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.
1. 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 Colgate-Palmolive (NYSE:CL) sells toothpaste. It's about understanding the company's competitive position and what drives increases or decreases in sales and costs -- for Colgate, that's commodity exposure, key customer relationships, and new-product development, to name a few.
2. 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 Novartis (NYSE:NVS), or from distribution systems and scale like those enjoyed by PepsiCo (NYSE:PEP), which also enjoys a recognizable brand. All of these qualities allow companies to maintain high returns on capital and equity, and stay profitable over the long term.
3. 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. Fastenal (NASDAQ:FAST) is a great example in this area.
4. 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 Paychex (NASDAQ:PAYX) as I am a company with a moderate amount of debt such as Pfizer (NYSE:PFE), so long as the cash flow is there to cover interest and debt payments. Beyond debt, I want to see a company that has a return on invested capital in excess of its cost of capital. This means that the company is generating cash rather than losing it, improving its free cash flow generation over time.
5. 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 Portfolio Recovery Associates (NASDAQ:PRAA), 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 here's the key to this strategy: By being conservative with discounted cash flow valuations, I should avoid a large number of expensive mistakes that would otherwise destroy capital.
To get started with a value-based approach like this, consider a free 30-day trial of Motley Fool Inside Value. With your free trial, you'll get access to the two most recent selections, all past recommendations, our online discounted-cash-flow calculator, and our dedicated Inside Value discussion boards. Click here to learn more. There's no obligation to subscribe.
This article was originally published on Jan. 12, 2006. It has been updated.
Colate and Pfizer are Inside Value selections. Portfolio Recovery Associates is a Motley Fool Hidden Gems recommendation.
Nathan Parmelee owns shares of Portfolio Recovery Associates, but has no financial stake in any of the other companies mentioned. You can view his profile here . The Motley Fool has an ironclad disclosure policy .
