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| Finding successful investments is hard work. My colleague Dan Ferris and I routinely evaluate dozens of companies before finding a few that are worthy of additional research. Unfortunately, that means we probably spend more time reading about businesses that we don't recommend than reading about those we do. Often, our research begins with a company's annual report. To achieve transparency with investors, public companies are required to file these reports with the U.S. Securities and Exchange Commission (SEC), which refers to them as "10-Ks." Annual reports provide a wealth of valuable data. Better yet, the data are accessible 24/7 on the SEC website. These reports are often 100-150 pages long and contain a mind-boggling array of numbers. Our challenge is to quickly separate what's important from what's not. Or as Arthur Conan Doyle's famous fictional sleuth Sherlock Holmes says…
How do you separate "incidental" from "vital" in a document loaded with thousands of seemingly important facts? You must have a plan. I have read thousands of annual reports in my investing career. Over time, I've developed a system that helps me quickly assess if a company is worthy of further study. My system starts with these five questions…
Question No. 1: Are there risks related to the company's revenue stream that aren't readily apparent? Typically, an overview of the business and how it generates revenue can be found within the first few pages of an annual report. Spend some time there. I specifically look for two risks…
Customer Concentration Ideally, we're looking for companies that sell to many, many customers. This limits the risk that revenue might suddenly decline from the loss of any one customer. It also limits the leverage any one company can have on the business. Raising prices on a customer that's responsible for 60% of your business will always be a challenge. Be aware that some industries routinely experience high customer concentration. Food manufacturers like Hain Celestial Group often report Wal-Mart as a major customer (10% or more of sales). Suppliers of original equipment manufacturer (OEM) auto parts typically have high exposure to one or more of the major car manufacturers. BorgWarner, for instance, reports that 17% of its 2014 sales were made to beleaguered Volkswagen. Companies in the semiconductor industry also routinely experience high exposure to just a few customers. Cirrus Logic is an extreme example. In 2014, 72% of its sales were made to a single customer, Apple. Exposure to Commodity Prices In addition to assessing customer concentration, you also want to determine if there is hidden exposure to cyclical commodities, like oil and gas. Remember, a company doesn't have to be in the oil and gas business to have significant exposure to its boom and bust cycle. Last November, I addressed this problem in the Stansberry Digest. Oil prices were starting to fall hard. I warned investors they might be unwittingly exposed if they owned companies that did a significant amount of business with oil and gas producers. Here's what I said at the time…
After I wrote that, the drop in oil prices did resume. And Emerson's stock price has dropped about 29% since then. Question No. 2: Are there other unusual risk factors? Toward the middle of a typical annual report, you'll find the Risk Factors section. Here, a company identifies and lists the primary risks for its business. Many of these risks are generally the same from company to company. For instance, if a recession appears, sales are likely to decline. If another company is acquired, the integration may underperform the expectations management has set. What I'm looking for are unique risks. Here's an example from the 2014 10-K of Molina Healthcare, which provides health care plans to more than two million members across the U.S. (emphasis added)…
This is something you don't see every day – a change of one percentage point in expenses potentially reduces income 91%! No matter how attractive Molina might otherwise be, this vital fact about its business model was a deal-breaker for me. Question No. 3: Has the company demonstrated that it can grow revenue and earnings? Near the Risk Factors section, you'll usually find a financial review covering the past five years. This lets you quickly see whether the company has been successful at growing sales and profits. Growth in these two metrics is vital because it typically means the products and services the company sells are enjoying greater demand over time. Companies that get bigger and better are exactly what we're looking for. Acxiom is an example of a company that has not been growing revenue or earnings. The provider of enterprise software has been around for more than 40 years, but sales the past two years were actually lower than they were five years ago. Earnings also trended down during this period. By glancing at Acxiom's five-year financial history just a few minutes into my research, I was able to quickly eliminate it from consideration. Question No. 4: Is there evidence of operating leverage? Operating leverage is simply the ability to grow profits faster than revenue. Superior business models often grow profits faster than revenue, so I consider this a vital fact that helps me quickly determine whether a particular company is worth further evaluation. Fleetmatics provides fleet management software services to 25,000 enterprise customers with large truck fleets. It's a textbook example of operating leverage. Over the past five years, revenue grew about 37% per year on average. Income grew a much faster 85% per year on average. Adding lots of new fleet customers didn't require the company to build a new plant. It just needed room for a few new employees and their computers. Capital-light businesses such as Fleetmatics routinely demonstrate operating leverage. Investors love rapidly growing companies that can grow earnings quickly. They regularly pay dear prices to own them. That's why these kinds of companies are rarely found in the Extreme Value model portfolio. Ideally, we look to buy these kinds of businesses during major market downturns when everything goes on sale. Question No. 5: Is the company generating free cash flow? The last thing I look for when starting the evaluation of a new company is its ability to generate free cash flow. This can be easily determined by going to the Statement of Cash Flows, which normally follows the Balance Sheet and Income Statement about two-thirds of the way into a typical annual report. Free cash flow is not a line item on the cash-flow statement. Instead, it has to be calculated by deducting expenditures for property and equipment (i.e. capital expenditures, or "CapEx") from net cash from operations (or operating cash flow).  As Dan likes to say, free cash flow is what gives equity its value. This is the surplus capital management has at its disposal to grow the business, reduce debt, and give back to shareholders via dividends and share repurchases. The cash-flow statement in an annual report normally covers the last three years. Ideally, what I'm looking for is growing free-cash-flow generation over that period. If a company was unable to generate even a moderate amount of free cash flow over the last three years, I usually lose interest in it as a potential investment idea. There are almost 7,000 companies listed on the three major U.S. stock exchanges: NYSE, Nasdaq, and Amex. Finding the handful of businesses that will translate into successful investments is hard work. Having a plan like the one outlined above helps us eliminate many subpar businesses from consideration quickly… and focuses our attention on those that are worthy of your investment capital. As you conduct your own research, I highly recommend you follow this guide. Good investing, Mike Barrett Source: Daily Wealth Follow us on Twitter: @blacklioncm |
Showing posts with label Extreme Value. Show all posts
Showing posts with label Extreme Value. Show all posts
Friday, December 11, 2015
Successful Investments Start With These Five Questions...
Tuesday, December 8, 2015
Three Steps to Protect Your Portfolio from the Next Bear Market
| Three Steps to Protect Your Portfolio from the Next Bear Market | ||
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In one of my recent columns, I noted that investment analysis has gotten far trickier over the last few years.
We have entered a period of “administrative markets,” in which equity returns are affected as much by government policies as they are by economic growth and corporate profits.
We have entered a period of “administrative markets,” in which equity returns are affected as much by government policies as they are by economic growth and corporate profits.
In the last few years, we’ve seen large-scale bailouts; trillions in fiscal stimulus; massive quantitative easing; nearly seven years of zero short-term rates; heavy-handed regulation; and sharply higher taxes on income, dividends, and capital gains.
Our corporate tax rate is the highest in the developed world, driving even iconic American companies like Burger King to move their headquarters to Canada.
These policies distort markets... and lately equity investors have been paying the price.
Our corporate tax rate is the highest in the developed world, driving even iconic American companies like Burger King to move their headquarters to Canada.
These policies distort markets... and lately equity investors have been paying the price.
A Shot Across the Bow
The S&P 500 recently plunged more than 10% in four days.Don’t shrug this off. According to Bianco Research, this has happened only eight other times in the last 80 years.
Yes, the markets took a significant bounce. But I still view this as a shot across the bow, a warning.
Here’s what makes the smart money nervous right now...
In the past, when the economy (and the stock market) went into the tank, the traditional policy response was to stimulate the economy with lower interest rates and deficit spending.
But interest rates are already at zero. And under the Obama administration, the national debt has soared from $7.4 trillion to $18.4 trillion.
What’s next? Are we moving to negative interest rates (like Europe), creating a situation in which you have to pay to leave your money in the bank and even more stupendous deficits? That policy prescription didn’t work well for Greece.
Don’t put me in the gloom-and-doom camp. I’m not a pessimist. But I’m no Pollyanna either.
I consider myself a skeptical realist who looks at both the positives and negatives. Despite the many government policy missteps over the last decade, there are factors to appreciate as well.
For instance, the U.S. economy posted a much bigger rebound in growth during the spring than previously reported… (The Commerce Department adjusted the annual expansion rate in the April-June quarter sharply higher to 3.7%.)
Plunging energy prices are a huge plus for everyone outside the oil and gas industry…
Inflation is negligible…
Housing is roaring back…
Unemployment is falling…
The dollar is strong... And the outlook for corporate profits is improving...
All this government meddling with the market makes this a challenging time for investors. We can only wait and see what policymakers dream up next, whether it’s higher rates or QE4 or something entirely new.
Investment legend John Templeton used to point out that no matter how strange things look, economic and market cycles are all essentially the same.
He famously noted that “this time is different” is the most expensive phrase in the annals of investing. That statement is generally true.
But check your history. When was the last time the national debt was bigger than our GDP and the Fed held rates at zero for nearly seven years?
This time really is different. Govern your portfolio accordingly.
Good investing,
Alex Green
Chief Investment Strategist, The Oxford Club
Plunging energy prices are a huge plus for everyone outside the oil and gas industry…
Inflation is negligible…
Housing is roaring back…
Unemployment is falling…
The dollar is strong... And the outlook for corporate profits is improving...
Three Essential Steps
Given the mixed outlook, what should you do with your portfolio now? Start with these three essential steps:
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All this government meddling with the market makes this a challenging time for investors. We can only wait and see what policymakers dream up next, whether it’s higher rates or QE4 or something entirely new.
Investment legend John Templeton used to point out that no matter how strange things look, economic and market cycles are all essentially the same.
He famously noted that “this time is different” is the most expensive phrase in the annals of investing. That statement is generally true.
But check your history. When was the last time the national debt was bigger than our GDP and the Fed held rates at zero for nearly seven years?
This time really is different. Govern your portfolio accordingly.
Good investing,
Alex Green
Chief Investment Strategist, The Oxford Club
Source: Bonner and Partners
Follow us on Twitter: @blacklioncm
Friday, December 4, 2015
Don't Let 'The Glidepath Illusion' Ruin Your Retirement
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| The traditional notion of retirement says you should take bigger risks in the stock market when you're young. You have more time to make up for losses than when you're older. As you age, you should take less and less risk, so you won't lose your retirement money. This strategy is called "Glidepath investing." And it could ruin your retirement. Let me explain… The emotional appeal of Glidepath investing is obvious. Young people feel like they're going to live forever, so it feels better to them to take more risks. Buying more risky stocks and fewer safe bonds feels right. Older people feel they have more to lose and might not be able to support themselves one day, so they tend to be more risk averse. For them, buying fewer stocks and more bonds feels safer. There's an army of financial planners and other "helpers" out there selling products designed to get you to retirement with a big, safe nest egg, based on this feel-good notion. However, research suggests that what feels good isn't necessarily what you should do… Investor and researcher Rob Arnott of Research Affiliates published a report in September 2012 called, "The Glidepath Illusion." Arnott says Glidepath investing will make you less money because it will lead you to put less money in higher-return investments (stocks). Arnott studied 141 years of stock and bond returns from 1871 to 2011. From these data, he hypothesized a range of possible outcomes. In general, Arnott found evidence that the range of outcomes from doing the opposite of Glidepath investing was superior to the range of Glidepath-based outcomes. It's well documented that stocks outperform bonds over the long term.Glidepath investors wind up putting a bigger percentage of their assets in stocks when they're younger and have less to invest. They put a higher percentage into bonds when they're older and have more to invest. That's the basic error. Investors put fewer dollars into higher-return investments, then interrupt the compounding process to put more dollars into lower-return investments. So they make lower returns than if they had done the opposite of Glidepath investing. Glidepath investing is a good recipe for feeling good, but a poor one for making as much money as possible in stocks and bonds. Arnott's conclusion is worth quoting and keeping close at hand as a reminder… Investors who are prepared to save aggressively, spend cautiously, and work a few years longer (because we're living longer), will be fine. Those who do not follow this course are likely to suffer grievous disappointment… No strategy can make up for inadequate savings or premature retirement. Save aggressively. Spend cautiously. Let your investments compound as long as possible before drawing them down. That's sound advice. Sadly, it makes perfect sense that the financial services industry is once again doing exactly the wrong thing for clients. Don't trust financial planners and brokers. They're commissioned salespeople. They're incentivized to sell investments, NOT to make you money in stocks and bonds. For as long as my health holds out, I'll stay productive and hopefully get well compensated for my efforts, saving aggressively and spending cautiously. I recommend you do the same. Good investing, Dan Ferris Source: Daily Wealth Follow us on Twitter: @blacklioncm |
Wednesday, December 2, 2015
How to Get One of the Highest, Safest Yields in Today's Market
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| Before we get started, I must admit… It's one of the most boring sectors of the market… You probably won't be bragging about it at the summer barbecue or your company's water cooler… If everyone purchased this type of investment, the financial news channels would die. Headlines would get a bit less shrill. And people would mostly ignore CNBC's latest "hot take" on the market… But most people would also enjoy better returns and have greater diversification. Rather than selling at bottoms and buying at peaks, investors would ride the inevitable waves and earn a fat return over the years. You see, the advantage to investing in this sector isn't just that it's safe… or nearly unknown outside of a group of select Wall Street "insiders"… It also returns a higher yield than nearly any other safe investment you could make today. In other words, this investment is a powerful tool for income investors that's right at the intersection of yield and safety. Today, I'm detailing the opportunity in what's known as preferred shares (or "preferreds")… the hybrid blend between bonds and stocks. Based on the benchmark S&P U.S. Preferred Stock Index, preferreds offer an average yield of 6.24%. That's a huge payout in today's low-rate world. That yield is also safer than traditional dividends. Preferreds are able to do this because they are fundamentally different than other securities… Here's how a preferred share works… If a company needs to raise $100 million in capital it could do this several ways:
The company could sell four million preferred shares at $25 each, collect $100 million, and agree to pay a dividend rate of, say 5%, in quarterly installments. Now, the preferred dividend isn't guaranteed (and neither are common stock dividends). If the company runs into financial trouble, it canchoose to suspend its preferred dividends. However, it can't pay a single penny in dividends on its regular common stock unless it keeps paying dividends on its preferred shares. Many preferred shares are also "cumulative," meaning that if the dividend is suspended for a few quarters, that tally keeps adding up and it must all be paid back when the company starts paying a dividend again. Preferred shares are typically issued as "perpetual" preferreds, meaning that they will go on paying that dividend rate indefinitely. Though like a bond, if the market price of a preferred share is higher than its issue price, a new buyer would earn a lower yield than the original rate. Other preferred shares are "callable," meaning the company can buy them back at a set price after a specific date in the future. So as a practical matter, preferred shares' dividends are much safer than regular dividends. And there are some additional benefits to preferreds… The way to build a safer and more profitable portfolio is by combining uncorrelated assets. For example, stocks and bonds don't move perfectly together. When you combine them, you can earn a better return relative to your risk. When investments move perfectly together, they have a correlation of 1.0; and if they bear no relation to each other, they have a correlation of 0. As you add more uncorrelated assets, you make a portfolio stronger and stronger. Preferreds, in particular, are in a class of their own. Preferreds have only a 50% correlation with stocks and are even less correlated with the bond market.  The closest correlation with preferreds are investment-grade corporate bonds. That makes sense. Preferred shares are high-quality, safe investments that pay regular income flows, just like good bonds. By adding preferreds to your portfolio, you've utilized an entire new asset class, making your portfolio more resilient to volatility. On top of that, the dividends paid by preferred shares are often considered "qualified dividend income." This means that they are taxed at the lower capital-gains rate, rather than as income. It depends on your income level, but if you're in the 25% tax bracket, you'll pay 25% on interest income from bonds, but only 15% on qualified dividends from preferreds. That means collecting $1 from a preferred is the equivalent of collecting $1.13 from a bond. Preferreds have improving financials, rising stock prices, and more potential upside than bonds if a company does well. At the same time, the income stream of preferreds is more dependable and fixed, like bonds. It also has a better claim on assets in the rare case of bankruptcy. If a company goes bankrupt, bondholders get to take what they are owed from the assets. After that, preferred shareholders take what they are owed. Investing in individual preferred shares is relatively simple – most preferreds trade over the major exchanges and are easily accessible through your broker. For investors looking for short-term capital gains, preferred shares don't make for the best investment. But the opportunity for an income investor should be clear. High yields paired with safety are exactly what I look for in Income Intelligence. Here's to our health, wealth, and a great retirement, Dr. David Eifrig Source: Daily Wealth Follow us on Twitter: @blacklioncm |
Monday, November 30, 2015
Starting Today, November 30, $1 Trillion Starts Moving to China
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| Nobody is talking about it… but two incredibly important things are happening TODAY that have to do with China's financial markets… These two things are just the beginning… The two things happening today represent the beginning of up to $1 trillion moving into Chinese financial assets. (That $1 trillion is not my number. It is from two giants of finance – Standard Chartered and AXA Insurance.) I'll share both of these big changes with you today and tomorrow. First, let's look at what's happening in China's currency… China will finally join the global superpower club. Today, China's currency, the yuan, will likely be allowed to join the big four currencies – the U.S. dollar, the euro, the Japanese yen, and the British pound – as the fifth member of the International Monetary Fund's currency (the Special Drawing Rights, or "SDR"). Specifically, earlier this month, the head of the International Monetary Fund ("IMF"), Christine Lagarde, said: "The IMF staff assesses that [China's currency] meets the requirements to be… [included] in the SDR basket as a fifth currency, along with the British pound, euro, Japanese yen, and the U.S. dollar." Here's the timeline for all of this… The IMF will OFFICIALLY announce if the yuan gets to join its SDR reverse currency basket today. If the yuan gets approved, China will "join the club" on October 1, 2016. The thing is, it's already a foregone conclusion… There's no need to wait to hear the answer. You see, any country protesting the inclusion of the yuan would look like an idiot at this point. So what does this mean? In short, it's a vote of confidence in China's drastic reforms by the world's major powers. This move is largely symbolic (as none of us actually use the IMF's currency). What it means is far more important in the long run… It means that China's currency "passes the test." China's currency is finally considered to be as legit as the other four, in the eyes of the world's superpowers. Most folks are blowing off the significance of this. I think that's a mistake… After today, hundreds of billions of dollars will likely flow into China's currency in the coming years, and from a variety of sources… As a reserve currency for central banks… as a way for investors to diversify outside of the U.S. dollar… as a speculation… as a medium of exchange in global trade… etc., etc. The era of China's yuan as a legitimate currency starts today. (You can check www.IMF.org to be sure it happened.) My humble suggestion is, get your money there first… Tomorrow, I'll show you what's going on in China's stock market… And why it gives us an incredible investment opportunity right now. Good investing, Steve Source: Daily Wealth Follow us on Twitter: @blacklioncm |
Tuesday, November 24, 2015
The Most Important Lesson When Buying Stocks
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| You're not going to succeed in the stock market by just buying the world's best businesses… For the past several years, my colleague Dan Ferris and I have urged Extreme Value readers to buy great businesses… Businesses that gush free cash flow, reward shareholders, have great balance sheets, earn consistent profit margins, and have high returns on equity. But if you pay too much, even a fantastic company can turn into a mediocre and possibly terrible investment… That's why we also tell readers to never buy a great business until it's trading at a cheap price. This is a discipline I impose upon myself and encourage you to embrace. To see just how a great business can turn into a mediocre – and even terrible – investment if you pay too much, let's look at American candy icon Tootsie Roll Industries (TR)…We've never recommended Tootsie Roll, but Dan and I have followed the high-quality business for years. Tootsie Roll's results don't change much from year to year or decade to decade. Since 2005, revenue and free cash flow (FCF) have compounded at low levels of about 1.5% per year. Since revenue doesn't change much year-to-year, neither do dividends or shareholder equity. Return on equity, or "ROE" (using free cash flow instead of the usual net income because the business is capital-intensive), is routinely a strong 15%-20%. Occasionally, when manufacturing equipment is updated and capital expenditures exceed 2% of revenue, the ROE drops to 5%-10%. Since things don't change much operationally, it's crucial you buy shares at a cheap price. Otherwise, you lock yourself in for years of meager returns, despite the regular cash and stock dividends. Let me illustrate… Right now, shares trade around 24.5 times trailing 12-month free cash flow. That's expensive for outside passive minority investors like us. If you'd bought Tootsie Roll in 2005, you'd have paid a similarly expensive multiple. Shares ended that year at $28.93, valued near 23 times FCF. Since then, approximately $10 in cash dividends and stock splits would have reduced your cost basis from $28.93 to $18.66. (Capital returned to you lowers your cost basis dollar for dollar.) At the end of 2014, shares closed at $30.65. That produced a compound return of just 6% per year over the full nine-year holding period. At Extreme Value, we want our investment capital to earn double-digit compound returns of 10% or better. It was the same story if you bought in 2010. Shares were trading near $29 and at an expensive 23 times 12-month FCF. By the end of 2014, your cost basis would have been reduced to $24 by cash dividends and stock splits. Again, that's a compound return of only around 6% per year over the four-year holding period. If you had bought when shares were cheap, though, it would have been a different story entirely… Shares temporarily dropped to $20 in 2009 and the valuation multiple was a much-lower 15 times FCF. Since then, cash dividends and stock splits would have reduced the cost basis to about $13.68… and the compounded return on investment would've been closer to 18%, not 6%, per year. This is one of most important lessons I can teach you about buying stocks: A great business is a great long-term investment only if you buy it when it's unusually cheap. Pay too much and you're doomed to underperform, or possibly even lose money. This is why you should be choosy about making new trades. Stock prices have soared the past six years so most individual stocks are still too expensive to buy today. In short, if a great business you want to buy is expensive right now, be patient. Prices tend to fluctuate. Eventually, you'll get a chance to buy it at a price that will also make it a great investment. Good investing, Mike Barrett Source: Daily Wealth Follow us on Twitter: @blacklioncm |
Monday, November 23, 2015
Four Steps for Finding Great Investments
Four Steps for Finding Great Investments
By
Wednesday, June 24, 2015
We're going to do something that's hard for most people in today's essay...
It involves some math. It involves thinking hard about rather abstract ideas. For most of you, it will involve learning new jargon, which is probably the hardest part. No, it's not as hard as walking across a giant desert for 40 days. But it's something most people will go to great lengths to avoid. So let me tell you why you should first calculate these four things every time you buy another stock.
What you'll find below is a nearly foolproof way to evaluate the quality and the value of any business. This four-part test will allow you to quantify, with surprising precision, exactly what makes a given business great, average, or poor. This knowledge will allow you to make vastly better and more-informed decisions about what any business is worth and what you should be willing to pay for it on a per-share basis. But that's not the best reason to learn this four-part test...
The real secret is, once you develop the discipline to always do this work before you buy any stock, you'll never make a quick decision to buy a stock ever again. Once you add something that's hard to do, that requires a little bit of time, a little rigor, and a little discipline to your investment process, you're going to greatly reduce the number of stocks you buy.
You're also going to radically improve the quality of the stocks you're willing to invest in because you'll have the skills to do so. And that will eliminate more than 90% of your investment mistakes. Remember... you don't need to find a great investment every month, or even every year. You just need to find them every now and then... and have capital ready to put to work.
As I explained yesterday, I believe the No. 1 thing you need to know to be successful as an investor in common stocks is what type of business makes for a great investment.
Investment legend Warren Buffett says the same thing. He puts it this way...
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So... what makes a great business? How can you be certain its earnings will materially grow over reasonable periods of time? To figure it out, let's take one of Buffett's most famous investments – Coca-Cola (KO).
Coke sells addictive (caffeine-laced) sugar water for more than the price of gasoline all around the world. It has integrated its brand into people's lives through decades of advertising spending – an investment that has paid off tremendously. Coke has one of the world's most universally recognized and admired brands.
But how do these advantages translate into hard numbers? The most obvious characteristic of a great business is high profit margins. High profit margins are proof of a great brand, a superior product, or some form of regulatory capture that permits greater-than-normal profitability. On every dollar of revenue last year, Coke earned nearly $0.25 in cash. And it brought in $46 billion in revenue.
To figure out exactly how much money Coke earns in cash, we simply look at the company's cash flow statement, under the line: "total cash flow from operating activities." We see that in 2014, this was $10.6 billion. (You can get this by looking at the company's annual report, Yahoo Finance, or any number of other online databases, like Bloomberg. Here's a link to Coke's cash flow statement on Yahoo Finance.)
Next, we divide those cash profits by the company's total revenue ($45.9 billion), which you can find on the income statement. Doing the math gives you a fraction that is commonly expressed in percentage form: 23%. Coke's cash operating profit margin is 23%. It's earning $0.23 in profit on every dollar it generates in sales. In our experience, businesses with cash operating profit margins in excess of 20% are world-class. If you were putting together a checklist, you could start there. A great business must have cash operating profit margins greater than 20%.
The next "mile marker" you're looking for is something we call capital efficiency. This is another concept that, like profitability, is easy for most people to grasp. All you're trying to understand with this test is how much capital the company requires to maintain its facilities and grow its revenues. For example, oil and gas companies are notorious for spending every penny they make on drilling more holes and building more facilities. Their capital-spending programs leave little of their profits to be distributed to shareholders (often less than zero).
We've developed a sophisticated way to measure, in precise terms, the capital efficiency of any business using several factors in our monthly Capital Efficiency Monitor – a part of our supplemental Stansberry Data service.
But you can use a much simpler equation as part of our four-part test of a great business. All you need to do is figure out whether the company in question distributes more capital back to shareholders... or spends more money "on itself" via capital-spending programs.
A great business is able to distribute more profits to its shareholders than it consumes via capital investments. Coke, for example, spent $2.4 billion on capital investments in its own business in 2014. It spent $5.35 billion on dividends and $2.63 billion on share buybacks in the same period. You can see that Coke is spending far more on its shareholders than it spends on itself. (By the way, all of these numbers are labeled clearly on the cash flow statement I linked to earlier.)
What's powerful for investors about businesses like these is that you don't have to depend on a "greater fool" to come along and pay you more money for your shares than they're really worth. You don't need lower interest rates or a raging bull market to be successful. As these businesses grow, they're going to increase their payout amounts, year after year. It's the compounding effect of this growth that will make you wealthy – not the misguided actions of foolish investors. That's why Buffett says you should never buy a stock you wouldn't be happy to hold for a decade, even if the stock market was closed.
The third part of our four-part litmus test for great businesses is return on invested capital. (Here comes the jargon.) Yes, it's a mouthful. But I promise, with just a little practice, you'll be able to easily calculate this figure in your head. We use this metric because there's no purer way of determining the value and the power of a company's "moat" – the degree to which the company is sheltered from profit-eliminating competition.
The business school formula for determining the precise amount of invested capital is complex and requires several different numbers (and judgments about each of them). It's a pain. And there's a much easier way to get a ballpark figure – just add the total amount of a company's long-term debt and the total value of the company's equity capital. You'll find both numbers as simple line items on the balance sheet.
Coke has $30 billion worth of equity capital and $42 billion worth of debt (adding the current position of long-term debt to long-term debt). So in our book, the company has invested capital of $72 billion. On this capital last year, the company reported $7 billion worth of net income, or "earnings." You'll find Coke's net income on the key statistics page, or you can look at the income statement directly. Once you have the numbers, you just do the basic math (seven divided by 72) to derive another percentage: 10%. As you'll see, this is where Coke falls a bit flat. The beverage market is ultra-competitive and Coke's brand only provides a small measure of protection against competitive pricing.
The last part of our great business test is also a bit "wonky" and will make you sound like a finance geek. It's called return on net tangible assets. This number gives you the best overall measure of the quality of any business. It's similar to the more commonly used return on equity (ROE) with two important differences.
First, measuring returns against net tangible assets takes goodwill out of the calculation. So companies with large amounts of goodwill (like companies with great brands) will typically show a much higher return. Second, this measure of quality rewards companies that can borrow most of the capital they need because their results aren't cyclical.
Calculating this number is also really easy. Yahoo Finance lists “net tangible assets” among its balance sheet statistics. All you have to do is compare this number with the company's net income for the last year. In Coke's case, net tangible assets total only $3.9 billion. Coke earned a profit equal to 179% of its net tangible assets – a truly outstanding figure.
(Note: In some cases, a company will actually have more liabilities than it has tangible assets. In those cases, the math you see above no longer works because you can’t divide using a negative net tangible assets figure. When that happens, we’ll subtract out only the long-term portion of total liabilities. This provides a more meaningful number, while still measuring the company's ability to safely replace equity with debt in its capital structure.)
Putting all of these factors together, our test of business greatness starts with profits. How much money, in cash, does a business earn from its operations, expressed as a percentage of its sales? The higher the margins, the better. This tells us that the company owns high-quality brands and products, and market position. We expect great businesses to produce cash operating margins of at least 20%.
Our second test is capital efficiency. Does the business produce substantial amounts of excess capital, and does management treat shareholders well? We test this by seeing whether shareholders receive at least as much capital each year as the business reinvests in itself.
The third test is return on invested capital, which is the best measure of a company's moat. Here again, we would expect to see returns on invested capital of at least 20% to qualify as a great business.
Finally, our last measure of great companies – return on net tangible assets – is the single best overall measure of the quality of a business. It combines brand value, capital efficiency, the quality of earnings, etc. No surprise, we expect returns on net tangible assets in excess of 20% annually.
Business quality is extremely important, but the stock price is equally important for investment outcomes. Our best advice is to value high-quality businesses by the amount of cash they earn before interest, taxes, depreciation, and amortization. In finance jargon, this measure of profits is called "EBITDA." You can't use this measure with lower-quality businesses, but it works well for high-quality businesses because it allows you to quickly judge companies in different industries against each other.
Now, let me show you a trick that will show you when to buy a high-quality company. We try to avoid paying more than 10 years' worth of EBITDA per share when we buy a business. We measure the cash earnings against the enterprise value of the business (the value of all of the shares and all of the debt, minus the cash in the business). But you don't need to do all of this work yourself. You can find this multiple on Yahoo Finance on the key statistics page for any given stock. Valuing businesses is a lot more difficult than evaluating their performance. You should be willing to pay more for a high-quality business that's growing.
Below, you'll find nearly 40 different companies we consider great businesses, according to their results over the last three years. Roughly half of these companies are trading at or close to reasonable prices. Not including the valuation figure (No. 5), the numbers below were compiled using the last three years of operating metrics, so these numbers may look a little different than the ones you calculate at home, if you're only using current figures.
Company
|
Symbol
|
Share Price
|
No. 1: Profits
|
No. 2: Efficiency
|
No. 3:
Moat |
No. 4: Quality
|
No. 5:
Price |
InterDigital
|
IDCC
|
$57.80
|
45%
|
29.3
|
21%
|
48%
|
6.2
|
Shanda
|
GAME
|
$6.95
|
39%
|
15.0
|
30%
|
99%
|
7.5
|
Apple *
|
AAPL
|
$128.60
|
32%
|
3.4
|
29%
|
35%
|
8.1
|
Gilead
|
GILD
|
$114.18
|
42%
|
4.0
|
29%
|
485%
|
8.9
|
TiVo
|
TIVO
|
$10.57
|
49%
|
21.2
|
16%
|
30%
|
8.9
|
Microsoft *
|
MSFT
|
$46.26
|
39%
|
3.0
|
22%
|
35%
|
9.4
|
Scripps
|
SNI
|
$67.80
|
30%
|
14.0
|
20%
|
413%
|
9.7
|
Edwards
|
EW
|
$131.77
|
30%
|
2.3
|
24%
|
38%
|
9.8
|
Coach *
|
COH
|
$35.88
|
25%
|
3.4
|
45%
|
50%
|
10.1
|
Oracle
|
ORCL
|
$43.78
|
38%
|
14.1
|
18%
|
606%
|
10.2
|
VeriSign
|
VRSN
|
$62.75
|
60%
|
13.5
|
46%
|
39%
|
11.6
|
Myriad
|
MYGN
|
$33.37
|
27%
|
10.3
|
21%
|
28%
|
12.2
|
Ubiquiti
|
UBNT
|
$31.29
|
27%
|
9.4
|
59%
|
59%
|
12.2
|
Lorillard **
|
LO
|
$71.22
|
25%
|
23.5
|
98%
|
35%
|
12.3
|
3M
|
MMM
|
$157.08
|
19%
|
3.2
|
21%
|
27%
|
12.3
|
Philip Morris **
|
PM
|
$80.04
|
30%
|
9.8
|
40%
|
34%
|
12.4
|
j2 Global
|
JCOM
|
$66.47
|
36%
|
4.9
|
15%
|
64%
|
13.0
|
AVG
|
AVG
|
$25.38
|
33%
|
0.3
|
162%
|
63%
|
13.0
|
F5 Networks
|
FFIV
|
$124.14
|
34%
|
11.6
|
21%
|
33%
|
13.2
|
CBOE
|
CBOE
|
$57.45
|
40%
|
4.5
|
69%
|
68%
|
13.6
|
Linear
|
LLTC
|
$46.67
|
44%
|
7.4
|
28%
|
42%
|
13.7
|
Check Point
|
CHKP
|
$83.87
|
58%
|
49.6
|
18%
|
23%
|
14.2
|
Moody's
|
MCO
|
$107.15
|
31%
|
15.0
|
41%
|
79%
|
14.3
|
MasterCard
|
MA
|
$92.36
|
42%
|
19.4
|
43%
|
62%
|
16.1
|
Verisk **
|
VRSK
|
$73.88
|
31%
|
2.3
|
22%
|
51%
|
16.2
|
QIWI
|
QIWI
|
$28.29
|
37%
|
5.7
|
57%
|
161%
|
16.2
|
Core Labs
|
CLB
|
$120.51
|
27%
|
8.3
|
56%
|
127%
|
16.6
|
Choice Hotels **
|
CHH
|
$56.36
|
22%
|
11.5
|
45%
|
26%
|
17.2
|
Biogen
|
BIIB
|
$387.78
|
32%
|
2.4
|
23%
|
51%
|
17.4
|
Sirius XM
|
SIRI
|
$3.90
|
28%
|
11.3
|
47%
|
71%
|
18.0
|
NetEase
|
NTES
|
$144.99
|
53%
|
3.1
|
20%
|
22%
|
18.6
|
Visa
|
V
|
$68.42
|
44%
|
8.6
|
13%
|
100%
|
18.7
|
Priceline
|
PCLN
|
$1,180.86
|
34%
|
6.4
|
28%
|
56%
|
18.7
|
FactSet
|
FDS
|
$164.58
|
30%
|
11.5
|
38%
|
85%
|
19.5
|
Celgene
|
CELG
|
$110.46
|
36%
|
12.6
|
17%
|
321%
|
25.7
|
TripAdvisor
|
TRIP
|
$75.41
|
33%
|
(0.9)
|
19%
|
89%
|
25.8
|
AbbVie
|
ABBV
|
$67.53
|
28%
|
5.9
|
24%
|
94%
|
27.9
|
Baidu
|
BIDU
|
$206.99
|
42%
|
(0.4)
|
22%
|
49%
|
28.6
|
Intuit
|
INTU
|
$105.59
|
33%
|
5.5
|
23%
|
55%
|
32.7
|
WisdomTree
|
WETF
|
$21.78
|
39%
|
0.8
|
45%
|
36%
|
35.9
|
* In the Stansberry's Investment Advisory model portfolio
| |||||||
** For Quality, using return on tangible assets because intangible assets minus long-term debt is negative
| |||||||
We believe the best overall measure of the overall quality of a business is return on net tangible assets. We derive this figure by dividing annual profits (net income) by the company's tangible assets minus total liabilities. Companies that can produce large profits on their asset base may sometimes have more debt on their balance sheets than equity, in effect replacing equity capital with long-term debt. While investors normally should seek to avoid highly indebted firms, companies like these that can produce high and consistent returns can safely use credit as a replacement for equity in their capital structure. This produces large returns on equity, making these businesses extremely attractive to outside passive investors. Please note: In certain examples, extreme amounts of negative equity made our calculations meaningless – you can't divide with a negative number. In those situations, we isolate long-term debt (as opposed total liabilities) to derive net tangible assets. If that still yields a negative number, we simply use returns on tangible assets as a substitute.
| |||||||
The Four-Step Test of Greatness:
| No. 1. Cash operating profit margin: cash from operations / revenue (should be greater than 20%). | |
| No. 2. Shareholder payout ratio: capital returned to shareholders / capital expenditures (should be greater than 1). | |
| No. 3. Return on invested capital: net income / long-term debt + shareholder equity (should be greater than 20%). | |
| No. 4. Returns on net tangible assets: net income / net tangible assets (should be greater than 20%). |
Bonus Step:
| No. 5. Share price multiple: enterprise value / EBITDA (ideally less than 10). |
Regards,
Porter Stansberry
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