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Portfolio Rule Six

I am more optimistic over how my asset management practice will start.  Thanks to all who have expressed interest.  Depending on how the state of Maryland replies to my filings, I will be able to get started sometime in November, December or January.  At present I am interviewing custodians who be clearing brokers.

Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.

Cash flow is the lifeblood of business.  In analyzing management teams, there are few exercises more valuable than analyzing how management teams use their free cash flow.

With this rule, there are many things that I like to avoid:

  • I want to avoid companies that do big scale acquisitions.  Large acquisitions tend to waste money.
  • I also want to avoid companies that do acquisitions that are totally unrelated to their existing business.  Those also waste money.
  • I want to avoid companies that buy back stock at all costs.  They waste money by paying more for the stock than the company is worth.
  • This was common in the 50s and 60s but not common today, but who can tell what the future will hold?  I want to avoid companies that pay dividends that they cannot support.

Intelligent companies pay a reasonable fraction of the earnings as dividends.  They only buy back stock when their stock is cheap.  They don’t buy their stock back when their stock is sort of cheap.  They only buy it back when it is cheap.

And as for mergers and acquisitions, intelligent companies don’t do large-scale acquisitions.  Instead, they do little infill acquisitions.  They do acquisitions that give them a new technology to extend their business.  They do acquisitions that give them new markets distribute their products or services through.  In general, they do acquisitions that allow them to grow more effectively organically.

Organic growth is what it’s all about.  Anyone can do a stupid acquisition, and give the appearance of growth, but real organic growth is hard to find; it is the acid test of determining what is a good management and what isn’t.

That brings another point to mind.  Unlike many investors, I don’t mind if intelligent managements hang onto cash.  Cash is valuable in the hands of the bright men.  It gives them flexibility during times of economic stress.  Giving intelligent management teams additional flexibility is a good thing.

When you hear the phrase “transformational merger,” hang onto your wallet.  Most big mergers do not achieve the goals that they were designed to achieve.  And as I said before, the best management teams are not looking to grow rapidly through mergers and acquisitions.  Rather, they do little acquisitions to facilitate organic growth.

That’s all for this rule.  If you want more information on this topic, you can review this set of five articles that I wrote for, that are freely available on the web.

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5 Responses to Portfolio Rule Six

  1. [...] Avoid companies that “buy back stock at all costs.”  (Aleph Blog) [...]

  2. microcap says:

    LOL David, you might want to write “avoid companies that “buy back stock at all costs” a lot more clearly.

    I read it as “I never buy stock in a company that buys in shares ever!”

    I am guessing you meant that you only are interested in companies that buy in stock quite cheaply, not at fair value or even a slight discount to fair value.

    Perhaps “at all prices” is better than “at all costs.”

    Am I the only one who took it this way? LOL

  3. Microcap, you might never be happy with me on this topic, but here are two places where I spent more time on the issue:

  4. microcap says:

    David, I think we are more in sync on this than you think, but I really would like a clarification as to your statement.

    Did you mean:

    a) Do not invest in any company that buys in shares ever?

    This I totally disagree with.


    b) Do not invest in a company that routinely buys in shares regardless of price?

    This I mostly agree with, though I am not so categorical.

    I also think it’s useful to distinguish between industries–as you have pointed out ad nauseum, it is REALLY dangerous for leveraged financial entities to buy in shares. They always need more capital than they think— a lesson that never seems to get learned.

    Finally, I 100% agree with your notions about the tax code favoring debt over equity. Look how few secondary equity offerings ever get done, even when prices are stupid high. They just don’t happen.

    For instance, I keep advocating that assuming the tax code reverts back in 2011, at least they should tax advantage dividends versus capital gains rather than the other way around.

    I personally think dividends should be tax free and cap gains around 25%, but that’s not going to happen.

  5. [...] Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock w… [...]


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.

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Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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