Methodology

We help investors understand financial strength and competitive advantage by running hundreds of profitability and credit ratios on all 5500 companies with market caps of over $5 million, and then comparing each company with all others.

Every investment analysis approach has strengths and weaknesses. It’s strength is that it is based on facts rather than conjecture or bias. It provides a comprehensive analysis of the emerging financial statement trends of all public companies. It uncovers, for instance, which companies are experiencing margin improvement and declining debt in relation to intrinsic value, or increased asset turnover (generating more revenues from the same assets) while improving their interest expense coverage by operating free cash flow.

The weakness of this approach? It places almost no emphasis on earnings predictions, including by management. Every company, even the most stable and consistent, experiences setbacks and weak quarters. We’re not particularly interested in weak guidance, for instance, other than as an opportunity to buy quality at a discount. We don’t know what is going to happen, so we don’t try predict. We’re experts in what has happened.

 

The best thing that happens to us is when a great company gets into temporary trouble… We want to buy them when they’re on the operating table.

  • “Homespun Wisdom from the ‘Oracle of Omaha'” Businessweek (5 July 1999)

Of course, the crucial, operative word is “temporary.” At its base, we’re betting on no fundamental, long term change.

 

Basically, he’s (Buffett’s) betting against change. We’re betting for change. When he makes a mistake, it’s because something changes that he didn’t expect. When we make a mistake, it’s because something doesn’t change that we thought would. We could not be more different in that way. But what both schools have in common is an orientation toward, I would say, original thinking in really being able to view things as they are as opposed to what everybody says about them, or the way they’re believed to be.”

Our analysis is based on two investment principles:

  1. Quality is reflected in the numbers. Saying a company is high quality but is experiencing a long-term decline in its margins and asset turnover like, for instance, Walmart (see below), is like saying Joe Smith was a world champion marathoner but his knees gave out as he aged. The unfortunate reality is, while he may still be a great guy, Joe’s no longer a great runner.
  2. Companies with declining debt/equity ratios (or no debt at all), with improving margins and growing sales outperform, over time, those with the opposite characteristics.

 

“Is it a great business? That’s the key question. Is it earning high returns on capital and commanding high margins? Does it have a good history of growing its intrinsic value and rewarding shareholders? Warren Buffett has this great phrase: “If a company has a lousy past and a great future, we’ll miss it.” It’s the same thing here.”

“By owning great companies, you can just forget about all the noise and the irrational market fluctuations. And slowly get rich.”

This analysis is used primarily to identify that one half of one percent of US public companies capable of generating, year in and year old, come hell or high water, recession or boom, Trump or no Trump, increased cash flow without increasing debt. In broad terms, thirty-four companies can be described as exceptional by four criteria

  • Consistent free cash flow throughout economic cycles
  • Annual free cash flow growth in excess of 8%.
  • Favorable trends in debt and interest coverage. Generally, these companies have either no debt, or more surplus cash than debt.

That’s our territory: companies with an inordinate ability to create owner value, or free cash flow compounders. No company is perfect, but some are better than others.

Graphs showing the relationship between stock price risk and financial statement risk. Company: Former Dow Jones Industrial Average Company, General Electric.

 

 

 

Distinguishing characteristics of our methodology:

  • Emphasis on free cash flow rather than reported earnings, although both are considered. Free cash flow is defined as net income (after deduction of one-time tax credits related to recent tax cuts) plus depreciation minus five-year average capital expenditures. No adjustment is made for fluctuations in inventory or receivables, although those are the primary considerations in our quality of free cash flow growth assessment (see below).
  • Both book value of common equity and estimate of intrinsic value are considered in financial strength, but the emphasis in this research is on estimated intrinsic value.
  • Quality Of Free Cash Flow: growth in debt, capital expenditures, inventory, receivables and payables in relation to the growth of free cash flow. Only companies with a competitive advantage and at least mediocre management are able to grow free cash flow faster than capital expenditures and debt, and free cash flow faster than growth in inventory, receivables and payables.
  • No emphasis on EBITDA because, as Buffett and Seth Klarman have pointed out, EBITDA assumes that depreciation and amortization are not real expenses. They are. Visit here for more.

Summarized, our risk/quality criteria:

(1) RISK

  • Stability: Free Cash Flow and Stock Price.
  • Balance Sheet Strength.
  • Balance Sheet Trend.
  • Overvalued/undervalued (overvalued increases risk, particularly in the 1-2 year term).
  • Quality of Earnings (growth in free cash flow versus growth in capital expenditures, debt, inventory, receivables, SG&A, dividends, cash liquidity).
  • Ability to compound owner or cash earnings (see below).

(2) REWARD/UPSIDE POTENTIAL

  • Ability to consistently, year in, year out, increase free cash flow per share.
  • Free Cash Flow Return on Capital.
  • Free Cash Flow Return on Capital Improvement.
  • Financial Statement Trends (Margins, Capital Turnover, Leverage, Liquidity).
  • Quality of Earnings (see above).
  • Return on Capital (Equity for Financial Companies) Improvement.
  • Growth (Revenues, gross profit, operating profit, net income, net income per share, book value per share, dividends and especially free cash flow).

There are overrides on some of these criteria. For instance if Apple’s liquidity trends were adverse, but it still has more cash than total liabilities, the relevant consideration is current position not trend when considering overall financial strength.

Long Term Ability To Compound Owner Earnings With Minimal Volatility

This is the single most important consideration in selecting companies for this research. We sort all public companies by

  • the number of quarters over the last twenty years (if available) in which the company was able to increase free cash flow versus the prior twelve months.
  • median rate of change.

So a company that, over the last 80 quarters, trailing twelve months, generated more in free cash flow than in the twelve months ended a year earlier in sixty percent of  quarters, it would receive a score of 75 by this measure. If, in addition, the average rate of growth was 3%, it would get a score of 30 by this measure. In order to give the 3% significant weight in the combined score we multiply it by 1000.

To put this in perspective, all public companies score negative 8 by this measure, and the 62 compounders I study score 51.

Intrinsic Value

Criteria:

  • Based on average fifteen-year (if available, shorter period if not) price-to-free cash flow ratio. So, if a company had an average price to free cash flow of 30, and earned $1 over the last twelve months, the value indicated by this measure would be $30.
  • Free cash flow discounted at 6.67% (P/FCF ratio of 15), the value indicated by no growth companies in the current low interest rate environment. We include this conservative measure to reflect the possibility, even if small, that the subject company will experience no growth over the next twelve months. A company earning $1 per share would, by this measure, be worth $15 per share.
  • PEG ratio applied to free cash flow. If a company is growing at 20% a year and earned $1 in free cash flow over the last twelve months, we would estimate value at $20 by this measure.
  • Dividend value as indicated by current dividend yield divided by average dividend yield over the last fifteen years. If a company on average yielded 2% over the last fifteen years, and now pays an annual dividend of $0.50, we would estimate value at $25 by this measure.
  • Value based on fifteen-year average price to book times current book value. If a company is not currently earning money, we base value on the minimum price to book over the last fifteen years, and then deduct from that one year of cash losses, if any. For example, a company that lost $1, and had a minimum price to book of 1.7 over the last fifteen years, and a book value of $15, would have an estimated value by this measure of $24.50.

By necessity, this is an abbreviated outline. Because the software compares various time frames, and in order to build redundancy into the results so that a data input error doesn’t invalidate conclusions, thousands of ratios are calculated and compared. An example would be a company with a radically different return on capital than return on equity. When such a situation is encountered the software looks at trends in earnings versus equity growth looking for anomalies, for instance due to stock buy backs, and bases conclusions on the which number best reflects the overall financial statement trends of the company. Acquisitions, divestitures and tax credits can also mask the key underlying trends, and this software seeks to identify and adjust for those one time or unusual events.

Earnings Versus Free Cash Flow

As mentioned, reported earnings are secondary to free cash flow in this analysis.

Like all research approaches, there are both advantages an disadvantages to emphasizing free cash flow over earnings. Companies with rapidly growing earnings, but with capital expenditures that are growing even faster, are penalized. That is usually a good thing, a positive contributor to investment performance. There are exceptions however, for instance Amazon.com.

Free cash flow is closest to earnings actually available to owners to fund growth, dividends and stock re-purchases. Although roughly three-quarters of the emphasis of this research is on free cash flow, growth in book value and in reported earnings are also considered.

Background

Over the last thirty years, I’ve developed credit quality analysis tools that identify financial statement trends, and then compare values and trends with thousands of other companies. For efficiency purposes, these tools have been coded in Python software.

This research evolved out of work I did in the early and mid-1980s for activist and special situation investors including Leucadia, Sam Zell, Jay Jordan, Richard Rainwater and an Australian company, Industrial Equity as well as institutions including the Royce Value Trust, Fidelity and T. Rowe Price. The focus of my research was out-of-favor and distressed securities, including the bonds of companies in default. Most of my work in those days consisted of investigative research. I would interview former senior executives, former directors, customers, competitors, etc. and sit in bars outside factories and talk to workers when they came off shift. What used to be fun — airports and hotels — became a little old.

In 1988, Buffett invested over $1 billion in Coca Cola at fifteen times earnings, twelve times cash flow, and five times book value. I had always thought of him as a value investor, and the stock seemed to me to be overpriced. When the position proved to be highly-profitable, I studied it and realized that the company was undergoing significant fundamental positive change, and that that would have been apparent to anyone who studied the company’s financial statements. Its margins and capital turnover trends were benefiting from the liquidation of mediocre operations and expansion into global markets.

To enable me to identify companies with similar characteristics, ten years ago I began developing software that scans all public companies looking for emerging and established trends in:

  • growth
  • profitability
  • leverage
  • liquidity
  • quality of earnings
  • price in relation to free cash flow, book value

Competitive Position Analysis

Michael Porter, a professor at Harvard, and author of several books, including Competitive Advantage, is perhaps the most widely-recognized expert in understanding and documenting the characteristics that determine competitive advantage. The key characteristics are, he says:
  • the overall profitability of a particular industry or sector
  • an individual company’s competitive position within that industry as determined by its ability to deliver to the customer something truly unique in the way of value or quality
  • both of these factors are largely determined by five sub-factors:
    • Competitive rivalry.
    • Bargaining power of suppliers.
    • Bargaining power of customers.
    • Threat of new entrants.
    • Switching Costs. Threat of substitute products or services.

A crucial consideration in assessing competitive advantage: how vulnerable to change is a particular company. Highly-profitable companies such as Microsoft and Apple are, for instance, susceptible to changing technology. Wrigley’s and Coca-Cola are significantly less so.

Financial statement trends explored:

  • Trailing twelve months versus prior twelve, latest quarter versus prior year quarter, five and ten year free cash flow:
    • as a percent of equity (equity works better in banks and insurance companies does than return on capital, allowing comparison between financial and non-financial companies)
    • growth relative to growth in debt, capital expenditures, total liabilities, receivables, inventory and payables (quality of earnings analysis)
    • trends in times interest coverage by free cash flow, and, secondarily, operating income
    • free cash flow as a percent of total liabilities
    • long term debt as a percent of assets
    • asset growth versus free cash flow growth — measures efficiency, financial stability
    • stability of (variance in) year-to-year free cash flow. All companies have variance — they are not, after all, machines but rather human enterprises that grow and shrink in a resistant environment — but one measure of quality is a degree of stability relative to other highly-profitable companies. On the other hand, a superior company in a highly-cyclical industry can have an exceptional long term average return on equity, but experience wide year-to-year variance based on industry cycles. Schlumberger was an example, although gradually, over the years, its return on capital has steadily declined, indicating that it may no longer be a particularly high-quality company.
    • Trends in capital turnover and margins, the constituent components of return on assets
    • Debt as a percent of equity, both book value and estimate of intrinsic value
    • total liabilities as a percent of assets
    • cash plus receivables in relation to current liabilities, total liabilities and total assets
    • accounts payable in relation to revenues
    • S,G & A in relation to gross profit
    • Book value per share growth
    • dividend growth

The emphasis in this analysis: the above noted trends over the last twelve months are compared to the twelve months ended three months earlier, and to the twelve months ended three months prior to that, and so on for three years. Twenty year trends in free cash flow per share are also considered, and in fact, almost all my research focuses on the top one percent of public companies in terms of ability to compound free cash flow per share.

Compare the graph below to that of GE at the beginning of this page:

 

See also Quality Versus Value: A False Dichotomy

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