When you begin to invest you need to develop an investing strategy. Having a strategy is like a google map. It will help direct you down the right freeway and hopefully help you avoid the pitfalls, er traffic, and get to the destination you want.  If you are at this website you know my overall approach is value investing. But value investing is sort of like the judge’s definition of pornography, “I know it when I see it.” I have set up two accounts with different although similar investing value investing criteria but with very different overall strategies. So what are the criteria for investments in the Small Investor and the 80-20 Portfolios?

The first account I set up was the  Small Investor Portfolio. I started it with $2000. I will add $200/month to the account. It is meant to replicate what a beginning value investor or a value investor with a small amount of capital might be able to do on his own.  You can see the three stocks I have purchased for this portfolio already by looking at IFON, DUCK and ORXE.

This fund will be  primarily an asset valued portfolio relying heavily on Net Net stocks and other asset valuation strategies in the vein of Benjamin Graham. The stocks should have at least a 33% discount to Net Current Asset Value or some other Margin of Safety from intrinsic value.   I will create a spreadsheet to track the financial information that I glean from a companies financial statements. I will also read the latest 10k and 10Q’s looking for trouble or problems. Finally, I will do a little scuttlebutt research to see if I can see if there is a sig alert (for non Los Angelinos, that is when one or more lanes get shut down on a freeway) for the company. The Small Investor Portfolio will rely  heavily on analysis both quantitative and qualitative. I will take my cue mostly from asset valuation focused investors like Ben Graham and not from future earnings oriented investors like Warren Buffett. I will not be doing any Discounted Cash Flow analysis or looking for Owner’s Earnings growth. The strategy will be to identify these cigar butt, stocks that are discounted from their Intrinsic value and purchase them with a Margin of Safety. Unlike some other value investors I will include ADR (foreign stocks listed on an American exchange) and Penny stocks that trade on the Pink sheets or over the counter. The stocks should have a positive net income. The exceptions will be companies with positive operating income, with one time charges offs or discontinued operations. The other exception to positive Net Income will be biotech or pharma stocks with huge upside potential.  I will hold the stocks until I have reached the stocks intrinsic value or the circumstances surrounding the company change significantly enough to warrant a reevaluation of the company. If my estimation of the company’s value changes significantly in a negative manner, then I will sell the stock. In some cases I will utilize some special situation stocks in the manner outlined by Joel Greenblatt in his book You Can be a Stock Market Genius. I will explore these situations as they come up. And although ORXE was a NCAV stock, I consider it a special situation stock. With only $2000 to start, the small investor portfolio will be a Focused portfolio containing initially no more than 4 stocks. As the account grows with profits or the monthly capital additions I will expand this to at most 8 positions, and begin to increase the dollar amounts as the account grows. If the opportunity is there I will try to remain 80% invested at all times, retaining 20% in cash for new opportunities that come up, particularly if the market declines. If the Net Net and special situations dry up, I will stay in cash or reevaluate the investment strategy. This will be a long only portfolio. I will avoid financial stocks because I do not know how to evaluate their assets in a meaningful way.

The concept for the 80-20 investing portfolio is simple. Set up a few simple established value investing principles, make them stringent and then buy every stock that passes the criteria. So while the value investing criteria may be similar to the Small Investor Porfolio the strategy is not.  Some of these criteria  are concepts I have not yet covered in this blog, but I will post about them in the ensuing weeks. The criteria will include a combination of the following:

1. Price to Book ratio in the bottom 20% of stocks screened.

2. a Piotroski F score of 7 or better.

3. The annual growth in total assets should be in the lowest 20% of companies screened (currently negative double digit asset growth).

4. A passing score on the appropriate Altman Z score.That means above 3.o for Manufacturing companies and 2.6 for other companies.

5. Net Current Asset value equal to or greater than market cap.

6. Ratio of current P/E to 7-10 year P/E is less than 1.

7. Price to Sales ratio  less than 1.

There is no margin of safety per se. I think that by combing the different criteria that have been tested over the long term and then adding criteria that should minimize the down risk suck as Altman Z score, I am hoping that I have built in a margin of safety into the criteria itself.

In the future I will introduce a system for Hedging downside risk by using LEAPs or long term Asset Protected securities. This is the flip side to long positions. More about this in a future post. Thus this will be a long and short (although only using options) portfolio.

The strategy is buy as many of these positions as you can.  If I run out of cash, I will only replace a position in the portfolio with a better position. Since intrinsic value will be more difficult to calculate, I will hold the stock until the stock appreciates 50% and sell. If it declines or fails to meet my sell price I will sell at two years.

All the analysis has gone into the set-up. I will not be doing heavy analysis for this portfolio. In fact, apart from verifying that the company passes the criterias, I will do NO analysis. I will make sure that a company passes all the quantitative criteria and that is it. This will be a mechanical trading system in a similar to the magic formula investing strategy. Because I am expecting that more stocks will need to be purchased for this system to function, I have established the 80-20 Account with $5000. I will add $300/month to this account.

You might ask why I am not combining both criteria. It is simple. I am experimenting. There is some research that suggests that we are our own worst enemies in investing, that emotion, and poor decision processes will hinder our investment performance. I want to test these theories in a real and concrete way.  With 80-20 Investing I want to remove ego and emotion and see if it is possible to make money in a more simple way. Some of the Net Net companies don’t pass the risk thresholds I have set. But I am not sure that means that they are statistically worse investments. I am attempting to discover for myself what really works.

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