Thursday, October 10, 2013

Profitability Checklist

I have a confession to make: I don’t have a fixed system when it comes to my investment research. I just keep calculating ratios, analysing risks and looking stuff up on Google until I’m reasonably sure I’ve arrived at the company’s true earnings power and its risk exposures. But I’m pretty sure that I can’t be an investing badass unless I have a proper system for analysing companies. That’s why I decided to create a checklist of the things I generally look for when researching companies so that I have some sort of framework which I can follow when I analyse stocks in the future.

When you cut through the bull shit, investing is all about maximizing risk-adjusted returns. It therefore seems proper for me to break my investment checklist into two: one covering profitability and the other covering risks. The following is my profitability checklist:

Return on equity (ROE):Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns” – Charlie Munger. Investors should listen to this O.G. of investing and look for companies that generate superior returns on capital. I generally require a company’s long-term returns on equity to be at least 12% before I would consider investing in its stock.

Return on assets (ROA): Some companies might boost their ROE by using a large amount of financial leverage. It is therefore important to compare a company’s ROA with that of its competitors to determine whether the company is actually earning superior profits without the excessive use of debt. Unlike the ROE, I don’t have any requirements on how high the ROA has to be so long as its high in relation to its competitors. This is the case as different industries have different ranges of ROA. For example: The beverage industry has significantly higher ROA than the banking industry.

After finding a company that generates superior ROE, you need to make sure that the company is able to sustain above average profits over the long-term. We need to look into the 2 main factors that determine a company’s profitability: the industry that the company is in and the company’s competitive advantage.

Industry analysis: You know you’re in a sucky industry when there’s fierce competition, powerful suppliers that bust your balls and customers that won’t think twice about telling you to go fuck yourself. But seriously, read Michael Porter’s 5 competitive forces to get a better understanding of the stuff that determine industry profitability. Once you have identified the main competitive forces that make a certain industry attractive, ask yourself if those forces are here to stay for the long-term?

Sometimes you may find a good company in a bad industry. There's absolutely nothing wrong with investing in those companies. Just like there's absolutely nothing wrong with dating the rare hot girl that does programming. Tight is tight! 

Competitive advantage: Strong brands, efficient systems, valuable patents, economies of scale, access to cheap supplies, intelligent management and high quality, difficult to replicate product offerings are some of the sources of competitive advantage and superior profits. Investors need to be able to make a reasonable determination as to the sustainability of a company’s sources of competitive advantage.  

True earnings: A company’s intrinsic value is simply the cash that shareholders can take out from the company over its life discounted at an appropriate rate. True earnings is therefore the cash that can be paid out to shareholders after deducting costs and the capital expenditure necessary to maintain current business volume. The cash don’t have to be paid out as dividends of course as shareholders will still reap the rewards if management is able to profitably reinvest in the business (see the profitable redeployment of capital section).

Some of the stuff involved in arriving at a company’s true earnings power are: adjusting for one-time items, smoothing out earnings to account for downturns and finding the capital expenditure needed to maintain current output. The topic of calculating true earnings is kinda detailed and deserves an article of its own (which I plan to write in the future). 

Revenue growth: For a company to continuously increase the cash it generates for shareholders (and therefore its 
intrinsic value), it will have to increase its revenue. There's only so much cost cutting that a company can do. I generally require a company to have grown its revenue at a compounded annual rate of at least 6% over the past 10 years. I would require the company to have a higher growth rate if its revenues are in a currency with high inflation risk.

Operating profit growth: Profits should be the only reason for you to ever do anything. Don’t let Obama tell you anything different. It’s pointless for a company to grow its revenue if it doesn’t result in a growth in operating profits as well. I usually require the company to have grown its operating profits at a compounded annual rate of at least 6% over the past 10 years (after adjusting for one-time items and smoothing out earnings, of course).

Philosophical side note: Profits don’t have to be in the form of money, as long as you’re getting something of higher value in return for your efforts you’re profiting. I personally profit every time I grab myself a McDonald’s double cheeseburger.

The purpose of looking at the company’s past revenue and profit growth is to check if management is capable of expanding sales and profits over the long-term. However, past performance does not guarantee future results. To get a rough idea of the company’s future revenue and profit growth rates, investors need to know the projected growth in industry demand as well as the market share breakdown for the industry’s major markets.

Profitable redeployment of capital: A company usually reinvests some of its profits to expand its business. However, management’s efforts to grow the company may actually be a disservice to shareholders. To find out if a company is redeploying capital at an acceptable rate, investors should look at the company’s returns on incremental equity. I usually require the company to have achieved a compounded annual return on incremental equity of at least 12% over the past 5 years (after adjusting for one-time items, smoothing out earnings, yada yada).      

The stuff on the checklist should be thought of as guidelines instead of rules set in stone. I have invested in stocks that did not meet all the criteria on the list because I felt they were cheap and that I could flip them for a tidy profit once the markets realized they were undervalued. However, this is not where the real money is at. You make the big bucks by buying top quality stocks at a reasonable price and holding on to them for the long-term. Top quality companies usually exceed most if not all the criteria on my lists.

The lists contain only general stuff that applies to most companies. Investors need to have an understanding of industry-specific stuff before they’re able to properly analyse a company. You can’t really tell if a bank is badass if you don’t know its net interest margin, average charge-off rate, efficiency ratio, tier 1 capital ratio and etc. Anyway, thank you very much for reading! I hope that you will check out my risk management checklist in the future as well. 

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