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Value Investing for Mothers-in-Law: 'Quality' Requires More Than a Story


Although some new investors think it's possible to pick a stock and create a tale about it, it's also necessary to have quantitative measurements.

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.
No positions in stocks mentioned.
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