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Investment Basics

January 29th, 2013

by Michael Kayes

of Willingdon Wealth Management

I've always been curious about how famous people would have done had they pursued completely different careers. Some of our former presidents make excellent examples. For instance, Abe Lincoln towered over his contemporaries. I wonder how he would have fared as a basketball player had the game existed during his life. Our heaviest president, William Howard Taft weighed well over 300 pounds. Had football risen to prominence a few decades earlier, could gridiron greatness have been part of his resume?

Athletes, as well, are interesting people to speculate about. John Wooden, the legendary basketball coach from UCLA, would have been an incredible money manager. Coach Wooden knew the importance of focusing on basic fundamentals, especially during the most important times of the season. In fact, when asked what he concentrated on as his team approached the Final Four, Coach Wooden explained that his team stressed the basic fundamentals even more. When other teams panicked, his teams played with poise built upon a rock solid foundation of fundamental skills.

Time to roll up your sleeves… And that is what I suggest investors do in order to get a sense where the stock market may go in 2013. In the short run, CNBC sound bites, political hyperbole, and the never ending stream of real-time noise perpetuate a volatile stock market environment. But on a long-term basis, actual earnings relative to expectations is the critical driver of stock prices. Underlying economic factors including: inflation, interest rates, monetary policy, government spending, and taxes are all inputs that determine the relative strength of earnings, as well as future earnings expectations, within industries and across the economic spectrum.

Research efforts, therefore, must be spent analyzing earnings growth forecasts, while developing a sense of the sentiment, or the level of expectations related to specific company forecasts. Expectations reflect the underlying confidence in the predictability and sustainability of earnings.

Astute investors are constantly searching for companies that have a relatively high probability of achieving earnings growth well above expectations. As the Internet provides a 24/7 flow of information to individual investors as well as Wall Street professionals, this search for valuation anomalies requires thorough analysis of current trends related to new product innovation, changes in business strategy, operational efficiency and profitability, shareholder friendly initiatives, and overall management vision. All of these factors for each company must be analyzed relative to a specific peer group and also in some historical context. The goal, in a nutshell, is to identify companies that are distancing themselves from their peer groups, while becoming better companies than they were in the past. Investors who discover these situations earlier than consensus usually win.

No rising tide… In our view, we may be in for an extended period of relatively slow economic growth and stubbornly high unemployment. We simply cannot have expanding government spending and deficits and still have strong economic growth. We can only have one or the other.

Stock selection is the key… The age old saying – it is a market of stocks not a stock market – clearly rings true today. I expect the gap between successful companies and struggling companies will widen as long as this slow growth economic environment persists. If this is the case, then it will be very important to focus on stock selection, and not spend too much time trying to forecast the unpredictable swings in the overall market. Some of the statistics we analyze in our stock selection process include trends related to: margins, market share, dividend growth, cash flow, and new product success rates. Again, all these factors are analyzed relative to competitors and relative to historical trends.

One big picture theme to look for… Over the last few years, corporations have been reluctant to hire and invest, preferring to build record levels of cash to prepare for higher taxes and increased expenses related to health care and expanding government regulation. As these costs are digested, companies will increasingly look for ways to more productively deploy cash to expand profits as well as to improve their competitive position. As a result, we are likely to see heightened merger and acquisition activity this year. Generally, this should have a positive impact on the stock market, but each situation should be looked at very carefully.

Nervous about the future… Given the uncertain world we live in, investors are nervous about the future. I'm often asked what I think about the market and what everyone wants is a level of comfort about the future. I do too. Yet, comfort can be built in multiple ways. For the remainder of this year we are going to follow Coach Wooden's example. We are going to focus on the basic fundamentals and not be negatively affected by the emotional gyrations in the market. So, while I may not be able to supply an eloquent sound bite about where the overall market is going, I can articulate why Coca Cola, with its international breadth, may have strategic advantages over its primary competitor, Pepsi, or why a super-regional bank like US Bancorp, might have advantages over more global players like Citigroup. Winning these stock selection battles, one industry at a time, will be critical to investment performance.

We hope we can provide comfort by building portfolios of strong, high quality companies. Ones that never let the emotion of the moment overwhelm the task at hand.

Michael Kayes, CFA

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