Investment in direct equities

It may seem strange that an adviser who advocates index funds would also be a stock picker, but both direct and indirect investments are suitable, in various proportions, to meet a wide variety of client needs.

Direct stock picking has the advantage that you can cut out ongoing fees entirely, though of course a small up-front amount will apply. Since I am keen to minimise fees, obviously there is scope for direct stock picking, provided there are adequate controls of risk.

The disadvantages of direct stock investing are that portfolio maintenance is necessarily going to be more time consuming (for both your adviser and for you, the client), and that it can be difficult and expensive to achieve a meaningful amount of diversification when the amount of money you have to invest is not great. On the other hand, we have to seriously ask the question whether the extra amount of money you might make out of direct investment is really worth the effort when the amount of money you have isn't that much. For small portfolios, the potential reward in dollar terms that could be gained from outperforming the benchmark index would probably not be large enough to justify the time and money spent. If you are looking for a place to put a few thousand dollars, an index fund is probably the way to go.

I favour index funds because they are broadly diversified and hence at least in the longer term not particularly risky, tax efficient and inexpensive. I don't however believe that markets are the completely efficient perfect pricing machines that advocates of the Efficient Markets Hypothesis would have us believe. I am a keen follower of Warren Buffett, Benjamin Graham, John Marks Templeton, John Neff and others, who have established remarkable track records lasting decades of highly significant market outperformance. Indexing mainly works on the basis of low costs, not because of perfectly efficient stock pricing, therefore I have no objection to direct stock picking provided you can duplicate the economics of indexing, by minimising brokerage and market trading costs.

The first step is to decide what level of involvement you wish to have in the management of your portfolio. If you aren't prepared to put in the time to maintain your portfolio, time which includes buying and selling shares, keeping good records of dividends and buy/sell information for capital gains tax purposes, then you are probably better off with managed funds, either actively or passively managed ones.

Provided you are willing to do a bit of work, mostly of an administrational manner, we then need to decide on an appropriate investment policy.

By policy I mean how aggressive are we going to be in stock picking. In my opinion, value investing as practiced by Buffett et al is not significantly higher in risk than index tracking (if Buffett's track record is anything to go by, his portfolios have actually lost a lot less money in bad years than broad markets). Nevertheless, there is tremendous scope to decide what sort of stocks you want to buy.

Benjamin Graham, in his famous book The Intelligent Investor defined two types of investor:

Ben Graham, in the chapter of this book titled "The Investor and His Advisers", wrote the following:

"If the reason people invest is to make money, then in seeking advice they are asking others to tell them how to make money. That idea has some element of naivete. Businessmen seek professional advice on various elements of their business, but they do not expect to be told how to make a profit. That is their own bailiwick. When they, or nonbusiness people, rely on others to make investment profits for them, they are expecting a kind of result for which there is no true counterpart in ordinary business affairs.

If we assume that there are normal or standard income results to be obtained from investing money in securities, then the role of the adviser can be more readily established. He will use his superior training and experience to protect his clients against mistakes and to make sure that they obtain the results to which their money is entitled. It is when the investor demands more than an average return on his money, or when his adviser undertakes to do better for him, that the question arises whether more is being asked or promised than is likely to be delivered.

[...]

Certain common-sense considerations relate to the criterion of normal or standard results mentioned above. Our basic thesis is this: If the investor is to rely chiefly on the advice of others in handling his funds, then either he must limit himself and his advisers strictly to standard, conservative, and even unimaginative forms of investment, or he must have an unusually intimate and favourable knowledge of the person who is going to direct his funds into other channels. But if the ordinary business or professional relationship exists between the investor and his advisers, he can be receptive to less conventional suggestions only to the extent that he himself has grown in knowledge and experience and has therefore become competent to pass independent judgement on the recommendations of others. He has then passed from the category of defensive or unenterprising investor into that of aggressive or enterprising investor."

I use this passage to guide how I invest the money of my clients. I feel client education is an important part of my role as an adviser, because many clients wish to invest in the kind of opportunities only available to the so-called "enterprising" investor. Although many people with an aggressive temperament toward investment risk wish to participate in the more sophisticated strategies, ethical considerations mean that I cannot possibly encourage anyone to follow this path until they have obtained the required minimum amount of education to support this.

My methods of investing require a working knowledge of the art of stock valuation (actually, all forms of investment require a certain amount of knowledge of valuing what you are buying - Graham's definition of "investment" implies that you have some idea of the value of what you are buying, anything else is "speculation".)

You can pick up this kind of knowledge by reading the books I recommend to "level three" stock pickers in my list of recommended books. Alternatively, or preferably in addition, I will do my very best to ensure that you know how I valued the company, and the limitations vs advantages of the valuation methodology employed. As suggested by Graham, it is prudent when approaching a new adviser (including me) for a reasonably "unimaginative" investment approach to be followed at least at first. Therefore, unless you are an experienced investor I'll probably start you out with a mixture of index and active funds and a few "blue chip" type stocks, at least until I can explain the basis of my more complex investment strategies to you.

 How direct stock recommendations are made

Since I'm not a stock broker, I don't place the stock investments myself. Instead, I make recommendations to the various clients by email. These clients then log in to their own broker's accounts, usually a discount stock broker like Commsec or Sanford, and buy the shares themselves.

My job then becomes one of pure researcher, having clients place their own trades and use their own brokers is a good way to ensure that the advice is unbiased. Unlike full-advice stock brokers, who have a reputation (well deserved, in many instances) of encouraging clients to trade excessively in order to increase their commission income, my fees for direct stock recommendations are based on an agreed annual fee, with or without a performance bonus for outperforming an agreed benchmark. I don't charge by the transaction and I don't charge by the recommendation or by the amount that you choose to invest in any given stock.

Because I do my own research, and use a fully disclosed valuation strategy and explain exactly why I believe a particular stock is worth buying, or selling, and at what price, there is also no concern about biased research. I do buy the same stocks I recommend to clients, so once again if my investment decisions fail I'll end up feeling the same amount of financial pain as any client - I'd expect nothing less of any adviser I chose to deal with.

Providing direct advice in this way is an excellent alternative to the increasingly popular "individually managed account" or IMA, being offered by many fund managers. By recommending stocks directly, rather than managed funds, it is possible to maintain a low portfolio turnover and improve tax efficiency and of course to customise the portfolio. Individually managed accounts have these advantages as well, except in my opinion their fees are usually too high and thus I doubt most clients would benefit from them.

 A primer on how I select stocks - the enterprising approach

What follows is a description of the process I use to select stocks for my "enterprising" clients. Most of my clients are "defensive", which means I stick with large, healthy blue chip companies trading at reasonable valuations compared to the smaller companies I usually buy. Hopefully after reading this you'll understand why I don't think direct stock investing is a suitable endeavour for the majority of people and that most people would be better off with managed funds.

Before I go any further, I'll quote from The Intelligent Investor again. The following passage is one of the most famous pieces of investment literature ever written. The story of "Mr Market" has long been a staple of price conscious investors, and is one of Warren Buffett's favourite quotes. This passage helps provide the most clear definition of what is speculation versus what is investment ever put in print.

"Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers to either buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

If you are a prudent investor or a sensible businessman, will you let Mr Market's daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgement and inclination. He must take cognizance of important price movements, for otherwise his judgement will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed - this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view, such signals are misleading at least as often as they are helpful. Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator's primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell."

As a basic concept, it is helpful at all times to remember what a share is. A "share" is a piece of a business that can be transferred from one owner to the next. Owning a share doesn't give you entitlement to any particular asset of the company, but to a proportion of the whole enterprise. All sorts of things affect the price of a share, but the only things that affect the value of a share are the profits of the business, including expected future profits, and the yield that investors ought to be getting for holding that business.

Unfortunately, or fortunately, depending on your point of view, there are very few true investors. Warren Buffett claims that fewer than 5% of market participants, and he includes professionals in this, are investors with a long term view. The rest, regardless of what they say or think they are doing, are actually short term speculators.

Any accountant worth their salt should be able to come up with a reasonable valuation for a private business. The valuer makes an educated guess of the company's future profits, adds them up and applies an appropriate "discount" to these future earnings that takes into account the risks of the business and thus the uncertainty of his profit forecasts. Taking into account growth expectations in the business and operational risks, some companies are valued at, say, ten times their average current profits, while others may be valued at five times or twenty times. It does require a certain amount of judgement and is never an exact process, but nevertheless at least in theory a business does have an intrinsic value and this value can be calculated.

Just as in Graham's "parable", Mr Market does have all sorts of funny and often irrational moods that ensure that often the total market capitalisation (the share price x the number of shares = the total price of the entire company) moves substantially higher, or lower, than the intrinsic value of the company. If you can have an idea, at least approximately, what the company is worth, then you can then conclude whether or not the company appears to be over or under priced, and do your buying and selling accordingly.

As Buffett said though, true investors are few and far between. Most people perform some kind of mumbo-jumbo in their head that fails to make any attempt to value the company and instead relies on the trend in prices. If somebody knocked on your door every day and offered to buy your house you'd not be tempted to sell to him just because his price today is lower than the price he quoted yesterday and the day before, but for some reason many people base their business buy and sell decisions on just such a technique.

"Technical analysts", the chart reading soothsayers of the market who say things like "the trend is your friend", to a large extent advise the purchase of stocks for no other reason than because the stock price is higher than it was previously, and to sell for no other reason than because the price offered in the market is slightly lower. If your accountant valued your business in such a way you'd have him carted away, but this is a widely accepted and indeed staggeringly popular method used by many stock traders.

Here is a simplified example of how to value a business:

Assume that a company with $1 per share in net assets (book value, or shareholder's equity) is able to earn a return of 10% on these net assets (return on equity). They will pay one third of their profits out as dividends (a 33% dividend payout ratio), and you expect that in 5 years this company will sell at 10x their earnings in that year (a price/earnings ratio of 10). After considering the nature of the business, you decide that you'll need a return of 8%pa to justify the risk you are taking.

Book value
per share
Earnings per
share
Dividend paid Retained
earnings
Cash flow
for the year
$1 10c 3.30c 6.70c 3.30c
$1.067 10.67c 3.52c 7.15c 3.52c
$1.138 11.38c 3.76c 7.63c 3.76c
$1.215 12.15c 4.01c 8.14c 4.01c
$1.296 12.96c 4.28c 8.68c $1.339

It is easy enough to set up calculations like this in a spreadsheet like Excel, and it is a simple matter to "discount" this income stream (the final column) by 8% to arrive at a "net present value" of $1.03. (You can do this yourself in Excel with the function =NPV(8%,{range of cells}). Since the earnings in the first year are 10c per share, a $1.03 share price means that in this case a "fair" multiple for this share would be $1.03/10c = a price/earnings ratio of 10.3 times.

This means that if you want an 8% or better return, the most you should pay for that stream of dividends and the proceeds of the eventual sale at 10x earnings would be $1.03. This is the intrinsic value of this business.

Of course we had to make a number of assumptions for this valuation. I had to assume that in 5 years the stock would be trading at a price/earnings ratio of 10, and that the company would pay one third of its earnings out as dividends. I also had to guess an appropriate future return on equity. If any of these factors had been a little bit different, the intrinsic value of the share would be different. How do I know what numbers to assume?

This is a matter of educated guesswork, and we all know that these guesses have a margin of error in them which at times can be very large, and this is simply the nature of businesses. No manager will ever know how much exactly his business is going to return in the future, and no investor will know with any greater certainty of course. I look at capital expenditure and "economic goodwill", profit margins, sales growth, return on equity, cash flow, level of debts and other fundamental factors. On top of this, I seek a margin of safety.

Ben Graham popularised the idea of a "margin of safety" in The Intelligent Investor. The more conservative we are about our assumptions, the more likely we are to underestimate the intrinsic value of the company, which means the less likely we are to be disappointed if we buy it at our cheap price and the business doesn't thrive as expected. We can be conservative by assuming a future return on equity much lower than the one achieved by the company in the past, we can also assume that the price/earnings multiple won't be as high in the future. The more pessimistic we are when putting together our valuation model right now, the bigger our margin of safety. If we only buy companies trading at a discount to appraised value of at least 30%, then we won't be hurt if our estimate is off by 20%, because the stock would still be underpriced.

So, we've appraised the intrinsic value of the company and after checking the price on the market we find that the above company is actually trading at 70c per share. We can calculate the expected return if we buy the company at 70c, plugging this into Excel and calculating the internal rate of return (in Excel that is =IRR(range of cells)), we find that if the stock is trading at 70c we'll actually get a return of 17.34%.

This introduces a concept that is very important. All things being equal, the less you pay for this stream of cash flows, the better your future rate of return will be. If instead of 70c, the stock were trading at $2, our spreadsheet tells us that the future return based on these assumptions will actually be negative 6.04%pa for the next five years. Investors look at stocks in a completely different way to speculators: if the stock has fallen in price then we are getting that future stream of dividends and the proceeds of the sale in 5 years at a cheaper price, and therefore we are getting a better deal. To investors, a fall in price is great because it enables us to buy companies more cheaply than before.

Graham used to say you should buy shares the way you buy your groceries, not the way you buy your perfume. The essence of "value investing" (a tautology, obviously) is to look for opportunities in the market to buy businesses at bargain prices. Thus, the recent bear market hasn't really bothered me all that much, because as far as I'm concerned a bear market is a great time for long term investors, and there are all sorts of companies out there trading at very attractive prices, promising excellent future returns.

The example above is somewhat simplified, I have a few refinements in the valuation worksheet that I actually use, and I use several other valuation techniques based on earnings growth, profit margins and sales growth, and asset values. Nevertheless, this at least gives a general idea of how I value a company.

What happens if we buy a company and it slides even further? Well we'd take another look at the company to see if we've missed anything of course, but lacking any obvious fundamental cause most of the time the only reason why a stock slides is because "sentiment" is negative on it - hardly a concern for long term price conscious investors.

John Neff, manager of the famous Windsor fund whose book I recommend you read, had this to say in John Neff on Investing when a bargain stock he'd already put massive amounts of money into fell even further:

"Nevertheless, Citi dashed our hopes again. As 1991 progressed, only Citi, among Windsor's banks, failed us on the earnings side. So we did what seemed logical. With an average cost of $33 a share and a going price of $14 a share, we bought more shares."

At that time, Citibank was subject to overwhelming investor pessimism driven by questions about their ability to survive the early 90s bust in commercial property that occurred in the US at that time, which threatened to do all sorts of nasty things to their book of loans. Neff looked at the stock, decided that the pessimism was overdone, and bought heaps. When the stock fell further, he bought heaps more. Neff was convinced, after a thorough look at Citi's business operations that it could easily survive the present crisis, nevertheless the misery in Citi was not yet yet over for Windsor's shareholders.:

"At that point, Windsor owned 23 million shares; a half-billion dollars of shareholders' assets were at risk. Meanwhile, Congressman John Dingle, Chairman of the House Banking Committee, hinted that Citi might become technically insolvent, and stories circulated about a run on one of Citi's Asian branches. The price kept on sliding to nearly $8 a share in late 1991."

But this story did have a happy ending, it turned out that the problems with Citi were greatly exaggerated and by early 1992 earnings and the stock price were on their way back up. By the end of 1992, the position was profitable, and eventually Neff sold out at a considerable profit.

A quote I'll always remember from Neff: "To us, ugly stocks were often beautiful. If Windsor's portfolio looked good, we weren't doing our job."

This is why I'm keen to pursue this value approach only with more sophisticated clients. The best investment returns come from bargain hunting approaches, but a large degree of faith in our analysis is required to get the best long term results. It requires doing things that appear to most market participants to be just plain stupid, because it requires a contrarian bias where you tend to be buying what everyone else is selling, and selling what everyone else is buying. As someone once said, "group thinkers rarely crack the Forbes rich list".

It isn't so much that I'm looking for sick companies, quite the contrary. My value approach, at least the approach I use with "enterprising" investors is very much about looking for companies that are underrated by the market. The trick isn't to find good companies, the trick is to find companies that are a lot better than the market thinks they are. This means I'm looking for exceptionally good companies that the market has given only an average price, or reasonably good companies that the market has given a very low price. I don't buy terrible companies at low prices, nor do I buy exceptional companies at high prices. I'm looking for unrecognised quality.

If I genuinely believe that a company is going to fail, I would not buy unless I was sure that the price was so low that equity investors would get a distribution from the breakup, but generally I prefer not to take the ultra-distressed "vulture capitalist" approach.

An example of such a company that I picked in late 2002 was Challenger International (CLI). Trading at a price/earnings ratio of only 3 and a price/book ratio of 0.6, though with a reasonably strong balance sheet, rapid earnings and sales growth, remarkably high profit margins and a high return on equity that has been consistently high for many years. From November 2002 through to early January 2003, the stock mostly traded in a range between about $1.50 and $1.80.

My quantitative value models all forecast a future return exceeding 20%pa (on a time frame of 10 years), and showed a fair value well over twice the then prevailing share price. My first line of enquiry was to identify why exactly this stock was so cheap. The answers to that were quite easy to come by: an earnings restatement in October 2002, ongoing speculation about the viability of Challenger's property-backed annuity portfolio, weak cash flow in recent years as the manager invested significant money into a series of acquisitions, and changes to the board. Equally unnerving were the regular stream of announcements showing that the directors were reducing their personal stock holdings in a series of off-market transfers. With the rats apparently abandoning the sinking ship, the market reacted predictably and savaged the stock price. Only the sickest of companies should trade on price/earnings ratios like this, so I delved a little deeper.

I looked into the earnings restatement and found what I considered to be a perfectly sensible reason for that, which did not affect my valuation in any way. I also looked at Challenger's risk management processes and after having read various statements by management became comfortable that the annuity model was somewhat more solid than it was generally rumoured to be. In addition, management made statements saying that they were happy with the business and did not intend to make any more takeovers for the time being. With a new focus on consolidation of the business and improvements in efficiency, I anticipated an improvement in cash flow in 2003. From these investigations I concluded that all the bad news was probably already built in to the stock price and that further disappointments were unlikely. I recommended all "enterprising" clients buy significant amounts of this stock, and for the more aggressive ones this came to be quite a major holding in their portfolio.

One of the things that I find attractive about stocks like this is that all the bad news already seems to be well known by the market. Buying a company with well known and publicised faults is generally less risky than loading up on the perfect growth stock generally thought to be on its way up to another record profit. We need only look at Commonwealth Serum Labs and see how it performed from mid 2001 onward. This company, which was receiving rave reviews from brokers and analysts and was one of the truly "must have" growth stocks, looked to me in a highly precarious position. After seeing one particularly bullish report from a leading brokerage house that I shall not name to protect the guilty, in late 2001 this was a "strong buy" because they forecast earnings growth of 50%pa for the foreseeable future.

Neff again: "Rather than load up on hot stocks along with the crowd, we took the opposite approach. Windsor didn't engage in the market's clamour for fashionable stocks, we exploited it. Our strength always depended on coaxing overlooked out-of-favour stocks to move up from undervalued to fairly valued. We aimed for easier and less risky appreciation, and left "greater fool" investing to others.

This strategy gave Windsor's performance a twofold edge: (1) excellent upside participation and (2) good protection on the downside. Unlike high-flying growth stocks poised for a fall at the slightest sign of disappointment, low p/e stocks have little anticipation, no expectation built into them. Indifferent financial performance by low p/e companies seldom exacts a penalty. Hints of improved prospects trigger fresh interest. If you buy stocks when they are out of favour and unloved, and sell them into strength when other investors recognise their merits, you'll often go home with handsome gains."

"Brand-name growth stocks ordinarily command the highest p/e ratios. Rising prices beget attention, and vice versa - but only to a point. Eventually their growth rate can diminish as results revert towards normal. Maybe not in all cases, but often enough to make a long-term bet. Bottom line: I wouldn't want to get caught in a rush for the exit, much less get left behind. Only when big growth stocks fall into the dumper from time to time am I inclined to pick them up - and even then, only in moderation."

"For momentum investors, who pin their expectations to high growth rates, any slip in quarterly performance can cause grievous results. There is little solace in missing targets by tiny amounts, even though accounting practices leave ample wiggle room. Most companies that are close to earnings targets should meet those targets - particularly when the stock price hangs in the balance. In high p/e territory, if lofty growth expectations are missed by an inch, it may mean that a company has really missed by a mile. Whatever the actual amount of the miss, uncertainty alone can mete out tough punishment, and creative accounting practices ultimately catch up to offenders."

On 20 January 2003, Kerry Packer's investment company CPH Investment Corp announced a scrip based takeover offer on CLI, exchanging 4.5 shares of CPH for each CLI. Within days, CLI was trading at $2.10 a share, at which point most of my clients sold, making a handy 20% in a matter of just weeks. So, now we know why the directors were selling their shares!

This was somewhat disappointing actually, because I'd prefer a 100% return in a year or two over a quick 20%, but a profit is a profit and in this one investment every participating client had their financial plan fees paid for several times over.

This provides a very good example of "enterprising" investment. I asked a number of colleagues what they thought about CLI and was told to stay away - and was given all the bearish concerns that I had already concluded were well and truly built in to prices and at any rate exaggerated. Several clients who decided not to invest also pointed out these concerns to me, worried that I'd somehow not noticed that this was a company with "dodgy accounting, a dangerous business model and acquisition crazed cowboys as managers".

The basic flaw in most people's thinking is that they think that "news is newsworthy". The market is efficient to the extent that news is quickly incorporated into share prices, so any opinion that you might have about a stock's prospects based on recent announcements and articles in the press is largely irrelevant. The market had already taken into account all of these concerns, which is why it traded at a price/earnings ratio of 3! My analysis showed not only that all this news was already incorporated into the price, but the news itself was largely exaggerated. If you have found that every stock you buy falls after you buy it, and every stock you sell rises after you sell it, then you are probably basing your decisions on opinions expressed in the media or by market pundits.

John Templeton, an investor whose fame is eclipsed only by Warren Buffett, had this to say in an interview published in Global Investing: The Templeton Way by Norman Berryessa and Eric Kirzner (Irwin Professional Publishing, 1993):

"It is crucial to understand, and very few people do, that attaining superior investment performance has nothing at all in common with succeeding in 99% of other occupations. If you were building bridges and a dozen consulting engineers experienced in bridge building all gave you the same advice, you'd be stupid not to build your bridge their way. In all probability, if the experts all agree, their way is the right way to do it. You'd build a better bridge at lower cost if you followed their advice. But the very nature of the investment-selection process turns that scenario topsy-turvy. Let's assume that every securities analyst you see says, 'that's the stock to buy!' You might think that if all the experts are saying "buy", you should. But you couldn't be more wrong. To begin with, if they all want it, they'll probably all buy it and the price will build up enormously, probably to unrealistic levels. By the same token, if all the experts say, 'it's not the stock to buy,', they won't buy it and the price will go down. It's then, if your research and common sense tell you the stock does have potential, that you might pick up a bargain.

That's the very nature of the operation. It's quite simple; if everybody else is buying, you ought to be thinking of selling. But that type of thinking is so peculiar to this field that hardly anybody realises how valid it is. They say: 'I know you're supposed to look where other people aren't looking,' but very few actually understand what that means."

Obviously this type of investing does have its risks. While it proved rewarding for Warren Buffett, John Templeton, John Neff, Ben Graham and many other famous value investors, it is reasonable to assume that every now and then the market will be right about something and that a really cheap stock will turn out to be a really sick company. This is where the investor needs to do his or her homework quite carefully, looking at the levels of debt, realistically looking at the prospects of the business and other factors. From this fundamental analysis, one comes up with the parameters to feed into the valuation worksheets. It certainly isn't for everyone, which is why I tend to direct the majority of clients into managed funds or somewhat more conventional "blue chip" direct stock portfolios. Elsewhere in his book, Ben Graham states that by definition only a small minority of investors should adopt the "enterprising" approach, and that most people are better off playing defensively. Index funds certainly fill that gap nicely.

Valuation models aren't just good for selecting what to buy, they are also helpful in deciding what to sell as well. In early 2002, my sell recommendations, which included Brambles (BIL) at over $9 and Commonwealth Serum Labs (CSL) at over $29 (though I was telling clients at my previous dealer group to get rid of it in 2001 at a considerably higher price than that) were just as successful in terms of disasters averted as my buy signals. The one thing I require from clients is that they understand that valuation isn't a timing tool. We're shopping around for good businesses to buy at good prices, based on a fairly simple mathematical valuation model, and of course a fair bit of due diligence in looking under the bonnet of the companies we buy.

In the short term, even if I'm right in the long term, the price may move quite some distance in the "wrong" direction. There is method to my madness, buying all these "bad" stocks, but I don't deny that there are risks and that this can be a great way to develop an ulcer or two, but that is part of the territory for "enterprising" investment. Fortunately, to date (Feb 2003), none of the stocks I have recommended as buys in the last year have lost any significant amount of money, despite the decline in the general market.

Since I only started as an independent adviser in the middle of 2002, and since every client bought stocks according to their own requirements, risk tolerance and resources and hence all held very different portfolios, no meaningful track record has yet been established. I'm not claiming to be an up-and-coming Warren Buffett, but clients have been pleased with their results so far, though how much of that is luck and how much is skill is still yet to be determined. I remind the reader at this point that past performance is no guarantee of satisfactory future results.