Vad's Best Ideas

"When somebody buys a stock it's because they think it's going to go up and the person who sold it to them thinks it's going to go down. Somebody's wrong."

If someone actually has read most of my previous posts one thing should have become obvious- I am not afraid to sell my positions quickly if something changes my view about a particular stock or sector but in other cases when I believe market is overreacting I simply stick with a losing position and even double down several times if necessary. No one out there is always right or wrong so there is little reason to be stubborn either way...In my latest post I stated that I have no intention whatsoever of stepping into the dangerously reckless "double or nothing" game just so I can win this contest and I will stick with this promise...Instead of chasing bubbles I'll now go back to the usual staff- stating my opinions on various things.

Over the course of the last several months I have received numerous e-mails from fellow posters asking me to explain in more detail why and how do I pick stocks. So, while trying to refrain from boring people to death in the next several posts, I will to try to explain my investing philosophy to anyone who is interested. Remember this is just my personal way of doing things- and while it has worked for me very well so far- there are numerous ways to be successful in investing and the key is to never stop learning...

First and foremost- word of advice- try hard to limit the information overload that we are all subject to every day. I spent most of my early "investing career" listening to talking heads on Bloomberg, MSNBC every day as well as reading tens of different newspapers, magazines and web sites. One thing I learned was as a result, that by the time I was done reading/listening, my initial opinion of the stocks that I held in my portfolio that same morning has changed dramatically. So I traded them mercilessly... And, as we all know, overtrading makes it some much harder to make money in the long haul. Next time you hear Cramer screaming "booya" - simply flip the channel to the Cartoon Network and buy the stock of the first company that you see advertising their products there. Over the long haul the end result is likely to be very similar...

The only newspaper that I personally try to read day EVERY day is the Wall Street Journal. I think that the main reason for that is the fact that WSJ provides me an objective and mostly unbiased overview of the main events in the markets without overloading my brain with the "analysis" part that I can do quite well on my own. I don't intentionally watch any TV shows related to stock market - period.

Now back to the stock picking part. Here are some of the key principles- I only buy stocks with a "business model" that I can understand. It is somewhat different from what Warren Buffet teaches and believes in. I don't necessarily believe that I have to understand in great detail the underlying product, service or technology that a company is providing- knowing the concept is sufficient for me. However, understanding the fundamental way of how the company makes money from these products is a "MUST". While customers are the ultimate judges of how good the products/services are, we- as owners (yes investing means owning a piece of company) should be concerned predominately with how they can money out of this product/service. Does the company have a recurring revenue stream vs. one time sales? Does it have long term contracts with customers? Is it responsible for any warranties/liabilities after the sale has occurred etc.?

Because of the business model differences, fundamental investing based purely on ratios like P/E, P/S etc to me is absolutely silly. What's more, I think ratios like Price/Sales are almost worthless and could be misleading for an average investor. Screening for stocks with the lowest P/S ratio will probably result in a bunch of stocks that either are retailers or simply have an extremely low profit margin. Same thing with (all the "value" guys out there- please close your ears) pure Price/Book ratio. Yes, I know that the fundamental difference between value and growth is defined based on this ratio, but unless we make some significant adjustments to it (like taking all the intangibles out or adjusting for market values instead of historical ones for the assets on the balance sheet) this ratio is not of much stand-alone value either.

To a certain degree the same thing could be said about the "absolutely overused and overrated" P/E ratio. This ratio is almost worthless without the other fundamental part - expected future growth rate of earnings. And that's were the fun part begins. Out of all the simple ratios out there I pay the most attention to the one called PEG.

It tries to estimate a relative worth of today's earnings based on their expected growth in the future. It is now readily available and some investors use simple "rule of thumb"- buy any stock with a PEG of under 1. I don't think it's quite that simple, but if you are going to use any ratios out there, PEG is definitely more valuable than most. It's most significant drawback is that the "growth" part is based on the average of analyst expectations and thus if the stock is not widely covered it might become difficult to estimate.

I usually use my own back of the envelope calculation to do a sanity check to make sure that these analysts are not blowing smoke before I pull the trigger. (To those who aren't yet bored - To do so I use a derivative of Gordon growth formula I learned back during my CFA studies- g("Expected growth") = ROE * dividend retention ratio ("1-dividend payout ratio"). To determine the sustainable ROE over the next five years you could use the DuPont-like analysis (profit margin, asset turnover and leverage) and so on so forth)...

I think that's enough for today... To be continued in the next few days:) Below is a quick take on a first batch of my holdings, as I am likely to hold most of them all the way to till the end of December unless something extraordinary happens. (Don't forget that due to the short-term nature of this competition my selection process for this fund is somewhat different from the core one...)

Consumer Staples
- Tobacco- RAI, CG and MO all provide stable income stream, dividend and attractive downside protection (little to no cyclicality in earnings) at a reasonable price. The main risk here is the potential regulatory impact if the latest legislation proposal actually goes through.

Tech:
- EBAY- core auction business is a cash machine, while PayPal is the real hidden gem as it will end up owning the e-commerce space that will be growing at 20% a year as far as eye can see.
- ARRS/CCBL - this is my merger arbitrage play- ARRS has put a bid to buy CCBL a while ago and market has been punishing them ever since. Both stocks are technology plays in a telecom sector, ARRS has cleared all of my fundamental checks, and merger rationale makes perfect sense to me .According to the market the price they offered for CCBL might have been a bit steep. And while I agree in general the punch line is that if the deal closes- CCBL is worth more than it is trading at today. ARRS looked undervalued for a while, which should in turn lead to a handsome profit on both. If the deal falls through (unlikely but possible) ARRS should spike up and offset any losses on CCBL. Hence nice profit potential with lower risk.
- MGI- bottom fishing here, might buy more if this one falls below $14. Explained my reasoning before, still like the core business, however, the scale of ETFC write downs scares me a bit. Market is way to conservative here but it could stay irrational longer than I expected and thus force MGI to sell assets at a discount...
- QLD- is a simple double play on QQQQ- roughly equivalent to 10% allocation to tech sector.

To be continued...
Trade safe and cheers,

Vad

Comments: View Comments |  Monday December 10, 2007  |  Stocks: ARRS, CCBL, CG, EBAY, MGI, MO, QLD, RAI,