Our Top Down Approach

By David Harper | May 20, 2005 AAA
Our job at Advisor is to identify, evaluate, and recommend individual stocks. Some investors handpick stocks and research them one at a time-this is called bottom-up. Some start with a large universe, maybe the entire stock market, and apply a set of filters (or screens) to winnow the list-this is called top-down.

At Advisor, we combine top down with bottom up. Later, we will elaborate on our bottom up approach, but I wanted to explain our top down perspective. First, we do employ screens to reduce the universe of 10,000+ stocks to a much more manageable group.

For example, in our core holdings portfolio, we want to see positive revenue growth for the last three years (i.e., typically at least 10% to 15% per year, but we will tweak it up or down depending on the sector).

In the core, we also want to see gross margins either improving or ahead of the sector/industry peers. Strong gross margins signify pricing power and resistance to product commoditization.

We also include days sales outstanding (DSO) and we exclude rapid deterioration in DSO – because a well-managed company almost never lets receivables get out of hand. In the core portfolio, we apply a "floor" on trading volume because without volume you can really get hammered in a liquidity crunch. Some items we collect and observe, like institutional ownership, but we do not eliminate a company for lack of it. We cannot get too mechanical.

In the case of institutional ownership, we generally like to see it, but not all institutional ownership is created equally – the filter just tells us that we should take a closer look.

Are they venture capitalists or "patient capital?" Are they proactive with management? Do they have a board seat? In my opinion, beneficial ownership and board seats are the most under-analyzed aspect of public company investing. Big owners are the market makers – they will move the stock. You can ride their coattails to prosperity or can be completely flattened by them despite your best analysis.

Especially in the "swing for the fences" portfolio, our qualitative approach to top-down is important. As you probably know, we try hard to favor promising economic sectors. First, we want to minimize our risk and second, we want to invest in compelling economic sectors because this is where we will find more of the high-growth companies. This is a seasonal but not a daily exercise. In regard to minimizing risk, we know from history that "creative destruction" is always and everywhere occurring.

Some industries, traditionally defined, are simply shrinking. From those, on average and over time, shareholder value will gradually leak away and gravitate toward more productive, value-adding industries-many which are not cleanly defined. For example, we do not have a current and keen interest in traditional retail, automakers, large airlines, and publishers.

The challenge with value-shrinking industries is you have to identify the one (at best, two) company that is redefining the industry, typically through low-cost leadership (e.g., Southwest (LUV), Wal-mart (WMT)). Further, in the "swing for the fences" we are not going to look hard at traditional manufacturing and consumer goods. Since e-commerce is growing at 20-30% per year and yet only claims 2-3% of the retail dollar, shareholder value will inevitable flow-drip by drip-from traditional retail to e-commerce. But of course you have to be careful about parsing industry definitions. For example, in technology hardware, the personal computer (PC) has reached maturity.

Yes, there is plenty of room for penetration of international markets. And Dell (DELL) has been an unstoppable company and a terrific stock, but the next leap in shareholder value creation probably will not come from a PC manufacturer – or if it does, it will likely be because they morph into something else. We know PCs have reached maturity because, on top of already tremendous deflationary trends (i.e., a rapid decrease in price vs. performance), the latest trend here is "going down market" to even cheaper-almost free-PCs.

And Gateway (GTW) is a terrific case study or, we should say, cautionary tale. You never had any good reason to buy Gateway over the last five years, or more-at best, they were and are a second-place competitor in a maturity industry. Take transportation. Consumer transport (e.g., airlines) is not promising. But business transport is very promising given globalization and increased international trade. And really exciting will be the companies that create the next business model in business transport-the companies that redefine logistics.

We also pay attention to macro-market factors – but, again, with a seasonal eye not with a hyperactive reflex. A couple of weeks ago, when the Fed raised the short rate to 3%, the financial press-in a routine that has become tiresome-was obsessed with parsing the language of the statement (as the raise itself was not a surprise). If you read the financial papers that week, you might have gone through an emotional roller coaster ride and ended up Friday in the same place you started Monday.

Some of this matters but some is just noise. Higher interest rates, and the expectation of them, indeed matters. But if you follow Greenspan's speeches (and some of the other governors) over the last few years, the real story is how uncertain he (they) has become about his (their) inability to foresee whether inflation or economic slowdown is the real bugaboo (not to mention the fascinating backstory about whether CPI/inflation is measured correctly). My favorite interpretation of a flat yield curve is: the latest evidence that the Fed has lost control over long rates.

But the point is, if we take care of the Bhudda's admonishment to keep perspective-to seek the "right view"-what can we say about interest rates? First, they do not impact our "swing for the fences" selections. Barring a serious recession or financial meltdown, good selections here are going to succeed regardless of interest rates and, frankly, temporary hiccups in consumer or business demand. The core portfolio is another story. We cannot predict exactly what will happen to inflation and long-term interest rates, but we can say there is a risk of higher rates in the future.

In the U.S., the burden of mounting federal debt and a widening trade deficit pose, at the very least, risks. Without engaging in a long debate, it is worth going back to economic first principles of supply and demand. The U.S. lends (this is the supply part) U.S. dollars to the rest of the world. Mostly, so we can purchase their stuff and finance our debt.

As long as demand meets supply-and dollars are demanded (including petrodollars)-the price can be supported. But if demand fades-where demand refers to foreign appetite for dollars and dollar-denominated debt vis-a-vis the increasing universe of investment alternatives-then the price will fall; a lower price here means that a higher interest rate must be offered to induce borrowing. Eventually, if we want to "sell" more debt and buyers are less interested, we will have to increase the price (interest rate) to induce them. Who knows what exactly will happen and when, but in the meantime, the implication for the core portfolio is: we are not keen on assuming long rate risk. So, for the time being, we are not too keen on certain financials, consumer goods, and REITs, for example.

In the case of financials, some will suffer from higher rates but some will not. You have to take a closer look at their so-called duration exposure – if they are asset-sensitive, then their assets tend to increase in value faster than their liabilities, and so they would tend to do better. If they are liability-sensitive, then we want to avoid them. Regarding consumer goods, they may be all the rage as "defensive plays," but our average consumer (of whom an alarming number hold adjustable rate mortgages and variable rate debt) is quite exposed to long rate increases and his/her discretionary income is squeezed with higher fuel costs.

So we actually think consumer goods are also exposed higher rate risk. Normally, REITs are a favorite asset class of ours-just not at the moment and not unless you are really selective. The relationship between REIT values and long interest rates is direct and inverse (i.e., a REIT is a lot like a bond with some upside), so there is a tremendous interest rate risk attached to them currently. These are just rough guidelines that tend to steer us away from certain sectors because we don't feel like we can justify the extra risk.

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