By Norman F. Klopp, Jr., CFA, Partner

The investment mantra in the hallway at Midwest Investment Management is “quality companies, steady growth, value price”. All three tenets are critically important. However, buying shares at a value price is indispensable to achieving good results because the price paid ultimately determines the investment return. Step one is to determine the fair value. This is necessary because knowing what to pay reduces risk and improves the odds of success. There have been countless examples, in the tumultuous markets of the past three years, of how wealth was destroyed by paying too much. “The market, like the Lord, helps those who help themselves,” says Warren Buffett. “But unlike the Lord, the market does not forgive those who know not what they do.”

Three models To determine fair value we use three models: A short-term earnings model using historical median valuations. The second is an internal rate of return model that incorporates ten future years of earnings and dividend growth, calculating a present value or “fair price.” Finally, a future cash flow model is used that calculates a fair value based on asset profitability and growth. The results of these are combined into a single price that we call “fair value.” Once a fair value price is calculated, we attempt to buy the stock at a 20-30% discount to that price. We call this our “Value Price”. In this way, a margin of safety is created. If we’re right about our assumptions, the gap between our purchase price and fair value should close, creating a profit. Of course, we hope to capture the annual upward march in value as well, as a company grows its business, profits, and dividends.

So, when do we sell? When shares exceed the fair value price, a stock is a candidate for sale. We revisit our valuation models and assumptions to make sure we’re not “leaving too much on the table”. A more difficult sale decision occurs when a company experiences fundamental disappointment, as inevitably some will. In those cases, when earnings are 10% below our forecast, we consider sale because our original assumptions are no longer intact. Mistakes can occur if management is given too long to correct a problem...and they can’t. The “Value Price” discipline is a tool to keep our expectations realistic. Our clients can thus have the comfort of knowing that every stock they own has been subjected to a rigorous process.

Intensive research, too In addition, we personally visit — and remain in contact with — each company whose stock is in our client portfolios. We watch stock prices closely for buy/sell opportunities and remain alert to changing fundamentals. Everyone on our staff involved with stock selection and portfolio management has 25+ years’ experience evaluating companies and stocks. • Clients with portfolios managed by Midwest Investment Management since the founding of the firm through June 30, 2003 were spared from the punishing market conditions of the past three years. If you are not a client with our firm and seek long-term growth of your portfolio without high-risk fads, contact Al Meszaros today at (216) 830-1133 or e-mail: elm@mimllc.com