Throughout my 20+ years working in the financial markets, I've developed my own process for picking stocks that has generated strong results for my portfolio. Clearly, it's not foolproof and not for everyone. It takes what I call a "quantamental" approach (combining both fundamental and quantitative analysis), which might turn-off purists from both camps.
You see, many professional investors spend the bulk of their time trying to figure out whether earnings for a particular company will get better or worse in the future. I, on the other hand, look for stocks trading for less than their current earnings power, which, to be fair, is difficult in today's increasingly efficient markets.
However, because I know such opportunities exist and I've developed a system to find them, I can focus most of my efforts on this part of the story and let the rest of the markets fight over future predictions.
In short, my strategy focuses on what a company is doing today rather than what it may (or may not) do tomorrow. It hones in on boring companies that are cheap, which might not be appropriate for investors looking for the next big thing.
So catalyst-driven investors looking to bet on better (or worse) days ahead need not read any further.
For those of you still reading, I'd like to share some of my ideas in a little bit more detail. As a big believer in putting your money where your mouth is, I thought it best to illustrate my process with an example of a stock I bought (and still hold).
West Corporation (Nasdaq: WSTC) is typical of the stocks that my methodology would pick. It is a technology company that provides communication solutions to clients in a variety of industries. Its services include hosting conference calls and webcasts, delivering alerts and notifications, facilitating 9-1-1 calls and supporting call centers.
Simply put, it is a stable business that can weather the ups and downs of the economy. This is readily apparent from looking at the company's top-line growth over the past several years. This growth didn't come at the expense of margins, which have remained steady.
Importantly, WSTC generates strong free cash flow and high returns on capital, which management uses to service debt and reinvest in the business, including acquisitions (most recently, it announced the purchase of Health Advocate to bolster its healthcare vertical).
WSTC's debt levels, while high, have been trending down due to repayments, while its cash flow has more than covered its interest payments. The company also started paying dividends in the second quarter of 2013, with its most recent quarterly payment of $0.225 per share equal to a 3.4% annualized yield.
That's all well and good, but here's where my strategy differs from the rest…
To value the stock, I start with an estimate of what the company can earn on a normalized basis. Rather than looking at the numerous variations of "adjusted" earnings derived from the income statement, I focus on free cash flows, which is the unencumbered, cold hard cash a company generates that is less prone to accounting manipulation.
By assuming it earns this level of cash flows into perpetuity and discounting them at an appropriate rate (similar to how one would value an annuity), I can put a value on the current earnings power of the company, assuming no further growth or improvement. If this value is materially higher than the current market value of the company, the stock represents a compelling investment opportunity.
WSTC's free cash flow generation has been increasing steadily, driven by continued top-line growth, operating leverage and working capital improvements.
Although this growth trend is likely to continue going forward, if I assume the company will only maintain its current annual rate of approximately $350 million in cash flows forever, the value of this earnings stream equates to $6.2 billion. Adjusted for its net debt, the value of the equity would be $2.7 billion, or $32 on a per share basis. Combined with its dividend, this represents 25% total return upside versus the current stock price of $26.
In other words, if WSTC merely maintains its current level of earnings power (which is a very conservative assumption), the stock is worth 25% more than what it is trading for today. Any further top-line growth or improvement in margins would be an added bonus but not central to my investment thesis.
Risks to Consider: Risks related to WSTC include a deterioration in macro conditions, emergence of new competing technologies and low public float (the founders control roughly 70% of the shares outstanding).
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