SECURITY SELECTION

Overview

Security selection at McCullough & Associates is conducted in-house and focuses on identifying companies that meet our four critical company characteristics. Our goal is to find the best companies in industries selling at attractive valuations and to hold them long term for maximum price appreciation. The four key company characteristics include:

1. Strong Financial Position 

We seek companies with solid fundamentals, specifically strong balance sheets with positive cash flows and positive profit margin trends. Asset rich companies such as these are more likely to meet capital needs from internal sources and maintain reasonable dividend payments. This is a competitive advantage during periods of tight credit, when external capital is expensive or unavailable.

We also focus on companies generating consistent “cash earnings” and assess the quality and character of these earnings. We stress cash earnings, rather than GAAP earnings, as cash earnings are more representative of the true operating and financial leverage that exists. We also carefully review capital expenditure needs and fixed assets replacement factors.

2. Shareholder Oriented Management

The second characteristic is shareholder oriented management. We seek experienced, capable management teams with a proven track record of success. Companies should utilize conservative accounting principles and align the financial interests of management and shareholders. We often invest in companies where management has large personal stock holdings in the business.

We also want to see commitment to controlling expenses and consistent capital allocation decisions. Shareholder oriented managements use free cash flow to create shareholder value. This is accomplished by reinvesting profitably in the business, paying down debt or returning money to shareholders through dividends or share buybacks.

3. Sustainable Business Model

Once we identify financially strong companies with quality shareholder oriented management, we examine our third characteristic, a company with a sustainable business model.

We build a holistic profile of the company which includes a thorough review of their operating functions including products and services, labor relations, raw material expenses, plant and equipment, capital reinvestment requirements, inventories, receivables and working capital needs.

We also want to understand any competitive advantages and whether a particular niche exists. This requires an analysis of their respective industry dynamics. Factors include bargaining power of suppliers, bargaining power of customers, threats of new entrants and threat of substitute products. We also look at the supply and demand equation for the industry and overall growth trends.

4. Attractive Valuation

"A good business is not always a good purchase, although it is a good place to look for one," remarked Warren Buffet. We perform fundamental research to establish a target price for the company by focusing on the intrinsic value of the business and assessing the near term risks to that value. Our objective in establishing a target price is to establish a "margin of safety" and reduce the risk to invested capital.

We also perform technical analysis which involves analyzing price trends to identify key support and resistance levels. In addition the supply and demand dynamics for particular securities are analyzed. When selecting investments, the portfolio management team places great emphasis on companies it believes can offer the best long-term appreciation and the highest probability of realizing their value.