The Perfect Stock Portfolio

While this will probably drive our lawyers crazy, the Perfect Stock Portfolio is a group of stocks that fit the definition of the ideal stock that I have developed over my career.

The selection criteria are lifted straight from Ben Graham’s “The Intelligent Investor” and are similar to the criteria he used in developing his suggestions for enterprising investors in the original edition of the book in 1949.

Let me clarify a few things. Just because a stock fits the definition of a perfect stock does not mean it will go up forever. It does not necessarily even mean it is going to go up ever. We have had perfect stocks that just never attracted any buying interest and dropped in price while we held them. It is important to note that even our collection of Perfect stocks is not immune to market crashes. In such scenarios, their value is likely to decline.

While the Perfect Stock Strategy has historically beaten the market by a wide margin, it does not outperform the S&P 500 yearly.

What the Perfect Stock Strategy does for you is ensure that you always own a portfolio of solid businesses that are in no danger of financial distress and are undervalued based on their assets.

Every company in the Perfect Stock Portfolio is profitable. We do things a little differently than Graham. He looked at profitability over a long period of time. We track profitability constantly and have no margin for error. If a company reports an unprofitable quarter, we part company with the shares.

The Perfect Stocks cannot owe too much money. While we accept that some debt makes sense to finance the needs of the business, excessive debt has killed more companies than any other factor. We will accept a debt-to-equity ratio of 0.40. We will pass if the company has borrowed more than $0.40 against every dollar of equity. If a company issues new debt that takes it over that level while we own it, we will sell the shares immediately.

A company must have more than adequate liquidity to qualify as a Perfect Stock. In other words, they must have enough cash and assets that can be quickly converted into cash to pay the bills and keep the doors open. If you cannot pay the light bill or your workers’ paychecks are bouncing all over town, the business will probably not last long for the world and certainly will not be anything close to perfect.

We measure liquidity using the current ratio, which is calculated by dividing a company’s current assets by its current liabilities. Current assets are cash and things that can be turned into cash in a few months. Current liabilities are bills that need to be paid sometime soon, including taxes. To make it into our portfolio, a company must have a current ratio of 2 or higher. In other words, the company must have at least twice as much as it needs to pay the short-term bills.

The company must pay a dividend. I do not care how high the dividend is, but there must be a dividend. A dividend makes a statement. Sending out the check to shareholders says that the business has generated enough cash to pay the bills, service the debt, grow the business, fund new products, and pay anything else that needs to be paid, and there is cash left over. Rather than hang on to it all, the company has decided to give investors a share of the excess profits.

Finally, to qualify as a Perfect Stock, we must be able to buy company shares for less than their tangible book value. The textbook will tell you that tangible book value is the total value of a company’s tangible assets minus its total liabilities. Tangible assets are stuff that can be seen, touched, or felt. It excludes intangible assets like goodwill, brands, patents, and copyrights. That stuff may or may not have value, and we do not include it in our calculations. If it turns out to be valuable, that is a bonus for us.

Being able to buy a business for below tangible asset value provides a significant margin of safety, reducing downside risk. Even if the business struggles, investors have a cushion in physical assets. It gives us significant upside potential when other investors recognize that the business is undervalued. In a worst-case scenario, the company could be liquidated, potentially returning more to investors than they paid.

Astute investors or activist shareholders might push for asset sales or restructuring to unlock the hidden value. The disconnect between market price and asset value may attract new management or buyout offers, potentially leading to positive changes.

A Perfect Stock is an ownership interest in a profitable business with a fortress balance sheet and plenty of cash that pays dividends. We can purchase this interest at a bargain price that creates a margin of safety and allows for significant potential share price appreciation.

It is important to understand that we are not Warren Buffett. We are not looking to hold forever. When the shares trade above tangible book value, we will be sellers. If the book value keeps increasing for an extended period of time and we can own it for an extended period, we are happy to do so. We are equally happy to harvest value at any point in which the market recognizes it.

We will be sellers if the company borrows too much money or runs low on cash. If the company eliminates the dividend, we will sell the stock immediately.

Every month, we review our portfolio and act aggressively to maintain a margin of safety and harvest value when it is recognized by the markets or the company undergoes a resource conversion event like a takeover by a competitor or buyout by management or private equity firm.

The Perfect Stock Portfolio cannot guarantee profits, but it can help you build a portfolio of companies that have the characteristics that have historically delivered market-beating performance while maintaining a margin of safety.