“A three-part test? Why bother?
Why don’t you just do what those Wall Street analysts recommend? You know, the ones that are on the financial news shows. They seem to know what to do.”
It’s true, the analysts you see on TV look like experts.
They work for well-known firms. They dress well, They seem confident. And they’re probably on a first-name basis with all the CEOs in the industry they follow.
Can a financial advisor in Omaha really have any insight that they don’t have?
Who Are They Really Talking To?
Lots of investment advisors follow Wall Street analysts. But analysts know that there are two groups they most need to keep happy.
- Managements of the companies they follow.
- Large, active traders.
Analysts have to earn their pay. They do so by helping their employers win lucrative lending and advisory opportunities.
Flattery is a proven sales strategy. By praising the business strategy of a CEO, a Street analyst makes it more likely that his firm will be hired to help raise money.
Criticizing a company they follow will have the opposite effect. Their firms will be shut out of new business.
Is it any wonder data services company Factset reported that only 6% of Street ratings were “Sell”?
Analysts also cater to large, active traders.
They offer insights that may help traders make quick profits from breaking news. In turn, traders may be good customers for securities and services offered by Street firms.
As a Financial Advisor From the Old School, We’re Looking for Something Different
When we use our three-part test, we are interested in estimating business value – say, what a knowledgeable buyer might pay to acquire an entire company. Fleeting news stories have little effect on this value.
As far as we’re concerned, Wall Street analysts can provide some useful information, but their opinions are biased toward managements and the short-term needs of traders.
Our interest as a financial advisor is helping our clients achieve their goals.
We want to take advantage of the mispricing that can occur when short-term concerns drive prices below our estimate of business value.
Our Three-Part Test
What we look at revolves around a three-part test for a stock.
- Is this a good, understandable business?
- Can we expect management to act in the best interest of shareholders?
- Is the stock available at an attractive price?
Answering these questions involves a lot of detail. It also means making estimates, which are subject to uncertainty and our own biases.
Having a systematic plan is a big help.
First Test: Is This a Good Business?
Stocks are ownership interests in businesses and may be for sale at prices above, below or equal to our estimate of business value.
A rising share price alone is not a reliable way to determine whether a business is good. Even companies that have poor sales and profits can see their stock prices rise from time to time.
Eastman Kodak was destined for oblivion when digital photography made film obsolete, yet its share price sometimes rose. Sears was headed the same way, though low interest rates help reduce its debt burden for a time and led to brief stock rallies.
Despite the coming doomsday for these companies, financial advisors who focus only on short-term performance may well have bought them.
A declining share price doesn’t mean a company is bad. Traders and Investment managers often feel pressure to beat the market and will sell quickly if the short-term outlook gets cloudy.
So, if we should consider a business apart from its stock price, what should we look for?
A Financial Advisor’s Checklist for a Good Business
Companies have to be understandable for us to invest. That’s an Old School idea for a financial advisor, it seems. We want to know how they generate revenue, what their expenses are and how much investment is required to operate.
Here are some of the criteria we test when considering if a business is attractive:
– High returns on the money invested in operations. It’s better to earn 20% on an invested dollar than 10%.
– Growth opportunities. A company will create more value if it has more investment projects that can generate high returns.
– A long period of expected growth. The only thing better than earning a high return for five years is earning one for ten or twenty.
– A competitive edge that will keep returns high for a long time. A company may have an advantage from being having low costs, great technology, patents or other factors. This edge is also referred to as a “moat”. It helps protect the business from competition.
Second Test: Is Management Shareholder-Minded?
Our second test is determining whether management is likely to do a good job of building wealth for shareholders.
How can this be done?
The first thing to realize is that management isn’t “good” or “strong” simply because recent earnings reports have been better than expected and the share price is up.
Don’t confuse good management with the price of a stock.
Financial commentators often do this. When earnings slip and the stock price falls, the same management will be criticized and said to “lack credibility with the Street.”
I’ve never seen a Wall Street recommendation evaluate managements the way we do. Again, this isn’t surprising given that analysts want to get business for their firms.
A Financial Advisor’s Checklist for Good Management
First, we gather all the information we think is useful.
This will include years of annual reports and other filings from the company and its peers, articles & interviews about the company and its industry, press releases and management presentations.
Then we ask questions:
Does management have a rational business strategy? Will they return cash to shareholders when growth opportunities are scarce? What is their track record with acquisitions? Did their stock price drop when past deals were announced?
Has management demonstrated good operating skill? Do trends in sales and profits suggest that management is doing a good job? How does their record compare to that of similar companies?
What is the background of key executives and directors? Do top executives have strong operating experience? Do company directors have experience that seems genuinely useful?
Does management treat shareholders as partners? Do they admit mistakes, or are they more interested in spinning a positive story? Does the Letter to Shareholders in the annual report sound as if the CEO wrote it, or is it the work of a public relations firm?
Do their accounting choices suggest they have integrity? Management can make earnings look good by deferring expenses and accelerating the recognition of revenue. Conservative accounting choices indicate that management is trustworthy.
How much debt are they comfortable using? Good management will be able to take advantage of difficult times and buy when others need to sell. This won’t happen if a company has a heavy debt burden.
Litigation/regulatory troubles. Does the annual report disclose serious lawsuits? Are there court records that provide an inside look at how management behaves?
How are executives compensated? Is compensation tied to creating shareholder wealth? Many bonus plans focus on growth in earnings per share, but this figure can be manipulated. Return on the money invested in the company is a better measure.
Do management and directors own a lot of stock? If so, they may think more like owners. A CEO who doesn’t own much stock may be more interested in empire-building and boosting his or her own pay. This can lead to overpriced acquisitions.
Have insiders bought or sold shares lately? If executives and directors have been buying shares, it can be a sign that a stock is cheap. If they are selling, it may suggest that shares are overpriced.
Third Test: Is The Stock Price Attractive?
We’ve looked at our test for a good business and considered how we evaluate a company’s management. The last part of our three-part test for an investment involves estimating business value and finding a good price.
“Hold it right there,” a student of modern finance will say.
“Haven’t you heard? The best estimate of value is the company’s stock price. It reflects all the information and opinions that are out there. Thousands of people helped set that price, but now you come along as a financial advisor and say that your opinion is better?”
We understand this argument. In fact, good businesses are usually fairly priced. On occasion, though, stocks won’t show the sort of cool-headed appraisal of value that modern financial theory asserts.
Fear, greed and pressure for short-term performance can overwhelm rationality in the market. In such instances, mob psychology can provide a better explanation of market prices.
A Good Price Gives a Margin of Safety
Our goal is to take advantage of the occasional difference between market price and our estimate of business value. This gives us the opportunity to profit as the market rises toward our estimated value.
Buying at a discount to our estimate of business value also offers some protection in case a company runs into problems that we didn’t anticipate.
Estimating Value Using Comparables
This valuation approach is familiar to anyone who has bought or sold a house. What prices have been paid recently for similar properties? Are there reasons to value this one at a higher or lower price?
Homes are often compared based on the price paid per square foot. Prices paid for companies are often discussed as multiples of revenue, cash flow or earnings.
For example, we may say that companies similar to one we’re evaluating have fetched prices equal to two times this year’s revenue or twenty times this year’s earnings.
Bidders in a takeover almost always offer a price to shareholders that’s higher than the current market value. They expect to recoup the premium through some combination of expense reductions and higher sales.
The prices paid by knowledgeable bidders in past deals can provide an estimate of the value of a company we’re considering. This is helpful even if we don’t expect a company to be acquired.
If the current market price is at a big discount to its potential acquisition value, this test may suggest we have a winner.
Estimating Value Using Expected Earning Power
Another way we determine a good price begins by estimating its “earning power” over the next two or three years. Without attempting to be precise, what is a reasonable estimate for what a company can earn in the not-too-distant future?
We then consider how the market is likely to value the expected earnings. Will these earnings be valued higher, lower, or about the same as the average for companies in an index like the S&P 500?
A fast-growing, highly profitable company with many reinvestment opportunities may sell well above the average. One with slower growth and declining profits will tend to trade below.
This valuation test is similar to the textbook “Discounted Cash Flow Model,” which we also sometimes use. The idea is to estimate the earnings that shareholders will see, but adjust this for timing and risk.
For example, two companies may have the same expected earnings, but we may have more confidence in one than the other. We’ll be willing to pay more for the one with more certainty.
Estimating Value Using a Combination of Methods
We sometimes use both of these methods to value a company.
If we think a company or a subsidiary of a company might be sold to a bidder, we’ll look closely at the prices paid for comparables.
If we don’t think a company will attract a takeover, we might use the expected earnings power approach to estimate a reasonable future trading price.
A stock that is cheap on both measures is especially promising. It suggests to us that we can profit from a takeover proposal or a recovery in the stock price as the outlook improves.
Our three-part test for a new stock seems simple: We want good businesses, capable management and a share price that is less than we think the company is worth.
A lot goes into evaluating each part of our test. Our aim is to find opportunities for profit with a margin of safety.
We’re pleased to be able to offer our investment management clients the expertise of two CERTIFIED FINANCIAL PLANNER™ professionals, Matt Holloway and Katerina Wiese.
Barry Dunaway, CFA®
America First Investment Advisors, LLC
This post expresses the views of the author as of the date of publication. America First Investment Advisors has no obligation to update the information in it. Be aware that past performance is no indication of future performance, and that wherever there is the potential for profit there is also the possibility of loss.