Something I’ve been thinking about a lot recently is how to rank a lot of seemingly cheap companies against one another.  Due to the recent market turbulence, there have been a lot of companies trading at very low levels in comparison to their earnings power.  So, the question I’ve been asking myself is:  Out of all of the businesses trading at attractive valuations, which one(s) am I most interested in investing in?

Even though I consider myself a value investor (which means that I look to buy businesses for less than their intrinsic value), I find myself constantly tweaking how I actually apply value investing principles in my own investing decisions.  Part of this is due to the fact that I tend to read a lot of investing blogs and books so I’m constantly exposed to other people’s ideas and thoughts.  But the greater part I think comes from accumulating experience in the market and seeing how your own decisions play out and how comfortable you are with them.

As I muddle along, I’m tending towards owning fewer, higher quality, more predictable businesses than I did in the past.  A lot of this has come from the fact that it’s actually hard to come up with a dozen or more businesses that are trading at an attractive valuation, have some semblance of predictability as to what the future will look like for the business, and have management teams that aren’t going to squander the money that the business brings in.

Get your Yields Here!

To start, I’ve decided that I’m only interested in opportunities that have a chance of providing a 15% compounded return into the future.  This means that I only want to buy stocks that have earnings or cash flow yields greater than this hurdle rate.

Now, there are many ways to come up with a stock’s yield.  The one I’ve currently adopted involves a company’s 10-year average free cash flow margin and current price-to-sales ratio.  In layman’s terms, I figure out how much cash profit the company produces per $1 of sales in an ‘average’ year, and then how many dollar’s worth of that company’s sales I can buy for a given dollar investment.  So long as the combination of these two numbers is higher than 15% (for example – FCF margin of 15% and price-to-sales ratio of 1), the company’s passed my first test.

Now, to find companies trading at or above your target yield you can either use a stock screener, or better yet, you can keep a watchlist of companies you’re interested in owning and the prices they’re available at in the market.  In any case, depending on the hurdle rate you’ve chosen, the list of stocks to evaluate further is likely going to be narrowed down significantly after this initial screening stage.

Back to the Future

So, now we have our list of possible investment candidates trading at attractive prices.  What next?  Well, something I like to think about is what each company does and what it will continue doing.  The reason this is important has to do with that average profit margin we calculated up above, and the sustainability of their results.  You see, even if we buy a company when it has a 15% earnings yield, we won’t make 15% on our investment if their operating results begin to suffer.  For example, Apple (AAPL) is on a lot of people’s list as a great stock to own.  And at first glance it may be as it sports a relatively low price-to-earnings ratio for a company that is growing so quickly.  However, I have two problems with Apple that I’d have to get comfortable with before I would consider investing.

First off, I have no idea what Apple will be doing in 10 years.  Probably something to do with phones, or music, or computers, but maybe not.  10 years ago, not many could have predicted that they’d now make most of their money on cell-phones, music, tablets and not their Apple computer line that had been their mainstay for decades.  In another 10 years who knows what they’ll be doing.  And this brings me to my second point.  Apple currently has very high margins – somewhere around 25%.  This means that for every dollar of sales they make, they have about 25 cents in pure profit.  Now, if you’re not impressed, you should be.  Very few companies have profit margins that are this high.  The reason I mention Apple’s current profit margin is that if I was investing in the company, I would be worried that they may not be sustainable.  For example, when the iPhone first came out, it had a lot of features you couldn’t find on any other phone, and so it was easy to charge a lot for it and have people pay.  However, other smart phones are now very close feature-wise to iPhones, but can typically be bought for hundreds of dollars less.  So the question is, can Apple keep charging much more than its competition for a similar product into the future?  Maybe, but maybe not.  And if competition erodes their margins, there goes your margin of safety.  Now this isn’t saying that Apple won’t be successful into the future, they very well may be, and people who buy their stock at these levels may make out very well.  But I can’t predict their sales or margins with any confidence 10 years into the future, and because of that, I won’t invest.

For me, if I can’t envision with relative confidence what a company’s sales and margins will look like at least 5 to 10 years in the future, I pretty much set the company aside.  A lot of investing is not just finding undervalued companies to buy, but being able to hold onto them until you get an offer for your shares that you’re satisfied with.  As companies may drop over 50% from where you first buy, and getting a good price to sell at may take years, being confident in a company’s future and their competitive position can be very important to the ultimate success or failure of an investment.

It’s Good to Have Friends

So, say we’ve got a company with a good yield, and we’re pretty sure we can make a guess of what they’ll be doing in 10 years and how profitable they’ll be.  What now?  Well, shareholders only really make out well if they actually see some of the profits that the business generates.  And that comes down to management.

In theory, the shareholders are the owners of the business and have the final say in how the profits of the business are used.  In practice, this is rarely the case.  From an owner’s perspective, profits that cannot be effectively reinvested in the business should be returned to shareholders through either buybacks or dividends.  However, many companies seem to pursue a value destroying ‘growth at any cost’ strategy in which they make acquisitions at outrageous prices to ‘grow’ or ‘expand’ the business.  In many cases, they later then have to write off much of the purchase price of these acquisitions as the acquired companies never achieve high enough profitability to justify their purchase price.  To provide an example of management pursuing this strategy, let’s take a look at HP (HPQ).

HP is a cash cow.  It spits out a ton of free cash flow each year.  Has for a long time.  So, what have they done with it in the last 10 years?  Well, first, they bought Compaq.  Then they recently announced they want to get out of the computer business.  They bought Palm and then used its technology to develop the HP Touchpad.  Then they killed that off within 6 weeks of release.  Now they’re acquiring Autonomy, an enterprise information management software company, for 10 billion dollars.  Though I wish them the best with this acquisition, they paid almost 10 times Autonomy’s 2010 sales for the company.  At this price tag, it’s hard to see how this acquisition will ever be ‘profitable’ for HP shareholders.  If instead, HP’s management used the $10 billion for the Autonomy acquisition to buy back shares, long-term shareholders would be much better as every dollar HP invested in their own stock at current prices results in an immediate 13% return on investment (HP’s current earnings yield).

So, how can you tell whether management is owner friendly?  Well the first is to check the share count over the last 10 years and figure out if it has been decreasing year over year.  It has?  Good.  Next, do they pay a dividend?  Yes?  Another positive.  Thirdly, look at executive compensation.  How do the managers get paid.  Is it mostly cash?  Bad.  Do they have a large ownership stake in the company compared to their pay?  Good.  If they have stock options, do they vest over 5 years?  Good.  Over 1 year?  Bad.

What you really want is a company that is focused on long-term value creation.  And the best way to ensure this is to make sure that the executives of the company are paid commensurate with this goal.  As value investors, we don’t want management making dumb decisions to try to increase the short term profitability (and stock price) at the expense of the long term.  Instead, we want management to think as owners themselves and have a significant portion of their compensation tied to how ‘owner’s of the business do over the long term.

For an example of what I would consider ‘shareholder friendly’ management, take a look at Gap Stores (GPS).  So long as their business continues to be profitable and you buy shares at a reasonable price, it’s hard to see how you won’t make out well over the long term as management consistently returns very high percentages of their free cash flow to shareholders through annual dividends and buybacks.

Now that it’s all said and done

So, I started out trying to explain what I look at when I evaluate stocks and why I’ve started to think that it’s better to own relatively few stocks, than to widely diversify.  If you use the three steps I’ve outlined above to really evaluate companies on your investment list, you actually rarely come up with any companies that fulfill all of the criteria.  And when you do, so long as you’ve done your due diligence, you know that they’re companies that are worth more than you paid for them, and that will continue to be worth more than you paid long into the future.  That way, you can be confident putting a large portion of your portfolio into them, and then holding until you get a good offer, whether it comes in 6 months or 6 years.  Though I was initially hesitant to throw away the typical mantra of ‘diversification’, I really do think that it can result in ‘diworsification’ in a lot of situations.  What do you think?

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:

The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

Full Disclosure:  Long GPS as of the time of this writing.