In the previous post I wrote about some of the ways Tweedy, Browne Company operates. Now, it’s time to dig deeper and see what exactly does Mr. Christopher H. Browne look at once he’s narrowed down his list of cheap stocks.
Give the Company a Physical
Now that you’ve determined the company to be cheap, it’s time start with the first of the financial statements and examine the balance sheet. The balance sheet is a snapshot of its financial condition at a given point in time. It shows how solvent the company is and if it’s in good or bad health.
Liquidity is Good
Liquidity provides the flexibility to withstand down cycles in the economy, pay dividends, initiate buybacks and take advantage of future opportunities. You want to make sure that the company is not overly burdened with debt, and that there is enough capital to stay in business during bad times. Look at the firm’s current assets. These are the ones that can be converted into cash within a year. Then look at current liabilities. This is what must be paid within a year. Subtract current liabilities from current assets and you get the current ratio (also known as working capital). A rough rule of thumb is to prefer it to be above 2. That is, the company has twice the amount of liquid assets as it has short-term debts and obligations.
Rising Inventories, Book Value & Capital Structure
Track inventory levels over the past several years to see if they have been steadily rising in relationship to the company’s sales. Without increasing sales, rising inventories may indicate a product that has decreased in popularity and would be difficult to sell at a profit. Rising inventories is not a problem if other important metrics are rising as well, such as earnings, book value and free cash flow.
Subtract total liabilities from total assets and you get the company’s book value. Also known as net worth. It’s the ultimate measure of how equity has built up over the years both from money raised and earnings retained and reinvested in the business. As the true value of intangible assets is hard to estimate, Chris Browne omits these from his calculation.
Another measure that gives us a good idea of a company’s solvency and ability survive is the the debt-to-equity (D/E) ratio. This is the total debt, both long and short term, divided by the shareholder equity. If the number is higher than one, we know that the company is funded primarily by debt rather than equity investment. This is not necessarily the end of the world, but it means you need to investigate further. It pays to compare this number with that of other companies in the same industry. A stable business such as a public utility can service more debt than a young tech company that needs cash to reinvest in research and development of new products. In general, a high D/E ratio means that a company has been financing its growth by borrowing.
Leverage is always a double edged sword. If the company can invest the money it borrows, and earn a higher return than it pays in interest, it should be able to quickly improve its profits. If not, there is a real danger of default and bankruptcy down the road. Generally the less debt on the balance sheet, the greater the margin of safety.
Examination Continues – Earnings Prospects
Once you are satisfied with the balance sheet, it’s time to look at the firms earnings prospects. When looking at the income statement, its generally advisable to look at yearly reports, since quarterly sales may be seasonal in nature. Another reason you should prefer yearly developments over quarterly, is because it puts you in the mindset of the long-term investor, and not short-term speculator.
Revenue growing over time is good. Without growing revenues, it’s hard to have growing earnings, which guides the stock price. It’s advisable to look at revenue a bit deeper. How diversified is the revenue stream? If the majority of the company’s revenue is dependant on one stream, ask yourself: “What happens if this stream is cut off?”. The man-made shutdowns during the pandemic showed without warning who’s been “swimming naked”, as Buffett would put it.
EBIT & ROIC
Just looking at earnings per share (EPS) development alone is not enough. Many companies have granted options to executives that can be converted into stock, or have issued bonds, preferred stock, or warrants that can be converted into shares. This is why you want to look at diluted earnings per share on the income statement. If the number is very low compared with the original EPS, it could be a warnings sign that perhaps the shares are not as cheap as they first appeared. What you also want to see, is growing EBIT (Earnings Before Interest & Tax) over time, also known as operating income. Strong, growing EBIT over time shows the true earnings power of the company.
The more stable a business, the better you sleep at night. What you ultimately should prefer is stable, possibly growing return-on-invested-capital (ROIC) over many years. This is calculated by dividing earnings in any given year by the beginning year’s capital, stockholders equity + debt. A company with a high return on capital has a much greater chance of financing growth with self-generated cash than one with a low return. Stability in ROIC indicates that management is doing an adequate job of investing and managing the reinvested profits each year.
Final Check-Up
Knowing certain numbers is critically important. But if successful investing was as simple as a mathematical formula, everyone would have nothing but winners in their portfolio. There is some art to identifying the best prospects, and you should analyse your list of companies in greater detail. The best way to approach this is to think of yourself as owning the entire business, and asking qualitative questions.
- What is the outlook for pricing for the company’s products? Can they raise prices without customers going to a competitor? The less competition in an industry, the easier it is to increase prices.
- Can the company sell more, and how? Does the company have the right incentives in place to increase sales?
- Can the company control expenses, and to what extent?
- What would the business be worth if it were sold?
Over time, you’ll develop your own checklist on what’s important to you in your investments. Whatever your approach, the best investment you’ll ever make is the one in yourself.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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