Just one year shy of a decade of experience investing my own money, I find that while I'm pleased with my portfolio, there's room for improvement. I'm spreading my money across too many positions and not putting enough cash into my best ideas. As an investor who spent his first five investing years with a portfolio that never exceeded 10 companies, I've allowed the idea of quantity over quality to seep in, and I now find myself with more than 20 companies.
Holding more than 20 companies does provide diversification, but not much more than I would get by holding a more Buffett-and-Munger-type focused portfolio of 10 to 15. It's my goal to get back to just such a concentration of companies, with a heavier focus on my top five ideas than my bottom five. I'm sure many other investors could benefit from a similar approach, so I'm going to share the five traits I'll be looking for in the investments on which I plan to double up.
An understanding of the business and its underlying fundamentals. This is the simplest of all the requirements, but one that investors often overlook. It goes deeper than knowing that Clorox
Strong competitive position. The best investments offer customers unique goods and services, making them more able to endure in the long term. This strength can come from patents such as those held by pharmaceuticals like Bristol-Myers Squibb
Shareholder-friendly management. Management needs to show that its interests are aligned with its shareholders'. This manifests itself in many ways, but the obvious indications are sound allocation of capital, opportunistic share repurchases, increasing dividends, and moderate compensation and dilution from stock options. TJX
Strong or improving financials. The most important thing here is not to confuse lack of debt with financial strength. I'm just as happy to consider a debt-free company like Buckle
A fair price. I've saved the most important step for last. If everything else looks good, but the stock is overpriced, the company might be a candidate for my watch list -- not my portfolio. Paying a fair price means being fanatical about valuation and discounted cash flow analysis.
Foolish final thoughts
Finding companies that meet all five of these criteria won't be easy, but I'm not expecting to hold more than eight to 10 companies in such a high concentration. To make the strategy work, I plan to gradually build up positions in companies like Costco(Nasdaq: COST), which I currently own and think is fairly valued to slightly undervalued. I'll most likely sell a few companies that come up short on one or more of the items on the list. But the key to this strategy is that by being conservative with discounted cash flow valuations, I should avoid a large number of expensive mistakes that destroy capital.
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Anheuser-Busch is an Inside Value selection. Costco is a Motley Fool Stock Advisor recommendation.
This article was originally published on Jan. 12, 2006. It has been updated.