The philosophy underlying the work at Napali Research is a combination of traditional value investing, the unprecedented availability of data and computational power, and psychology.

Stock is Ownership

We start with the axiom that a share of stock represents partial ownership of a business, as espoused by history’s most successful investors such as Benjamin Graham, Warren Buffett, Joel Greenblatt, Walter Schloss, and many others. A share has a value that can often be estimated to a rough degree by conservatively analyzing the business.

At the same time, many factors, frequently psychological in nature, affect the current price of that share. When there is a wide mismatch between value and price, there is an opportunity. This philosophy works equally for buying and selling, long or short.

Therefore our work concentrates on finding ways to assess the value of a share in the context of screening thousands of companies. Many valuation methods are used in the financial industry for different purposes and for different types of companies. How do we pick an appropriate valuation method?

Categories

We are big fans of an evolutionary model of the economy and business (an outstanding resource is The Origin of Wealth by Eric D. Beinhocker). This model suggests three useful categories of companies for our investment screening purposes:

• Stalwarts: Only a tiny handful of businesses shows long-term competitive advantages and business predictability. These are companies such as GE, Johnson & Johnson, Berkshire Hathaway as a few examples. Limiting ourselves only to these can lead to good but unexceptional investment returns unless these companies can be bought at unusually low prices. However, risk is generally low.
• Shooting Star: By far most companies come and go as a few good ideas propel them to success, but the inability to follow up with more successful products eventually leads to failure.
• Scrappy Survivors: There is a small but significant group of companies that continues on a bumpy road over the years, doing well for some time, slipping up or being caught by a change in their economic environment, but later recovering with new products, in cycles on the order of 5 years. According to work by Wiggins and Ruefli as cited by Beinhocker, about 1% of companies are in this category, or about 100 in the current SI Pro database, and this fraction appears to be increasing slowly over time.

We would like to be able to identify companies in all three of these categories and be able to value them and assess their risk to a reasonable degree. Under the right circumstances, a company in any of these categories can be a successful investment. (Of course, there is probably a fourth category which contains companies that never really create any value at all. We will try to avoid those entirely.)

Categorizing a company is the first thing to do. Fundamentals over the longest available time period sets a background, and against that background, recent fundamentals may help us find cases where a company is currently moving up or down the “food chain.” Assessing the company’s history of value creation, share dilution, debt management, etc., should help us assess risk.
(more…)