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Focussed Diversification:
Most financial advisors recommend that you diversify for your own protection. What they fail to tell you is that it is also for their protection. For someone starting out, or with a relatively small portfolio, sa broad based ETF or combo of ETF’s is a good idea. Indeed, a personal stock portfolio must be diversified to some degree. After all, none of us wishes to “put all our eggs in one basket” and expose ourselves to the inherent risk of holding only one stock.

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But if you want to beat the market, you cannot be the market.

The problem today is that many funds and other investment products on the market hold between 50 and 300 stocks. According to the modern portfolio theory, you come very close to achieving optimal diversity after adding about the 20th stock to your portfolio.
So why are fund and investment managers operating this way and creating below average returns for your portfolios over time? Well, we think the following quote from the world’s greatest investor, Warren Buffett sums it up.

“Wide diversification is only required when investors do not understand what they are doing.” - Warren Buffett

To give you an idea of how little Buffet himself believes in over diversification, recently a study of his portfolio over the last 25 years was completed. Within his multi-billion dollar portfolio he averaged only 33 stocks per year. Perhaps more astonishingly, his top 5 holdings, on average, comprised 73% of his portfolio - so much for diversification.

While we do not advocate under diversification to beat the market long term, we recommend a strategy of “focussed diversification” within the growth segment of your portfolio.

“Why not invest your assets in the companies you really like? As Mae West said, ‘Too much of a good thing can be wonderful. ” - Warren Buffett
Focussed Diversification – Your Small-Cap Growth Stock Portfolio
• 8-12 Stocks (ex. $100,000 split equally between 10 companies: $10,000 each)
• Select stocks from a variety of sectors: manufacturing, gold & precious metals, oil & gas, healthcare, financials, technology, retail, etc. and with exposure to a variety of geographic regions: Canada, USA, China, India, other BRIC nations, Europe, etc.)
• If 1 stock performs very poorly, 3 average, 2 above average, 2 very well, and 2 excellent, it has been our experience that the overall return of a growth stock portfolio (link to our trackrecord) constructed like this has been very strong. We do our research and focus our buy recommendations on the companies we like best. By investing with conviction and with a realistic time horizon, our strategy allows our winning recommendations to truly affect the value of your portfolio over time.
A Real Example
If just one of the types of long-term winners below that KeyStone has been successful in uncovering over the past decade enters your portfolio over the course of the next year, it can change your financial future. In fact, if you would have taken our advice in February of 2002 and invested $10,000 in Hammond Power Solutions (HPS:TSX), a Canadian-based manufacturer of custom electrical-engineered magnetics and electrical dry-type transformers, your $10,000 would have grown to approximately $201,538 if sold five short years later on our recommendation in September 2007, when the company’s shares traded at $13.10.
Others from our track record (link to the track record page) page. Not all of our recommendations will be successful. In fact, you should expect some will not be. But any service that advises you differently is being unrealistic and you should certainly run from without haste. However, by employing our time tested fundamental earnings-based strategy, KeyStone has proven that within the small/mid-cap sector, we can give both near-term traders and in particular long-term investors a fighting chance in the quest to beat the market.
Invest for Value & Growtth (GARP)
Value is perhaps the most important concept to understand as an investor (next to risk). Most people intuitively understand this in their everyday lives. Unfortunately, it is less understood in the arena of stock investing. What is value? Value, in this sense, is when you get a great deal on buying an asset. In the case of investing, it is when you are able to buy $1 worth of assets for $0.80 or less. When you are making the purchase of an item, like a house, or a car, or a television, and you put extra effort into finding an item of equal or greater quality but at a lower price, you have made a value purchase. It is the same in the stock market. When you purchase a share of a company, you are buying an ownership interest in an underlying business – an asset.

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Almost any stock will have a story describing how the managers will try to make money, but if it’s a real business, it will have more than just that. It will have real products, real sales, real profits, and real business models. A successful business will generate cash flow and it will reinvest this cash flow for growth or it will pay this cash flow back to its shareholders in the form of dividends. When we find those unique opportunities to purchase successful businesses at prices well below their real or intrinsic value, we have made a value investment.

The tricky part is determining what the stock is actually worth. This is by no means an exact science (not even close) and there are many different techniques that people use with varying degrees of success. The reality is that two different people can be given the exact same information on a company and arrive at two different conclusions of what they think the company is actually worth, and neither one of them is necessarily right or wrong. So rather than trying to determine the exact intrinsic value of the company (stock) you are purchasing, focus more on fundamental principles. If a company is not profitable or is not breaking into profitability, then it is not an investment, it is a speculation.

If the company is trading at a premium price, risk increases. If that company is trading at a discounted price, risk decreases. The more solid companies you buy at attractive prices (that are making money), the better your portfolio will perform over time. The more you buy speculative ventures, which are innately impossible to value, the worse your portfolio will do over time.

Having said this, our Small-Cap Research Service is not strictly a “value” service. We are also focussed on growth in revenues, cash flow, and earnings per share. As such, our investment style is a hybrid of both value and growth investing. Essentially, we are looking for “Growth at a Reasonable Price,” or GARP as it is affectionately known. GARP is a mix between stocks whose earnings are increasing rapidly and stocks whose price is low relative to underlying assets, like book value, cash, etc. Because GARP is a subjective animal, a precise definition is a difficult exercise.

To simplify things, we will break it down. The “G” or growth is in reference to earnings and/or revenue growth. The “RP” or reasonable price refers to whether a stock is currently considered a value or not based on an analysis of its financial position. As a general rule of thumb, many analysts see GARP when a stock’s price-to-earnings ratio (P/E) is less than half its growth rate. For example, if a potential investment were estimated to grow earnings by 30 percent next year, GARP analysts generally look for a P/E of 15 or less.

Of course, one’s definition of growth and a reasonable price can differ greatly by sector, market size, and other factors, but this should leave you with a basic understanding of our GARP methodology.
First Coverage
As individual investors one of the best weapons you can employ is the ability to buy stocks before larger institutions can or can find them.

Many institutional investors are prevented from buying smaller, high growth companies due to restrictions in their fund, investment policy, a lack of liquidity, or size. As a small to mid-sized investor you do not have those restrictions. You are able to buy in before these larger investors, often selling to them down the road as the high growth small-cap grows its revenue and earnings over time to the point where it is now “big enough” for The Street (larger investors) to buy in. This can drive a great stock even higher.

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The question is, with just under 4,000 stocks listed on the Toronto Stock exchange and over 8,000 in the U.S., how do you identify this type of great small cap and buy it before the broader market? The answer is simple, use our Small-Cap Research Service. Each year we identify a select number of high growth, fundamentally undervalued small to mid-cap stocks and provide our clients with first independent coverage on these potential long-term winners. Using our fundamental earnings based analysis we simply dig deeper and search further into areas where traditional big bank or large institutional research will not look - providing you with independent first coverage on some of Canada's fastest growing small-cap stocks.
First Coverage Provides Tremendous Long-Term Gains
Year Average Return Date
2014 14.01% Jan 23, 2015
2013 45.68% Jan 17, 2014
2012 83.49% Jan 18, 2013
2011 11.58% Jan 27, 2012
2010 48.32% Jan 21, 2011
2009 79.02% Jan 21, 2011
2008 1.02% Jan 21, 2011
2006 5.73% Jan 21, 2011
2005 40.20% Jan 21, 2011
2004 38.29% Jan 21, 2011
2003 78.87% Jan 21, 2011
2002 11.19% Jan 21, 2011
2001 22.37% Jan 21, 2011
2000 14.10% Jan 21, 2011
1999 83.00% Jan 21, 2011
1998 62.15% Jan 21, 2011
“16-Year Average Gain: 39.94%”
In 2007 the service was unavailable for 6 month’s as Key­Stone transitioned from a 5 publication subscription based service to a real-time research service via one interface. As such, a one year sample is not available for 2007.
Patience Without Emotion – Allow the Market to Identify Value & Growth
We do our research and invest in high growth companies typically with strong balance sheets and with a long-term outlook (1-3 years). At times, a stock will react faster than this, but we must remember that the greatest investor of all time considers any time period under 5 years to not truly be investing. Patience is key, but the returns can be excellent for the savvy long-term investor.

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“We believe that according the name 'investors' to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a romantic.” - Warren Buffett

In fact, some of our best stock recommendations have initially gone down in price. In several cases we have recommended buying more. “If the fundamental reason you bought a stock has not changed and it goes down, you buy more.” Of course there are limitations on this, but the basic principal is sound. In the near term, the market will do what it will do. There will always be mini and major crisis, economic cycles, upturns and downturns, and even natural disasters, surrounding a stock, so trying to time a top or bottom is most often a fool’s game. If we find a great company with strong management, trading at good valuations with strong growth potential, we BUY it. If the stock trends down initially (1-6 months) and nothing has changed fundamentally, we hold it or consider buying more.

Real Examples of How KeyStone Invests with Rational Patience:

Company Name: Bridgewater Systems Corp. (BWC:TSX) Original BUY Recommendation: Date: July 2008 Price: $3.08 What Does Bridgewater Do: Bridgewater Systems develops subscriber-centric service control solutions; including access control and policy management software for fixed, mobile, and converged networks. In layman terms, Bridgewater’s software stores cell/smart phone subscriber information and answers questions such as, “Does this subscriber have access to this feature?” or “Does this subscriber belong on the network?”

Basis for Original Recommendation:

From our Initial BUY Report: “Bridgewater has been growing at a 43% CAGR and has delivered profitability for the past 14 quarters. Its revenue growth has mirrored the growth in mobile data ARPU, or Average Revenue Per User, and mobile data subscribers. We expect some lumpiness in terms of quarterly earnings in the near term; management estimates 25% growth revenue in 2008 and EBIT margins in the range of 8-12%, which should allow for solid year-over-year profitability. With $42.2 million, or $1.65 per share, in cash in the bank and 2009 EPS estimates currently in the range of $0.27-$0.30,

Bridgewater appears like a relatively inexpensive way for our subscribers to gain exposure to the growth in network convergence, devices, and mobile data applications – an area we continue to see significant potential in over the next several years. We initiate coverage on Bridgewater with a BUY rating.” Referencing the chart below, our BUY recommendation is represented by the green dot. Initially the stock traded higher, then moved lower and consolidated for about 4 months and by December of 2008, as the uncertainty of the financial crisis gripped the market, the stock moved as low as $1.90. Here we fielded a number of questions from concerned clients including;

“What is wrong with the stock?” and “Should I bail?”
At this point we were barely 4 months into our recommendation and the company had reported one set of quarterly results which were strong, yet many investors were thinking of exiting. In fact, most trading programs would have you out at this point. But there was nothing fundamentally wrong with the stock. Cash per share had grown to $1.85 (basically what the stock was trading for in the market), EPS was in the range of $0.25 with solid revenue growth and a decent outlook. Basically, someone had just put a giant “on sale” tag on the stock and we confirmed our BUY rating near the lows. Two months later, as the market calmed, the stock had begun a strong move. If we reference our longer-term chart below on Bridgewater, we find that that little period of concern, over the first 6-8 months, turned out to be just noise as the stock put together a tremendous run, having us SELL-HALF our position at the $8.36 in September 2009 and HOLD the remaining position.

At this point we were barely 4 months into our recommendation and the company had reported one set of quarterly results which were strong, yet many investors were thinking of exiting. In fact, most trading programs would have you out at this point. But there was nothing fundamentally wrong with the stock. Cash per share had grown to $1.85 (basically what the stock was trading for in the market), EPS was in the range of $0.25 with solid revenue growth and a decent outlook. Basically, someone had just put a giant “on sale” tag on the stock and we confirmed our BUY rating near the lows. Two months later, as the market calmed, the stock had begun a strong move. If we reference our longer-term chart below on Bridgewater, we find that that little period of concern, over the first 6-8 months, turned out to be just noise as the stock put together a tremendous run, having us SELL-HALF our position at the $8.36 in September 2009 and HOLD the remaining position.

A little patience gave our clients a return of 171% in just under 18 months on Bridgewater.

Company Name: Alliance Grain Traders Inc. (AGT:TSX)
Original BUY Recommendation:
Date: August 2007
Price: $6.65
What Does Alliance Grain Do: North America’s largest processor and exporter of lentils and pulse crops – definitely not the sexiest story on the street, but it made a ton of dough doing so and we have loved the world of agricultural for a number of years. In a limited Canadian agriculture market to invest in publicly, Alliance Grain provided a great option.

Basis for Original Recommendation:

From our Initial BUY Report: “The combined entity, Saskcan Pulse and Agtech, is estimated to generate approximately $100 million in revenues. In addition to significantly increasing the size of the company, the financing that was undertaken for the purchase increases the number of shares outstanding from just over 1.0 million to approximately 6.6 million, half of which will be held by insiders. The increase in shares outstanding will make it easier for investors to accumulate a position. The company’s current distribution is $0.125 per quarter, giving it a yield of 7.5%. We feel that Alliance Grain offers investors the opportunity to stay invested over these uncertain times as they operate in the relatively stable food industry. Given that its forward looking PE is well below 10 and the expected growth over the next 2 years in terms of revenues and earnings should exceed 50%, we rank Alliance Grain a BUY.”

If we reference the chart below, we find that initially the stock moved up to as high as $15, then retreats to the $7.50-$8.50 range when the economic crisis hit in September 2008. At this stage (the red circled area below), we fielded questions from clients asking what was wrong with the company and should they sell their shares. Our response was simple. We were 12 months into our recommendation, the stock remained up 20% despite the sell-off and most importantly, the company had grown revenues, earnings, and cashflow and thus traded at even more attractive valuation than 1 year earlier.

Our recommendation was to BUY more. The stock promptly doubled within a month (for those short-term traders we advised to take profits) and we shifted our long-term rating to HOLD where it remained with the shares up 400% in the $34.00 range.

Again, another excellent example of how our patient strategy paid off for excellent short, mid, and long-term gains.

When we make an initial BUY recommendation on a stock our investment is designed to perform over 1 to 3 years. The mean is probably closer to 18 months, but it depends on the individual stock and specific market conditions. In fact, in the past we have sold for great gains within a month in a couple of cases and there are stocks we continue to hold from 10 years ago – it is very stock specific. As long as the company continues to produce strong financials and trade at reasonable valuations, we will ride out our winners.
9 Steps to Uncovering Explosive Small-Cap Stocks
Below are the 9 simple steps we follow in order to find, research, and analyze small-cap stocks that could put big gains in your portfolio.

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Growth Trends: Identify growth trends and market sectors positioned for rapid growth in the years to come. Be they sector specific such as energy (oil & gas), gold & precious metals, technology, healthcare, etc. or geographic such as China, India, Brazil, North America, Europe, etc.
Old Fashioned Real Research: Actually read over the financial statements and MD&A’s of more than 7,000 publicly traded companies to find relatively unknown, high growth small to mid-cap stocks that display GARP and are positioned to grow.
Financial Performance - The Fundamentals are Key: Review and evaluate key metrics in the company’s financial statements to understand historical financial performance. Strong fundamentals within an individual company can often lead us to growth trends within an industry.
The Business Matters: Understand the business and industry of the potential investment, including products, services, and management’s ability to run the business.
Quality Management: After reviewing the company’s financial statements and reading their MD&A, if the company meets our fundamental GARP based criteria, we find it important to interview key management to understand their strategy and clarify their outlook going forward.
Earnings Quality: Look for red flags that indicate anything from cyclicality, financial manipulation, or even fraud to avoid investing in these type of situations.
Growth Outlook: Develop an understanding of expectations for growth to make valid valuation comparisons.
Peer Comparisons: If they are available, we find it instructive to compare relative valuations of companies within the same specific business or industry to provide more “apples to apples” type information on how the market values similar companies or at least those within its industry segment.
The Investment Decision: Factoring in all of the relevant information above and paying particularly close attention to current market valuations, we determine whether or not the investment is a good BUY. If it is, we issue a full report to our clients with the corresponding BUY action and within what price range we find it attractive.
KeyStone’s Analyst Hosted Q&A Session
  • KeyStones next exclusive “client only” weekly SCR chat sessions is scheduled for:

  • Date: 8/20/2018
    Time: 5:30 p.m. Pacific Time/8:30 p.m. Eastern Time
Duration: 1 hour

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