My mother-in-law is known to my kids as Doodles. The name’s origin is a long story, but what’s important here is that she is extremely smart and a very capable businesswoman (she doesn’t go by “Doodles” professionally). Despite her business expertise, she is always asking me questions about the stock market that seem to miss the underlying philosophy behind long-term value investing.
In an effort to not seem like an evasive jerk, I will attempt to explain once and for all what I actually do.
(For the record, Doodles is just a proxy for every social acquaintance who has ever asked me a question about the stock market. If I am addressing a dumb statement, assume that it was an insane distant relative who inspired my commentary. If the question is nuanced and complicated, assume it was the work of Doodles.)
In What "Buy and Hold" Really Means
, I talked about the characteristics you might look for in a suitable candidate for long-term investing. I suggested that you want to look for businesses with an identifiable competitive advantage that one would expect to strengthen or at least remain intact for the foreseeable future. Forgive me, Doodles, if I made it seem like all you have to do is pick a stock and create a nice fairy tale about what makes the company so great. You are probably going to need some quantitative way to filter out the weak options and focus your deeper investigations on the juiciest targets. Then you can work on the fairy tale.
Remember, we are trying to find businesses where the returns of the business exceed the costs of the capital that is required to run the business. An easy conceptual example might be the lending activities of a bank like JPMorgan Chase
(NYSE:JPM), whose product is money. Way back, JPM obtained money from the capital markets (either by borrowing from investors or selling equity in themselves). Getting access to that money cost JPM (either explicitly via interest on its debt, or implicitly by needing to meet equity investors’ expectations in exchange for them forking over their hard-earned cash). Then they lend that money at some interest rate to earn profits. OK, OK… the real JPM is a little more complicated than that (it actually has a bunch more ways it makes money), but the general idea is that there better be a decent spread between the cost of the money and the amount JPM earns by lending it. Otherwise, it will eventually be out of business.
Non-bank businesses work the same way, but they add the step of turning that money they raise into other assets and then selling those assets, thereby converting them back to money.
To find a list of potentially attractive businesses that maybe, possibly fill this prescription, we’ll need some way to quantify the quality of the business. I like to use a screen to quickly whittle down the vast universe of publicly traded companies. Our choices for screening criteria need to provide useful information, but not be so specialized that they make comparing companies on the list an exercise in apples and oranges.
We could set the criteria at “high margin businesses.” In general, I’d say I am in favor of higher margins (who isn’t, besides the occasional FTC regulator?). However, you can’t look at margins in a vacuum. Margins don’t tell us anything about how many dollars we get out of a business for each dollar we put in.
For example, a business like Costco
(NASDAQ:COST) has fairly low margins (operating margins were just under 3% for the trailing 12 months). We might conclude that the business really stinks because it is not super-profitable compared to its revenue. If we just looked at margins, Kohl’s Corp.
(NYSE:KSS) would look significantly more attractive at a ~10.6% operating profit. We might see a different picture when we include capital in the analysis. But how do we measure returns on capital? We could use Return on Equity. The danger here is that the more debt a company uses, the more attractive its numbers appear. For comparison purposes, we want to make sure we are measuring the actual business, and not the whims of management’s financing decisions. Next!
A common definition of Return on Invested Capital would have us take some profit measure (Net Income, NOPAT, etc.) and divide it by (Long-Term Debt + Shareholder’s Equity). This is closer to what we are looking for, but it also has some problems. This measure muddies comparisons when businesses have different levels of Cash, different levels of Current Liabilities, or different levels of Intangible Assets leftover from prior acquisitions. Differing tax rates add to the headache. Close, but no cigar!
No, as a first pass, I want to really try to focus only on the actual business, and leave judgment on management’s financing and capital allocation decisions for later. That’s why I use a measure of Return on Tangible Assets. If you happen to have read Joel Greenblatt’s excellent The Little Book That Beats the Market
, his Magic Formula uses a similar measure as part of its screening process (suspiciously similar, in fact… hmmm… I’ll take the Fifth).
The formula is roughly:
Total Assets – Cash – Intangibles – Current Liabilities + Interest-Bearing Current Liabilities
This will give you a simplified way to rank and compare a diverse range of businesses. It seeks to isolate the net operating assets of the underlying business and remove the effects of excess cash, prior management M&A pricing decisions (Intangibles) and financing choices. It also takes Depreciation policy and Tax Rates out of the comparison. But what does this ratio mean for an individual company?
Here’s the dirty secret. I don’t really care what the precise number is for any one company.
The number is kind of a fantasy number that doesn’t mean much by itself. I don’t use this number to value the business or use it as a key debate point when discussing the business with other stock geeks. The only reason I need this number is so that I can look at a ranking of many different businesses and say, “Hey, this group of 300 companies is probably better than this other group of 3,000 companies. Maybe I should focus on the first group first.”
The ratio is “dumb” in the sense that there have not been any adjustments for one-time events, cyclical peaks and troughs, and countless other details. You have to assume that the reported financials are representative of the business. For this reason, turnarounds are hard to spot, and deeply cyclical businesses can be misleading. It also doesn’t work well for finance companies or utilities, as their financial statements don’t fit as neatly for screening purposes. Finally, just because this screen says the business
might be attractive, it doesn’t say that the price
is attractive. Despite all these weaknesses, over time and with some further digging, it is easy to get a list of attractive businesses so you’ll be ready in case they hit the bargain bin someday.
PS: If you use the ratio on our friends COST and KSS, you’ll find that despite the lower margins, COST’s business returns ~10 percentage points higher on their Tangible Capital than does KSS’s business. I am not suggesting you forego Kohl’s for the grandkids’ birthday presents, but maybe look at Costco first for their trust funds. (They are getting trust funds, right? I mean, college is expensive.)
PPS: Seriously, you should read Joel Greenblatt.