INVESTORS SHOULD UNDERSTAND THAT THESE ARE NOT THE ONLY QUESTIONS THAT CAN BE ASKED WHEN VISITING COMPANIES. DEPENDING ON THE BUSINESS, SOME OF THESE MAY NOT BE RELEVANT.
Many other questions may come up, especially questions pertinent to a specific industry.
As mentioned above, the questions asked to understand an insurance company are very different that the questions asked to understand a software company. Different types of business have different sets of questions which will be pertinent to understanding that business.
WE DETERMINE WHAT THE VALUATIONS ARE FOR THE STOCKS IN THE INDUSTRY GROUP AND WE SORT FOR THE LOWEST PRICE TO GROWTH RATE.
Other firms have different investment parameters. We use several factors and valuation parameters to pick stocks such as: Price to Book value, Price to Earnings ratio, Cash Flow per Share, Earnings per Share, Enterprise value to EBITDA, and many more.
The appropriate valuation metrics will differ with different industries. As different businesses use different financial valuation methods to determine how they are doing, an analyst must also look at different parameters to value different types of companies. A steel company is looked at in a much different way than a retailer. A bank is valued using much different metrics than a retailer and so on. Once we have done our analysis and spoken to analysts and, if possible, the company.
We rate the companies by valuation looking at both the current and expected valuation. For example, we look at the current P/E ratio and other valuation metrics, as well as next years, two years, five years etc same for other valuation metrics.
A valuation is a function of not just current earnings, but also of many other financial ratios including book value, enterprise value, cash flow, EBITDA and others. It is also valued on other financial metrics and on the discounted value of various future dates in many of these metrics.
Finally, an array of valuations for comparable companies is created and for that the best opportunities are selected.
THE STOCK SELECTION PROCESS
Let me give you an example of part of the process that we often undertake to pick stocks for investment at GIM.
1. We look for companies that have fallen in price or have not appreciated recently due to:
- Stock market declines leaving the stock cheaper on a statistical basis that its mean valuation over the past 10 years.
- Industry group declines due to cyclical reasons or due to market perceptions about a specific industry.
- Company specific problems that lead to a stocks underperformance for a period of several quarters.
- Problems of market perception that lead to undervaluation because the market does not understand the nature of the company and it prospects, or the market has a difference of opinion with us as to the appropriate valuation for the company.
2. Once the proof of low valuation is established, determine by thorough research and communication with the company, industry peers, competitors and analysts that the problem is short lived or is drawing to a close and a new day is dawning for the company. Outside proof of this is reassuring, like insider stock purchases, changes in the company’s growth rate, etc.
3. Wait until the end of the period of underperformance is approaching in your judgment and begin to accumulate shares.
4. Use the following traditional valuation parameters EV/EBITDA, PE, Price/sales, discounted cash flow, earnings models, cash flow models, inventory turns, etc.
5. Be sure to account for enough strength in the balance sheet to avoid unnecessary and dilutive financing if current cash flow is a problem.
6. In turn around cases, the cash flow statement is important. Be sure to know and understand the sources and uses of cash for the coming months.