Constructing a Winning
Portfolio
Lessons in Stock Analysis from
Master Investors
Key Questions for Investors
Out of all the possible stocks in the world, how do
you decide which ones merit a closer look?

Stock “screening”
What is your comparative advantage?
 Invest in what you know!
 What is your universe??
 Can’t just ask, would Warren Buffett invest in this
stock; need to ask, would Warren Buffett invest in
this stock if he were you??
How will you know when you are wrong about a
stock?
How will you know when you are right about a
stock?
Growth + Value
3 Legendary Investors:
Philip Fisher


Started in 1928, still investing today
“It’s quality that counts”
Warren Buffett


Berkshire Hathaway
Investing from a “business perspective”
Peter Lynch


Fidelity Magellan (1977 – 1990)
Invest in “understandable” stocks
It’s Quality that Counts: the
Philip Fisher Approach
Wrote “Common Stocks and Uncommon
Profits”
investing as a mix between science and art
investment decisions often boil down to a
judgment call about the relative importance
of relevant qualitative factors
wanted companies that could generate and
sustain long-term growth
Philosophy
Investment in “outstanding” companies that, over the
years, can grow in sales and profits more than the
industry as a whole.
Key features of “outstanding” companies:
strong management with a disciplined approach
designed to achieve dramatic long-term growth in
profits
products or services that have the potential for
sizable sales long term
other inherent qualities that would make it difficult
for competitors and newcomers to share in that
potential growth
Universe of Stocks
No restrictions on universe of stocks to select
from; OTC stocks shouldn’t be overlooked,
but “outstanding” companies not necessarily
young & small
Criterion for initial consideration:
15 points, divided into 3 categories:



Functional factors
Excellence in management
Business characteristics
Functional Factors
Products or services w/ sufficient market potential for sizable
increase in sales for several years; major sales growth, judged
over series of years
superiority in production - lowest cost provider of goods or
services
strong marketing organization - efficiency of sales, advertising,
and distribution
outstanding R&D - amount expended relative to its size;
effectiveness as indicated by ability to bring research ideas to
market
effective cost analysis and acctg. controls; choice of capital
investments that bring highest return
financial strength or cash position - sufficient capital to exploit
prospects w/o needing to sell additional equity
Excellence in Management
Entrepreneurial attitude among management - keep
innovating w/ new products or services to keep sales
growing
Development of good in-house management & teamwork
Management depth
Good labor and personnel relations; labor turnover relative
to competitors
Long-range outlook by mgmt., even at the expense of
short-term profits
Good investor relations & willingness to talk freely about
problems
Mgmt. of unquestionable integrity; salaries & perks in line
w/ those of other managers
Business Characteristics
Above average profitability



compare profit margins w/in industry and over
several years
older & larger firms usually best in industry
younger firm can have narrower profit margins if
spending (investing) a lot in research and/or
marketing
Ability to maintain good profit margins; good
position relative to competition due to:


skill in a particular line of business
patent protection
Secondary Factors
Once “outstanding” company is found,
purchase stock when it is out of favor
due to:
market has temporarily misjudged true value
of company, or
general market conditions
outstanding companies can be purchased at
fair value, but investors should expect a lower
(though still respectable) return
Monitoring / When to Sell
3-year rule for judging results if stock is
underperforming but no fundamental changes have
occurred
hold stock until there is a fundamental change in its
nature or it has grown to a point where it will no
longer be growing faster than the overall economy
don’t sell for short-term reasons
sell mistakes quickly once they are recognized
don’t overdiversify - hold 10 - 12 companies in a
variety of industries having different characteristics
“The Warren Buffett Way”
“An Unreasonable Man”


Influenced by Benjamin Graham and Philip Fisher
“The reasonable man adapts himself to the world. The
unreasonable man persists in trying to adapt the world to
himself. Therefore all progress depends on the
unreasonable man.”
– George Bernard Shaw
General Philosophy of Warren Buffett


Invest in stocks based on their intrinsic value, where value is
measured by the ability to generate earnings and dividends
over the years.
Target successful businesses – those with expanding intrinsic
values – and seek to buy at a price that makes economic
sense, defined as earning an annual rate of return of at least
15% for at least 5 – 10 years.
“The Warren Buffett Way”
Step One: Turn off the stock market.


Mr. Market and the Lemmings – the market as
manic-depressive
“After we buy a stock, consequently we would not
be disturbed if markets closed for a year or two.
We don’t need a daily quote on our 100 percent
position in See’s or H.H. Brown to validate our well
being. Why, then, should we need a quote on our
7 percent interest in Coke?”
“The Warren Buffett Way”
Step Two: Don’t worry about the economy.


“If Fed chairman Alan Greenspan were to whisper
to me what his monetary policy was going to be
over the next two years, it wouldn’t change one
thing I do.”
Buy businesses that have the opportunity to profit
regardless of the economy.
“The Warren Buffett Way”
Step Three: Buy a business, not a stock.

Four categories of tenets companies must satisfy
to be considered as potential investments:
 Business tenets
 Management tenets
 Financial tenets
 Market tenets
 Will be described in more detail later …
“The Warren Buffett Way”
Step Four: Manage a portfolio of businesses.
 “Know-nothing” investors should own a large
number of equities and space out their purchases
over time
 Use an index fund and dollar cost average purchases.
 Will enable investor to outperform a majority of
investment professionals

“Know-something” investors
 “if you are … able to understand business economics
and to find five to ten sensibly priced companies that
possess important long-term competitive advantages,
conventional diversification makes no sense to you.”
 If the best stocks you own present the least financial
risk and have the most favorable long-term prospects,
why would you put money into your twentieth favorite
choices rather than add to your top choices?
Back to Step Three:
Buy a Business; Not a Stock
Business Tenets:



Is the business simple and understandable? How
does it make money?
Does the business have a consistent operating
history? Do earnings exhibit a stable upward
trend?
Does the business have favorable long-term
prospects? Is the business a “consumer
monopoly” or a commodity-type business?
Monopoly vs. Commodity
Consumer monopoly:

Repeat business, plus one or more of following:
 Strong brand or other barrier (Nike, McDonald’s, Amgen
(patent), rock quarries)
 Necessary gateway for mfrs. to reach customers
(worldwide advertising agencies, newspapers)
 Provide necessary services (tax preparers, insurance)
Commodity-based business:

Low profit margins, low ROE, absence of brand
loyalty, presence of multiple producers, existence
of substantial excess capacity, erratic profits that
depend on management’s ability to optimize the
use of tangible assets
Buy a Business; Not a Stock
Management Tenets:



Is management rational? Do they invest the
company’s cash profitably?
Is management candid with its shareholders?
Does management resist the institutional
imperative?
Buy a Business; Not a Stock
Financial Tenets:


Focus on return on equity, not earnings per share.
Calculate “owner earnings.”
 NI + (D + A) – (capital expenditures necessary to maintain
economic position)

Look for companies with high profit margins.
 Want company’s management to view earnings as belonging to
the shareholders.



For every dollar retained, make sure the company has
created at least one dollar of market value.
What is the value of the business?
Can the business be purchased at a significant discount to
its value?
 “Margin of safety” to protect against mistakes
 Focus of Benjamin Graham
Investing in a Business: the
Warren Buffett Approach
Advantage of stocks over bonds

Stocks have opportunity for growth in yields
“Margin of safety” vs. “margin of protection”



“Margin of protection” comes from investing in
successful companies
Get good growth opportunities even if stock never
moves all the way up to its intrinsic value
Contribution to Warren Buffett’s thought from
Philip Fisher
Universe of stocks
No limitation on stock size, but analysis
requires some operating history
Criterion for initial consideration:
Consumer monopoly, not “commodity-based”
business
Strong management
Business that is easy to understand & analyze

also must have ability to adjust prices for inflation
Indications of capable management:






Strong upward trend in earnings
Conservative financing
Consistently high return on S/H’s equity
High level of retained earnings
Low level of spending needed to maintain
current operations
Profitable use of retained earnings
Valuing the Stock
You’ve found a promising company, now how
much should you pay for it??
Buffett uses several approaches, incl:

Compare investment in bonds:
 relative value = EPS / LT T-bond yield

Project value forward using historical data:
 estimate growth rate in EPS using past 10 years’
worth of earnings data
 future EPS = current EPS * (1 + est. g)
 multiply by high & low P/E’s over past 10 years to
get estimated future price range for stock
 Q: will this future price allow 15% return?
Monitoring / When to Sell
Prefer investment in small no. of companies that
investor can know & understand extensively

Diversification not favored
hold for long term

hold as long as company remains “excellent”
 consistently growing
 quality management operating for S/H’s benefit
Sell if:


these circumstances change, or
alternative investment offers a better return
“Invest in What You Know”:
the Peter Lynch Approach
Wrote “Beating the Street”
Bottom-up approach, selection from
among companies with which investor
is familiar, then through fundamental
analysis that emphasizes a thorough
understanding of the company, its
prospects, its competitive environment,
and whether the stock can be
purchased at a reasonable price
Philosophy
Investment in companies in which there is a wellgrounded expectation concerning the firm’s
growth prospects and in which the stock can be
bought at a reasonable price
A thorough understanding of the company and
its competitive advantage is the only “edge” that
investors have over other investors in finding
reasonably valued stocks
Find a “story” for the stock:

slow growers, stalwarts, fast-growers, cyclicals,
turnarounds, asset opportunities
Universe of Stocks
All listed and OTC stocks, but ...
Size DOES matter!
Other than that, specific criteria depend on company’s
story, but factors to examine include:








earnings - stability & consistency w/ an upward trend
P/E in lower range of historical average
P/E below industry average
(P/E) < (g + D/P) / 2
low levels of debt financing relative to equity financing
high levels of net cash per share
if co. pays a dividend, look for low payout ratio but long records
of regularly increasing dividends
esp. for cycicals, want inventory growth < sales growth
Other Favorable
Characterisitics
Boring name, product, or service; or company does something
disagreeable or depressing; or rumors of something bad about
the company
spin-off
fast-growing company in a no-growth industry
niche firm controlling a market segment
repeat-purchase product that customers must keep buying
even in bad times
not a technology producer, but can take advantage of
technological advances
low % of shares held by institutions; little analyst coverage
insiders buying shares
company buying back shares
Unfavorable Characteristics
Hot stock in hot industry
Companies (particularly small firms)
with big plans that are yet to be proven
Profitable companies involved in
diversifying acquisitions (“di-worseifications”)
Companies in which one customer
accounts for 25% - 50% of sales
Monitoring / When to Sell
As with Fisher & Buffett,



don’t diversify simply for the sake of
diversification, esp. if it means less familiarity w/
firm
for diversification, invest in several categories of
stocks, but invest in few enough firms that you
can still fully research & understand each firm
don’t put all your eggs in one basket, but don’t
use so many different baskets that you can’t
watch them all!
Monitoring / When to Sell
Review holdings every few months, rechecking the
company’s “story” to see if anything has changed sell if:


the story has played out as expected or
either something in the story fails to unfold as
expected or fundamentals deteriorate
Price drops should be viewed as opportunities to buy
more of a good prospect at cheaper prices
Consider “rotation” - selling played-out stocks with
stocks w/ a similar story but better prospects
Maintain a long-term commitment to the stock
market & focus on relative fundamental values
A sampling of other
approaches:
Value

Benjamin Graham –The Intelligent Investor;
Security Analysis
Growth



The Motley Fool –Rule Breaker / Rule Maker
Geoffrey Moore –The Gorilla Game
George Gilder –Telecosm Paradigm
Quantitative

Robert A. Haugen – The Inefficient Stock Market
Technical Analysis

Martin Zweig; Martin J. Pring; John J. Murphy