Stock Selection methods from me and my colleagues Part 2
3. Dividend Protection and Growth.
Dividends play a role both in added income and in risk reduction. To maximize these benefits, a corporation's dividend policy must be established and stable. The decision as to what portion of earnings will be paid to shareholders in the form of cashdividends, relative to the amount retained to finance future corporate growth, must be reasonable.
A consistent dividend policy, providing adequate assurance that the dividend will continue to be paid (protection) as well as increase (growth), reduces the possibility of unpleasant "surprises." It also reduces the number of stocks we find suitable for investment consideration.
4. Liquidity.
One of the primary advantages of common stock as an investment type is maneuverability; theinvestor can buy or sell quickly with very low transaction costs. This ease of movement is termed liquidity.
Liquidity involves two elements, which vary as to the characteristics of individual stocks:
- The number of shares a stock trades daily. This is the standard measurement of liquidity. It is only reasonable to confine interest to thoseissues that provide sufficient trading volume so that orders can be accommodated without disrupting price.
- The "mix" of investors in the stock's market. To us, the liquidity factor also involves an aspect largely ignored in conventional analysis. Professional participation mandates the realization that success depends on the actions of other investors. It is only logical, therefore, that the more varied the market participants interested in a particular security, the more areas of potential profit.
We will detail that market participants can be isolated and categorized (public, institutional, market makers, etc.) as to their repetitive behavior, which can provide us opportunity. The more varied and abundant the prey, the easier the task of the predator. Consequently, our liquidity requirements provide a dual function in filtering for both the number of shares traded and the number of different participants. Accordingly, the list of qualifying stocks is decreased.
5. Shareholder Concern.
Unfortunately, a corporation's fundamental (earnings) success does not automatically translate into the success of shareholders. In a variety of ways, management can intervene to block owners (shareholders) from experiencing presumed benefits. Greenmail is the corporate acronym for blackmail. The usual form is a "hostile buyer" (supposedly independent of management) who purchases a relatively small amount of outstanding shares and then threatens to buy controlling interest. The connotation is that with such control it will oust current management and ravage the corporation's assets.
To avoid the greenmailer's threat (and retain their paychecks), a common reaction is for the management to deem it "wise" to buy the green- mailer's stock at a price above "market." That is, "pay off" the greenmailer at prices higher than those available to other owners (shareholders).
Although greenmail could conceivably be justified in some instances, in general we question the credibility of managers that engage in such practices, thereby disqualifying their corporations from investment consideration.
The capitalization structure of corporations (that is, the monies the corporation utilizes to fund its activities) involves two basic sources: equity (monies contributed by and/or earned for stockholders) or borrowings (debt). The capitalization "structure" is simply the ratio of debt versus equity.
To avoid "hostile takeovers," greenmail and other activities that could interfere with management's security, a popular maneuver is to restructure. The general pattern of restructuring is for the corporation to add debt to the point that the new debt load makes the corporation less attractive to potential buyers. The excessive debt has the net effect of reducing the corporation's fundamental quality, with the excessive interest charges detract from earnings and making it more difficult for the corporation to survive adverse economic conditions.
