Never judge a book by its cover?
That’s great advice for a book. For a person, however, it’s usually good advice but sometimes the cover is just so obvious. I mean, if the person is clearly a weirdo (by your standards), why waste time on him or her? In the dating world, let’s just call it “minimum standards” – like age, common interests, geographical location, personal hygiene, favorite binge-worthy show etc. If someone doesn't meet the minimum standards, we should move on. I know, I know – we should be completely open-minded. But let’s face it – most of us are not that evolved as human beings. And we don’t have unlimited time. Screening by minimum standards is efficient. But there are two main downsides to this in the world of dating: 1) Screening can be too restrictive and possibly deprive us of a soulmate (isn’t that a myth?) and 2) Sometimes, it’s downright offensive to the person who didn’t make the cut in our superficial screener. That could be an awkward conversation; or hilarious, for the fly on the wall.
With investments or companies, I needn’t worry about those downsides. First, in investing, I’d feel much worse about holding on to a turd than I would about missing out on a diamond in the rough. FOMO is a killer. I learnt that from my own experience, which were then reaffirmed by the writings of the great Warren Buffett. Second, it’s unlikely that an investment idea will be offended if it doesn’t pass my superficial test.
So, what are your intentions?
Let’s assume we’re at the stage where like the (very superficial) look of a company. Maybe it’s in an industry we like. Or they make a product we love. Or they were featured in an article, in which their CEO really impressed us with her business acumen. Many investment ideas simply pop-up by being aware and observant of the world around us. Look around your home – there are at least 50 different products made by 50 different companies. Maybe half of those companies have publicly traded stocks. Maybe 10 out of those are products you really, really like. And maybe a couple of those are truly world-class. At this stage, when we’ve got a company or two to consider, there are 2 key questions we need to ask on that first date.
- Is it liquid – can I trade this stock easily?
- Is it worth digging into this company? Is it worth a first date?
Can I get out without drama?
To make sure we can either buy into a story easily or, more importantly, get out if the story turns out to be a turd, the stock needs to be liquid. To ensure that there is minimum drama, I look for 2 specific things:
- Can I buy it through my broker without major issues?
- Does enough of this stock trade on a regular basis?
For the second question, I usually look at the Market Capitalization of the stock, and the average daily liquidity over the past year or so. Specifically, I prefer to buy into stocks that meet these minimum standards from a liquidity standpoint:
- Market Capitalization of greater than $500 million.
- Average Daily Volume over the last year of at least 20 times the number of shares I would purchase.
I can assure you that you and I won’t have much trouble finding many candidates with these minimum “no drama” standards.
Is this worth my time?
That’s a far cry from “Should I invest in this?”. We’re talking about a first date here, not about wedding plans. But even then, our time is limited. To expedite this process, most investors (and traders) use Financial Ratios. That’s fine – I do too. But I don’t use the readymade ones we find on Yahoo Finance or Google Finance or MarketWatch or even on research reports coming out of Wall Street. And that’s because those ratios are not clean. Earnings or EPS – the denominator of P/E ratios – are dirty accounting (not economic) numbers. There are just too many Accounting shenanigans in them. So, P/E is a dirty number and, similarly, Return on Equity (ROE) becomes a dirty number. Those are two of the most popular “screeners”. Sadly, many so-called investors use these ratios as a green light to invest. It’s bad enough using these dirty numbers as screens. But to use them as “buy” signals is only slightly better than shooting in the dark – only slightly.
Here are the 3 main questions I’d put in the “Is this company worth my time?” bucket:
- Does the business generate a lot of cash for shareholders?
- Is it a high Return-on-Equity business?
- Does the company use too much debt?
And then there is a 4th question that just helps me prioritize, in case I have 3 or more companies to look at in a single week (sometimes I’m just so damn irresistible). If I’m looking at just one company, I don’t worry about Question 4 yet (which is usually the case – I’m not that irresistible on most days, sadly).
- Is this company outrageously expensive? If it is, I’d rather spend my time on the one that may be borderline-expensive. I have a quick way of measuring this, which I’ll talk about below.
Answering these questions – quantitatively – takes a maximum of 30 minutes. That’s 30 minutes per company, on a lazy day.
Does the company generate a lot of cash for shareholders?
Many “investors” look at Earnings or Earnings-per-share (EPS). Instead, I look at a rough measure of Free Cash Flow. And the reason I like Free Cash Flow is because it is a cash number. Because, you know, cash is cash is cash – there is no argument. EPS is not cash. It’s a weird Accounting number that has a myriad of Accounting assumptions built into it. In most cases, this rough measure of Free Cash Flow brings me close to the somewhat more nuanced Free Cash Flow number I use in my detailed valuation. To get a quick, rough measure of Free Cash Flow, this is the math I use:
Cash Flow from Operations minus
Capital Expenditure minus
An arbitrary 20% Cash Tax Rate
= Rough Free Cash Flow.
This calculation takes about 10 minutes. I can usually find numbers for the last 3 years in the last Annual Report. Easy-Peasy. Here is specifically where I find them:
Cash flow from Operations: The Statement of Cash Flows. You can find this statement after the Income Statement and the Balance Sheet. “Cash Flow from Operating Activities”, as it’s sometimes called is the first table in this statement. It comes before “Cash Flow from Investing Activities” and “Cash Flow from Financing Activities” (labels may change slightly depending on the company, but the sequence remains intact).
Capital Expenditure: This number resides in the “Cash Flow from Investing Activities” – the second table in the Statement of Cash Flows. It may have some other names like simply saying “Additions to Property, Plant and Equipment”. That just means cash spent on Property, Plant and Equipment, which is the definition of Capital Expenditure. There may be additional entries like “Acquisition of Software”, which would qualify as Capital Expenditure. I skip any permutations of “Cash spent of Acquisitions” at this stage. That’s because I assume that acquisitions are generally funded via cash on the Balance Sheet or Debt or Equity, rather than Cash Flow from Operating Activities.
Arbitrary 20% Tax Rate: This is a bit of a crapshoot. Different companies pay different amounts in taxes. You hear politicians debate the high “corporate tax rate” of 35% and so on. But the cash tax amount companies pay is often very different. Usually, they’re much lower, thanks to the mindbogglingly complex tax code in the US. 20% seems like a reasonable placeholder until we dig in to do a more nuanced valuation. Sometimes, if we’re lucky, we can find the real number – “Cash Paid for Taxes” – in a small section called “Supplementary Cash Flows” at the bottom of the Statement of Cash Flows. In my experience, however, that’s true for less than half of the companies.
Rough Free Cash Flow: The emphasis in on the word “Rough”. For starters, I haven’t deducted cash interest payments to arrive at Free Cash Flow to shareholders. That’s because that number is usually hidden somewhere in the footnotes. Again, if we’re lucky, we’ll find in Supplementary Cash Flows. But otherwise, it’s too time-consuming to dig into for a first date. The other nuance to remember is that these are historical numbers. The real analysis is in coming up with a “Sustainable” Free Cash Flow number. That mostly involves a very qualitative analysis of the business and the ecosystem within which it operates. That, of course, is time-consuming.
Is this a financially productive business?
Sounds cool but what is the point of knowing this? Charlie Munger puts it for us succinctly:
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns.”
The financial-ratio translation of this is: Return on Equity (ROE). This number tells us 2 things: 1) As Munger mentioned, it gives us a rough idea of the long-term returns we can expect from my investment in the business. 2) It tells us something about Management Quality – are they good stewards of shareholder capital? Munger’s more famous partner-in-crime, Warren Buffett, believes that the primary function of top management is “Allocation of Capital”. How do they invest shareholder capital to maximize long-term return? With this screen, it tells how they’ve done recently. If they’ve done well – as implied by a decent ROE number – it gives us some confidence that they could keep doing well into the future.
The usual, published ROE number is very dirty. It’s usually measured as Net Income (Earnings) divided by Average Book Value. As mentioned before, the Earnings number (Net Income) itself is a very dirty number. I use my rough Free Cash Flow number as the numerator instead of using Net Income. So, my ROE ends up being [Rough Free Cash Flow divided by Average Book Value]. If this number is in double digits – consistently higher than 10% - I tend to get excited. If it’s, say, 5% consistently, it’s a real bummer. That suggests that, over the long term, I shouldn’t really expect to beat my level of inflation by investing in this low-ROE business.
Does the company use too much debt?
One way to bolster ROE, sneakily, is to borrow a lot of money. Other peoples’ money (OPM – see what that sounds like?) boosts returns in any portfolio of investments. That’s why they call debt “leverage”. With too much leverage, the ROE number could mask fundamental problems in the business. For example, a paltry 2% return, levered 5X, amounts to a nice 10% return. The problem is that too much leverage goes the other way too – it comes with 5X the risk. The main risk for any investor is permanent loss of capital. And the probability of permanent loss of capital increases with the level of debt. The main reason is that interest payments on that debt eats up a lot of cash flows. A string of bad years for the business could mean that the firm almost dies (declares bankruptcy) because it can’t meet its high interest bills with cash flows from its operations. Ultimately though, a high level of debt implies an incompetent Management. If a firm or a portfolio’s returns are primarily dependent on borrowed money, I’d rather invest elsewhere, thank you very much.
How do I measure “too much debt”? I prefer to invest in companies with a Long-Term Debt/Equity ratio of less than 2X. That’s a high enough number, so any companies with a higher ratio are unlikely to make the cut. There could be exceptions in cases where I have good reason to believe that the Management will pay down debt with cash it generates from its operations, or maybe using cash on the Balance Sheet. But that’s a second-date type of analysis.
Optional: Is it outrageously expensive?
Outrageously expensive means the company is trading at a valuation far above it’s ROUGH intrinsic value. This is how I measure ROUGH Intrinsic Value: 20 times Rough Free Cash Flow. If the Market Capitalization of the company is much higher than this ROUGH Intrinsic Value number – say by 30, 40% - the company is probably too expensive to go on a Buy List. Maybe it’s a better use of my time to look at something that’s just 10% above ROUGH Intrinsic Value.
I can hear the murmurs. The “20 times” assumption raises a lot of questions. There’s no magic in this number; it’s not the result of some high-brow academic paper from the Journal of Something We’ve Never Heard Of. The thinking is simple – I guesstimate what I think is MY rate of inflation – that’s my cost of capital, if you will. And that’s usually around 5%, regardless of what Treasuries suggest currently or at any given point in time. This is my long-term cost of money. And long-term is important, because I assume the company will around for a long, long time. If that’s the case, I simply do this: Rough Free Cash Flow divided by 5%. That results in “20 Times”.
The philosophy behind using long-term inflation as a discount rate is a fascinating but long topic. It’s a direct rebuke of all the “high-finance” taught in business schools, and the way Wall-Street operates. There is no “Cost-of-Capital” mumbo-jumbo in my approach. It’s simply an opportunity cost calculation – do I invest my money in this company, or do I sit I cash? If I invest, it better cover my cost of money. 5% is an arbitrary number, but it’s really how much poorer I feel every year if my income doesn’t increase. It’s as simple as that. By the way, this isn’t a novel method. This is how a certain Mr. Buffett operates. He never calculates a “weight-average cost of capital” or any such academic concept. His partner-in-crime, Charlie Munger, doesn’t mince words:
“I’ve listened to many cost of capital discussions and they’ve never made much sense. It’s taught in business school and consultants use it, so Board members nod their heads without any idea of what’s going on.”
But this is whole another topic that gets into the weeds of Finance. But as I mentioned earlier, I do this rough valuation only when I have too much on my plate. Usually, I don’t care about price on the first date (I’m nice like that). And that’s because I’m more interested in finding out if it’s a good company before I think about price. If it is indeed a good company, it will probably go into my Watch List, so I can pounce when/if the price is right.
And then the real work begins.
If a company passes the first date tests, we take it further. The next few dates take a lot more work, but they are way more fun. The next few questions, in order, are:
- Is this a good company?
- Is it a good price?
“Is it a good company?” is a subjective analysis. The intention is to figure out if a company’s cash flows will remain steadfast or even grow in the face of heavy competition.
“Is it a good price?” is a more nuanced look at valuation. It takes a lot longer than 30 minutes. And even here, the analysis is mostly subjective because it’s inextricably linked to “Is it a good company?”
It’s not perfect. But it “satisfices”.
“Satisificing was [Herb Simon's] idea (the melding together of satisfy and suffice): You stop when you get a near-satisfactory solution. Otherwise it may take you an eternity to reach the smallest conclusion or perform the smallest act.” – From Fooled by Randomness by Nassim Nicolas Taleb.
On a first date, we should just look for a satisficing conclusion. In any case, I don’t think a “perfect” screener exists. But bad ones do, and we should stay away from them. If you feel compelled to use financial ratios as outright “buy signals”, I would strongly suggest using something like the first date screener here. At a minimum, I highly discourage using naïve P/E, P/B, P/S ratios as indicators of value. If it was that easy, we’d be rich. But it’s not; because those numbers are dirty.
The first date screener here isn’t squeaky clean. For starters, it is a historical number just like those readymade ratios. But it is closer to the truth. In many ways, valuation is an exercise in finding the “truth”. The harsh truth, ironically, is that we’ll never get to a “true” valuation. It’s a mirage. And it keeps changing. At best, we can estimate if something is clearly too expensive or too cheap. That requires having some basic idea of an asset’s Intrinsic Value. Most importantly, it requires the realization that Intrinsic Values is just a rough marker. But if something trades much below – say 30% below – this rough marker, it means that the probability of being wrong is significantly lower. That, in a nutshell, is the concept of Margin of Safety, which is the central pillar of Buffett’s investing philosophy – Intelligent Investing.