MCM employs a filtering process to assemble an inventory of potential investments. Designed to filter out as much uncertainty as possible, MCM optimizes research time by concentrating on only those businesses worthy of further consideration.

We begin by having our analysts specialize in specific economic sectors like energy, healthcare, or manufacturing. MCM equity researchers thus develop a high level of familiarity - or "circle of competence" - similar to what one might expect from a beat system in police work or journalism. This familiarity allows us to know which companies are the best long-term performers - the "stars," if you will.  We often set up screening programs that compare the financial data of these successful businesses with other companies.  By looking at signature features like high return on earnings, high insider ownership, low (or no) acquisitions, and low debt ratios, we find companies that strongly correlate with these "best practices" businesses. Those go in the top of the MCM funnel.

But we have to be careful here.  Look-alikes are not necessarily act-alikes. We need to go further in our research to find out which, if any, of these potential stars actually qualify as good investments. For that purpose, we apply more specific filters designed to look at candidates in granular detail, assigning a grade of "A" through "F" at each stage of the process.

Filter 1:  The Business

When you bought your first home, did you buy it sight-unseen? Highly doubtful. Few people would even think about purchasing real estate without first thoroughly inspecting the physical condition of the house (asset) and its location (environment). The same should be true of equities. Our focus starts on the business. An inspection of the physical plant, an assessment of the business model, an analysis of the competitive environment, and a review of the financial statements are among the research activities that help gauge the intrinsic value of the total enterprise. 

We also use research data to project future cash flows and compare them to the current stock price - a metric that largely determines return on investment. Generally speaking, a business is unlikely to penetrate our filter unless it has a long history of producing an average ROE of 15% or more over time. We have a strong preference for companies that have achieved sustainable competitive advantages and operate in relatively stable and predictable industries, where proper assessment of past performance is useful in understanding the future. If no precedent exists, forecasting future events and trends becomes much more difficult and therefore less certain.

Businesses that make the grade at this stage move on to our second funnel filter.

Filter 2:  The Management

While the business model is crucial, even some of the best companies in the world have been run into the ground by poor leadership and lack of vision. Thus, the second critical filter in investment selection is the management of the business under consideration. Are the managers responsible stewards with a track record of both sustaining the business and growing it? Do they have the ethics and integrity to lead the company through inevitable periods of difficulty? Assessing the competence and integrity of a company's management team can be challenging and, some would say, inherently subjective. After all, exactly how does one quantify integrity?

The truth is, there will always be qualitative components in making judgments about management, and we try to address those by meeting in person with the managers of the companies we elect to study for possible inclusion in the MCM portfolio. Furthermore, because of our circles of competence, there is also a good chance we already have contacts in the industry of the company we're studying, and those people can provide additional valuable insight. Like an astute baseball scout, it pays to know not only the managers... but the players and coaches on the other teams who know those managers' tendencies.

That said, empirical, quantitative data from balance sheets, income statements, and other documents also shed light on company leaders. The attitude of management toward shareholders becomes readily apparent from the paper trail of decisions about allocation of capital. Proxy statements often expose important details about compensation and stock option policies in addition to possible conflicts of interest. Acquisitions are also quite revealing. In most instances, the only constituency guaranteed to be better off after an acquisition is management because a CEO's compensation is typically a function of the size of the company.

If we assign good grades for the business and its management, our consideration turns to a third filter.

Filter 3:  The Price

The characteristics examined thus far are beyond our control. We cannot change a business model to create a more sustainable competitive advantage; we cannot change the demeanor of a manager or management team to behave in a more shareholder-friendly fashion. But at this last stage of the filtering process, we finally encounter a determinant that is entirely our call: price. Of course, we can't set the asking price for any common stock - the market does that. But we can determine what we think is a fair price to pay for the company being studied and then patiently wait until that price is low enough relative to the company's intrinsic value to provide a margin of safety for our investing clients.

In shopping terms, you might happen across a cashmere sweater of impeccable quality - but at $750, the price is simply too high for the value of the item. Three weeks later, perhaps after the frenzied demand of the holiday shopping season, the same exact sweater ends up on the clearance rack priced at $50. Having done your homework, it's an easy decision: It's still a great sweater, and that's a terrific deal. In much the same fashion, we examine the quality of the merchandise in the stock market. Having a good idea of a company's value, we then resist the urge to buy until we're convinced we've gotten a bargain.

Though no investment is a slam-dunk certainty, this value-driven process accomplishes two things for the investor: 1) It increases the odds of a positive outcome by recognizing that stock prices over time tend to gravitate toward the intrinsic value of the business - "buy low, sell high," in other words; and 2) It reduces the potential size of a loss that may occur if the stock price falls, because it was purchased at a reduced cost to begin with.

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