) easier when debt levels are low or non-existent.
Solid Management
We look to do business with people we trust and admire. While it’s impossible to sit with each company’s CEO, we like to get to know them through their actions and their words. Three critical pieces to ascertaining the quality of management are:
High Returns on Invested Capital (ROIC): We believe management must create a long term and sustainable business model where return on capital exceeds cost of capital. Solid management identifies ways to improve product, beat competitors, and achieve pricing control to meet this goal. Great managers (and companies) do this year after year.
Clear and Concise Communications : We like to read and hear corporate communications where management is clear about the current business environment, choices facing the business, and a clear path forward. We don’t invest in companies where CEO’s use acronyms, consulting buzzwords, or can’t answer at least one question a quarter without a simple “yes” or “no”.
Pay Structure and Incentives : We like to invest in companies where management’s and shareholders incentives/rewards are aligned. We look for these measurements to focus on the creation of long-term, sustainable value to the company.
Margin of Safety
Without a doubt, we recognize the short comings of our evaluation and valuation tools. To that effect we look to utilize Ben Graham’s concept of “margin of safety”. Simply put, we look to purchase companies at a significant discount to our valuation. The amount of discount differs by size, financial condition, industry, etc.
Utilizing these criteria, look at the following companies as tremendous investment opportunities. Some are at a level to purchase today, while others currently do not offer an adequate margin of safety. Over the next several weeks I will evaluate each of these and offer our specific thoughts on each company.
As always, we look forward to your comments on our writings.
List of Recommended Stocks
FactSet Research Systems (FDS, Financial)
Expeditors International of Washington (EXPD, Financial)
Corporate Executive Board (EXBD, Financial)
Graco (GGG, Financial)
3M (MMM, Financial)
Franklin Resources (BEN)
Strayer Education (STRA)
Coach (COH, Financial)
The author is currently long FDS, EXPD, FAST, EXBD, GGG, MMM, and COH.
_____________
Mr. Macpherson is a partner at Macpherson Consulting Group. He specializes in corporate strategy and financial modeling. He received his undergraduate and graduate degrees from Harvard University.
