One of the questions we’re commonly asked is how we pick stocks that end up in client portfolios. It’s a fun and creative process, of which we’ll share some of our secret sauce in this post.

Our investment philosophy at JSA is to identify and own “excellence” and avoid “mediocrity.” We construct portfolios of 20-30 reasonably priced stocks of businesses that are responsible, well-managed, competitively advantaged, participate in attractive industries, and don’t take on too much debt. We are in this pursuit together. That’s an important piece of this puzzle. We are in the same boat and will endure losses and enjoy gains right alongside you. We spend a lot of time trying to identify and own “excellence” and avoid all else. That means we’re looking for the rightmost section of the “bell curve.” Perhaps you remember being “graded on the curve.” A teacher would explain test results—with the most common score in the middle while other scores surrounded that center.  Please note the graphic below to get a visual. It turns out that the performance of stocks looks much different than the simple bell curve. For example, while the typical stock returned about 8% a year over the last three years, about a quarter declined in value, and another quarter increased more than 16% per year! One look at this graph, and it’s obvious we’d like to do everything we can to:

      1. Identify investments in companies that can do very well (on the right) and
      2. Avoid those that don’t (on the left)

That tilts the odds in our favor for a successful investment outcome. It sounds simple. But it’s not easy, considering how complex and dynamic markets are. We can’t just:

      • “Buy household names (blue chips).”
      • “Invest in companies whose products we like.”
      • “Buy the dividend payers.”

While common and widely referenced, we’ve found strategies like this don’t produce the kind of investment results we’re striving to achieve. We constantly think about the fundamental question: How do companies wind up as good or poor performers? It’s one of our obsessions, really. So, let’s start with the poor performers. “What types of companies (or stocks) do you avoid?” Here are some of the characteristics we typically see in poorly performing companies:

  • They focus on the wrong things: Poor performing companies generally:
        • Pay too much attention to Wall Street analysts
        • Overmeasure things that don’t matter, like earnings per share
        • Prefer profits over customer success and employee engagement
        • Blame forces outside the company when things go wrong
  • They borrow too much: That’s unhealthy for any of us—why would it be different for companies?
  • They aren’t transparent in their disclosures: Best case, this could lead to disappointment and, worst case, fraud. More often, it’s just that there’s not much great news to show consistently.
  • They aren’t unique: If what the company does can easily be replicated, someone will likely do just that. We throw out a lot of possible ideas on this point alone.
  • They spend money frivolously: Here are two red flags (of many):
        • Excessive pay for company executives, especially for poor or mediocre performance
        • Buying other companies at any cost (empire building)

Now we’ll flip our question and ask, What types of companies (or stocks) do you prefer? Here’s where we believe excellence often shines through for high-performing companies:

  • They focus on customers: Companies can’t exist if they don’t have customers, users, or clients (whichever term applies).
  • They are advantaged (or winning) somehow: It may sound ruthless, but demonstrating that you’re beating the competition in business is a very good thing. We try to determine what this advantage is and whether it will persist. Sometimes, it’s because a company has the lowest cost. Costco’s small markups are a good example. Other times, customers pay a high price because of their preference or quality. Original Nike Air Jordan’s fetch over $1,000 on eBay. Nike and Jordan’s brands are worth something. And don’t get us started on the cost of a Louis Vuitton handbag!
  • They can be a leader in a large and growing market: We try to find companies that can be much larger in the future. Ideally, they provide a unique product that can do an essential job better, cheaper, or faster than before. Consider how much Amazon’s re-engineering of the global supply chain has forever changed how we shop.
  • They are “systems thinkers”: Perhaps the most difficult to explain on this list, but we prefer companies that are process & feedback-focused, encouraging both autonomy & accountability among their people. This concept matters a lot—good processes usually drive good results.
  • Executives treat the company’s money as their own: One of the most valuable things a CEO can do for their company is invest well. That may include reinvesting in their business, buying other companies, purchasing/issuing the company’s shares, or paying dividends. Being good stewards of investors’ money is a theme across our portfolio.
  • We can be proud to own the company: We try to find executive teams that act reasonably and companies that sustainably provide goods or services that are productive for society. Not doing these things, we find, tends to bring about unwanted risks to a business.

Hopefully, that discussion sheds some light on how we look for companies that stand a good chance to be “excellent” and how we eliminate those that won’t be. We believe this work can tilt the odds in our favor for a better investment outcome.