Poetic Portfolios

One thing that I should point out regarding my holdings, and this will be true of the other portfolios I introduce as well, is that I tend to focus on smaller companies for my individual stock holdings. There are a few reasons for this.

1. I can gain exposure to large companies more easily through mutual funds.
2. Smaller companies are often easier to understand.
3. It’s easier to gain an advantage in smaller companies.

The market tends to be much more efficient in regard to larger companies. My best example of this is ADP. They are a mature company with plenty of analysts covering them. They are likely widely held by institutional investors. Every year when their annual report comes out, I sit down and enter data into my instrinsic value calculators. They are often priced within 10% of my value. There is miniml volatility in their shares, and the market knows what to expect from them. When I purchased ADP, I think I received a 25% discount to intrinsic value. It was probably more like 20%, but that was because they had just interrupted something like 25 years of consecutive double-digit earnings growth. Now they are back on track, and their market value reflects this.

I will make the argument that many smaller companies are easier to understand. Often, appearances can be misleading as was the case with Yamana Gold, as we shall see. Still, companies like Dawson, Middleby, or even Select Comfort are easier to understand than conglomerates like Disney, GE, or GM.

Smaller companies are often more volatile and present more opportunities to purchase at a discount to intrinsic value. My recent analysis of Dawson Geophysical provides a good example. They have traded at a P/E range of 14-28 over the past year. This from a company that was growing earnings at 70% year-over-year. Now, I acknowledge that growth is slowing, but you could have bought Dawson at a P/E of 14 one year ago. I was valuing Dawson at around 70 when I purchased their shares around 28. There was a clear advantage for an individual investor when looking at this stock then. Jupiter Media is another good example. Their shares have been between $3 and $10 over the past year, all while reporting break-even earnings and cash flow of around $16 million. Again, there is an advantage here.

This is a good time to point out something I’ve learned the hard way this year. Just because a company moves into your buying range does not mean that it is still a good value. In other portfolios, I purchased Washington Mutual on the way down. I really didn’t understand how bad the mortgage crisis really was. Washington Mutual appeared to be operating as usual, and it was a sizable company with good cash flow. There were multiple analysts following it closely. Still, it was too difficult to understand. It is important to identify risks ahead of time and be aware of the change in stories. I feel much better about my purchase of Jupiter Media below $3.50 per share than I did at buying First Marblehead at $18 a few days ago. I know the story at Jupiter Media. I do not know the story at First Marblehead. There are too many unknowns in the middle of this credit crisis. In many ways, the unknowns are affecting the credit markets, which in turn creates even more uncertainty.

It is important to incorporate news into valuation models before buying a stock that has come in to your valuation range. If you can’t project how the news will affect the price, that is a definite reason not to buy.

This entry was posted on Thursday, December 13th, 2007 at 5:34 am and is filed under General Information, Portfolios, Two Roads Diverged. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.