5 Rules for Doubling Up

5 Rules for Doubling Up

By Nathan Parmelee (TMF Doraemon)

 

 Holding more than 20 companies does provide diversification, but not much more than a more Buffett-and-Munger-type focused portfolio of 10 to 15. 

 

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 Procter & Gamble (NYSE: PG) sells shampoo. It's about understanding the company's competitive position and what drives increases or decreases in sales and costs -- for P&G, that's commodity exposure, key customer relationships, and new product development, to name a few.

 

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 Abbott Laboratories (NYSE: ABT), or from distribution systems and scale like those enjoyed by Coca-Cola (NYSE: KO), 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.

 

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. Claire's Stores (NYSE: CLE) is a great example in this area.

 

Strong or improving financials. The most important thing here is not to confuse no debt with financial strength. I'm just as happy to consider a debt-free company like Boston Beer (NYSE: SAM) as a company with a moderate amount of debt such as Limited Brands (NYSE: LTD), 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.

 

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 becoming fanatical about valuation and discounted cash flow analysis.