Stock Selection methods from me and my colleagues Part 3

In the middle to late 1980s, the restructuring binge financed by junk bonds resulted in many previously superior corporations degenerating to bankruptcy. Despite past records of earnings predictability and growth, we usually delete corporations that have restructured with excessive debt because they are less likely to meet earnings projections.

Inordinately high compensation (in the form of salary or options) to senior management and/or their families and friends is another managerial practice that can disqualify a corporation from our list of issues suitable for investment consideration.

Many corporations have various classes of common stock. The most important differentiations among the classes are usually concerned with rights involving dividends and/or voting. The various classifications are usually distinguished alphabetically—Class A, Class B, and so on. Note that alphabetical positioning is not necessarily indicative of the merit of the class of stock. For example, Class A may be nonvoting and Class B voting.)

Of particular concern is the restriction of the voting right and/or preferential right to dividends to a class that is not available to the public. This characteristic is usually found when a family or other tightly knit group is able to sell the public the lower classes of stock. The public is, in effect, capitalizing the holders of the preferential stock and accepting disproportionate risk. Although such "class" issues are defended rather vigorously, those most vocal in the defense are those holding the preferential stock.

It is a general policy of ours to disqualify such stock issues, but not because of the voting right. As discussed in Chap. 1, the vote is relatively meaningless to the vast majority of stockholders. Our objection is to the basic attitude of the issuing corporation. The motivation demonstrated by any corporation selling "ownership" (via common stock) and then not allowing the stockholder even the gesture of a vote, carries the implication of pomposity at best and hypocrisy at worst. Neither of these traits is desirable in any form and the avoidance of such issues is prudent.

Family-held/publicly-traded situations are similar to those involving stock classes, except that all outstanding stock has voting privileges and equal rights to dividends. The majority of outstanding shares, however, remain under the control of one family. Thus, nonfamily stockholders are effectively as powerless as if their stock has no voting rights.

Such circumstances, although quite common, are not an automatic reason to disqualify the stock issue from investment consideration. Almost all publicly traded corporations will eventually fall under the control of a few individuals whether or not they personally control the majority of outstanding stock.

Family-controlled corporations must, however, be closely monitored to isolate those instances in which management is passing from one generation to the next.

Managerial ability is not a genetic trait. Quite often, when the second and/or successive generations become dominant, the intelligence and drive that initially allowed the corporation to prosper tend to lessen. Another potential problem is sibling rivalry, which can result in effective stagnation of corporate growth.

In summary, the basic intent of our criteria is to select corporations that are stable and predictable. We want to minimize "surprise" from fundamental corporate events. By doing so, the process of actual market participation becomes greatly simplified because attention can be focused on intrinsic market mechanisms (timing and the other aspects of trading that are most affected by internal market structure).

Also important is the fact that our filtering process is a search for the quality of two elements: the corporation's business and its record in conducting that business, as well as the individual managers directing the corporation.