Methodology

Methodology

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

While the focus of this research is on understanding risk, including emerging risk, risk is considered in the context of potential upside. The summary risk reports do allow subscribers to sort the companies in their portfolios by risk alone using a simple tab, however clients may find that this ranking is less useful than risk adjusted for potential upside. Obviously, if an investor wishes to totally avoid risk, he or she should focus on sovereign debt of countries with a diverse economic base, favorable trade policies and relatively little debt in relation to GDP.

Distinguishing characteristics of our methodology:

  • Emphasis on free cash flow rather than reported earnings, although both are considered
  • 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.

Primary elements in our analysis:

(1) RISK

  • Stability: Free Cash Flow and Stock Price (25% weighting)
  • Balance Sheet Strength (25% weight)
  • Balance Sheet Trend (25% weight)
  • Quality of Earnings (25% weight)

In addition to those criteria, we heavily penalize companies with three characteristics, regardless of balance sheet trend and strength:

  • Latest quarter free cash flow negative.
  • Two quarters return on capital decline from prior year, same quarter.
  • Trailing twelve months return on capital lower than prior twelve months.

(2) REWARD/UPSIDE POTENTIAL

For investors seeking long term participation in the growth of quality businesses, and willing to assume risk, risk in relation to potential upside is a more relevant ranking than risk alone. If an investor’s sole goal is to avoid risk, treasury bills are probably the answer.

  • Return on Equity (20% weight)
  • Financial Strength Trend (20% weight)
  • Quality of Earnings (20% weight)
  • Return on Capital Improvement (20% weight)
  • Growth (20% weight)

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.

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.

Intrinsic Value

A current estimate of intrinsic value is provided in numeric form, as well as a graph comparing our estimate to net asset value to the stock price over last several years. Discount or premium to intrinsic value is not included in the risk/reward ratio because it can obscure or minimize the importance of quality of the business. We assess the quality of the business, and then, separately, the value relative to the value the company’s historic value. We use several approaches to value, and then compare the average and median values indicated by the different approaches:

  • value indicated by free cash flow (average two year earnings plus depreciation minus five-year average capital expenditures) discounted at 6.7%. Unlike the other approaches to value that I follow, this approach gives no premium for growth.
  • value indicated by the average of the median and low five-year (for non-cyclical companies, fifteen-year for cyclical companies) price to free cash flow ratio. This provides an implicit premium for growth as it is valuing based on the subject company’s average free cash-flow-to-price ratio, rather than the overall average ratio of the market.
  • Ben Graham valuation as outlined in the 1962 edition of Security Analysis. This approach suggests P/E ratios that vary by prevalent T-Bill interest rates. In the current (early 2017) rate environment, the indicated P/E ratio ranges from 9.8 times to 48.1 times. For an excellent discussion of this subject see Benjamin Graham And The Power of Growth Stocks by Frederick K. Martin. Instead of P/E ratios, I apply price to free cash flow ratios.
  • value indicated by average price to book value discounted by trailing twelve month loss in free cash flow, if any. This approach is particularly important for cyclical companies and companies that are routinely unprofitable at the bottom of the business cycle, and highly-profitable at the peak.
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.

In those days, I had a two-to-one, losers-to-winners, ratio in the companies selected for in-depth reports to institutional investors. Fortunately, the winners made a lot more than the losers lost. Thinking about that Buffett position, I seemed obvious that had I employed the financial statement trend analysis techniques that Buffett was apparently employing, I could have avoided almost all of the major losers in my own portfolio and the losing investments I had recommended to clients. Financial statement analysis, done carefully and exhaustively, could have allowed me to focus my time and travel where it could generate the best returns.I spent the next six months developing an Excel-based financial statement analysis model. This was before the internet was a glint in Al Gore’s eye, and I had to use an OCR scanner to accumulate historical data from 10Ks, 10Qs etc. on microfiche. I worked on that problem day and night for several months, but ultimately gave up. During the bear market of 2009, after running a successful company for eighteen years, I began this work anew, and have over the last ten years developed analytical software, condensing the number crunching that took me a couple of months to complete as recently as September 2016 into a couple of hours. This software helps me identify emerging and established trends in:

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

Reported earnings are secondary to free cash flow in this analysis. The definition of free cash flow varies from analyst to analyst. The definition I use:

  • two year average net income plus depreciation minus five year average capital expenditures
  • no adjustment to free cash flow is made for fluctuations in inventory, receivables or payables, or deferred taxes, but major consideration is given to these factors in rating quality of earnings. The primary elements of quality of earnings: growth in capital expenditures, debt, receivables, inventory and payables relative to growth in free cash flow.

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.

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

Eighty percent weight in this analysis is given to trailing twelve month versus prior twelve months, ten percent to five year trends and ten percent to latest quarter versus prior year quarter. In effect, this gives 30% emphasis to latest quarter.