Taylor Investment Services

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Investment Philosophy

Ben Graham, the father of analytical investing, said that an investor should only "do those things as an analyst that you know you can do well, and only those things". Through continuous testing of performance and self-examination, I have striven to improve my investment technique while developing principles to shape my investment philosophy. These principles are as follows (in no particular order):

  1. Analyze the business, not the stock.
  2. Apply the circle of competence concept by focusing on specific industry groups.
  3. Rotate through a fixed population of companies.
  4. Place the highest emphasis on developing and following the story.
  5. Look for specific data to track.
  6. Use checklists extensively.
  7. Specifically identify factors behind future earnings growth
  8. Prefer businesses with free cash flow.
  9. Look for solid balance sheets.
  10. Avoid complexity.
  11. Remain specific.
  12. View stock volatility appropriately.
  13. Evaluate and scale according to the risk/reward scenario of a business and value.
  14. Continually study an investment style that already works.
  15. Be flexible.

These principles are described below.



Principles

1. Analyze the business, not the stock.

I focus on the business first, not the stock price, in the belief that over time the stock price will mirror the underlying progress of the business.

2. Apply the circle of competence concept by focusing on specific industry groups.

In the 1992 Berkshire Hathaway report, Warren Buffett said that "What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know". Peter Lynch called it investing with an edge. The key is knowledgeable buying and selling. I have attempted to enhance this approach by focusing on industries where my knowledge is the highest as evidenced by our own returns. I am also continually working to expand my circle of competence.

3. Rotate through a fixed population of companies.

I concentrate my efforts on particular industry groups because more opportunities can be reviewed that way with the same level of knowledge. For example, if one is following a single asset manager, it makes sense to follow several, because the same skills that master the first company can be applied to many others. This increases the odds that a profitable investment can be found, because the overall population of stocks can be expanded with less additional effort. After all, individual sectors are not homogeneous and stock prices fluctuate continually, offering opportunities to those who are watching - but you have to pay attention. Also, I believe the most attractive business is one that does what you expect. The actual results may or may not be favorable but what ends up hurting the company is generally not a surprise. And when an undervalued situation develops, I expect to be there to see it - the value will be obvious. I believe it is easier to identify an undervalued stock when you already know the company versus trying to identify an undervalued opportunity in a company you don't already follow.

4. Place the highest emphasis on developing and following the story.

I believe that even the most stable businesses experience peaks and valleys in performance. Therefore, I spend the majority of my time not in trying for absolute precision in estimating future earnings but in checking to see exactly how a company plans to increase its earnings and use its existing assets most effectively. Periodically I will check the situation anew to assess the company's progress.

5. Look for specific data to track.

I look for companies that have business models which lend themselves to simple mathematical analysis, that have some tangible, measurable visibility to future results. I like restaurant and retailers because their growth rates and results can be quantified; for example, if you compare how many units a retail company expects to open in the next 12 months versus the year before you can get an expected sales growth rate. You do not have to "guess" at the growth rate. I like asset managers because an investor can look at previous asset levels and current performance. Compare this with a business like wholesale apparel, which is more difficult to predict because growth rates do not lend themselves to easy measurement.

6. Use checklists extensively.

I use a systematic approach to analyze each possible investment and use checklists extensively to assure continuity and thoroughness in the investment process. Check the following link to see the latest version of this checklist; you will need the free Adobe Acrobat reader to view this document. TIS Stock Checklist

7. Specifically identify factors behind future earnings growth.

I believe that most explosive stock price rises come from a combination of strong revenue growth with solid margin growth, leading to significant earnings increases. As Peter Lynch noted, what makes a company valuable and why it might be more valuable tomorrow than today revolves around earnings and assets, but especially earnings. He noted there were five basic ways a company can increase earnings: reduce costs; raise prices; expand into new markets; sell more of its product in the old markets; or revitalize, close or otherwise dispose of a losing operation. I attempt to identify the sources of earnings growth in all selections, with a particular emphasis on finding a reason why the next year will be better than the last.

8. Prefer businesses with free cash flow.

I prefer companies that generate significant free cash flow, which is the amount of money available after all normal capital expenditures have been subtracted from net income. These companies have significant flexibility to buy back shares, pay dividends, or make acquisitions. They can also fund their operations internally, without need for outside capital sources.

9. Look for solid balance sheets.

I prefer to avoid trouble. Investing is almost like tennis: you can win by simply not losing. One way to avoid losing is to stick with companies with conservative financing, those with strong balance sheets. Manageable debt can be useful in growing a business but excessive debt can lead to problems. This can be easily seen on a personal level; mortgage debt is certainly appropriate in correct amounts, but when credit card debt is added to the mix a temporary loss of income can have a catastrophic impact on finances. I have simply chosen to avoid this problem entirely by focusing attention almost exclusively on companies with strong balance sheets.

10. Avoid complexity.

I try to keep things simple, relatively speaking. I like companies that can be found through the power of common knowledge, which can be easily evaluated, monitored, and identified when undervalued. I want to identify the easiest opportunity possible. Investing is not college football -- there is no strength of schedule involved in determining how much money you make. With some exceptions, our companies are as boring and pedestrian as they come. They have good balance sheets with lots of cash. They make money in ways that are easily understood. They have relatively simple annual reports.

11. Remain specific.

I do not make stock market or economic forecasts, unless they relate specifically to the business in question. I believe the health of the economy, the growth of GNP, and other large and general questions will not help you evaluate whether company ABC is a purchase candidate or not. In fact, such large deep-thinking issues can often obscure what is really important in a company.

12. View stock volatility appropriately.

I try to focus much more on the fundamentals of a company verses a stock price for that company. I believe that frequent price checks make an investor more liable to forget there is a real, live business behind a gyrating stock price. Stocks are invariably more volatile than the businesses they represent, and following a fluctuating price can introduce emotional elements into a decision. You base decisions on the stomach, not the head. Risk should not be defined by how much a stock price fluctuates, but rather by how inexpensively the stock can be purchased in relation to its intrinsic value.

13. Evaluate and scale according to the risk/reward scenario of a business and value.

TIS tries to be optimistic about our holdings, subject to verification, but also with the view that it is only what we own that can hurt us. This has often led to rapid portfolio turnover, especially when our positions are undergoing substantial volatility. In part this is a function of the type of stocks we follow. Retailers in particular undergo wide price swings, as their progress is usually updated monthly. You might think that having more information available would increase the patience and intelligence that investors possess but the opposite is often true. In essence, it appears that more information on a short-term basis results in a short-term viewpoint. Since this leads to substantial changes in valuation, we will buy and sell as circumstances dictate.

14. Continually study an investment style that already works.

From the beginning, I have carefully studied the philosophies and practices of very successful investors. My two biggest influences are Peter Lynch, former manager of the Fidelity Magellan fund, and Warren Buffett, the most successful investor of the 20th century. Both have written extensively about their investment approach. I have found Lynch, who wrote the books One Up on Wall Street and Beating the Street along with numerous magazine articles, to be particularly helpful, especially his stock category system and extensive industry analysis. Buffett is obviously the standard for long-term investment success and I have carefully studied his discussions of superior business models.

15. Be flexible.

I am continually attempting to refine and improve my investment technique. I have explored alternative investment techniques (e.g., merger arbitrage securities), industries (e.g., semiconductors), investment styles (e.g., very small speculative purchases in 1999 and 2000), and countries (e.g., Canadian securities starting in 2011). In the end, I am only interested in what works over the long-term and will remain open to anything which results in a fundamental improvement in my technique.