The below criteria were carefully extracted from the works of Seth Klarman (Margin of Safety), Peter Lynch (One up on Wall Street, Beating the Street), Warren Buffett (Buffettology, the Making of an American Capitalist), and Ben Graham (Securities Analysis, Interpretation of Financial Statements). This is a list that should not be violated, lest you’d like to subject yourself to undue speculative risks. These constraints are difficult if not impossible to satisfy, and in fact, these authors agree that finding one advantaged company per month may be above average depending on the stage of the business cycle. For your reading pleasure:
-Should have a natural asset cycle showing cash to inventory to accounts receivable to cash (cycle)
-Gross profit above 40% is ideal (strong competitive advantage) and over 20% is still okay in a highly competitive industry. Has this number changed in last 7 years and if so, why?
-Operating expenses – SGA expense less than 30%
-R&D not great, shows company must constantly reinvent.
-Depreciation – industry leaders have lowest depreciation to gross profit ratios.
-Interest expense – Because very high competition or a former leverage buyout. Should be less than 15% of operating income
-Gains/losses on sale – remove these items, as they are non-recurring
-Income (net earnings) – 7 year historical uptrend. Good companies have higher % net earnings to total revenues (20% or more is ideal; 10-20% is okay); these can be invested in buybacks, dividends or retained earnings.
-Historical per share earnings increase
-Operating capital – assets; lots of cash and little debt is a good sign.
-Are all subsidiaries profitable? Are there any advantaged companies owned?
-Inventory and net earnings should both be rising
-Know what has created cash over last 7 years
-If receivables less bad debts is low in industry, there is a competitive advantage
-Company can offer longer repayment periods if there is strength on balance sheet
-Working ratio – not necessary if company earns significant cash currently
-More PP&E indicates higher competition
-Goodwill and intangible assets will almost always exist if an ‘advantaged company’ exists. Brand names are categorized here typically
-Long Term investments – Marked to lower of basis or FMV. These are assets chosen by MGMT
-Current Liabilities – Companies ladder debt to get spreads, risky to borrow short term
-Long term debts – best companies need debt to maintain business so rarely have debt due as current liability. May restructure in order to remain long term debt.
-Maybe self-financing (look at debts over last 10 years
-If company plans to pay off debts with retained earnings over next 4 years or less, this is a target for an LBO.
-Debt to equity – Factor in treasury stock too. Look for less than 0.8 ratio. Banks less than 10:1 is good. Who holds the debt (investors or institutions)?
-Equity to book value – common shareholders benefits if business sells. Preferred stock usually not issued by best companies. Stay away from issuers of preferred.
-How will growth be financed in the future? What are dilutive values?
-Retained earnings – Look for steady growth.
-Treasury stock – Shows a company is liquid enough for stock buy backs
-Check the return on equity ratio. Advantaged companies have highest Return on equity. Negative ratio with positive growth shows an advantaged company ready for a breakout
-If cash is coming from debt payments, what are chances debtor defaults? This will impair net cash flows
-Advantaged companies use very little earnings for capital expenditures (stay away from telecom generally for this reason)
-To check this, compare 10 years of capital expenditures to 10 years net earnings
-If Buybacks are consistent over 10 years, this is good (i.e. cash is being generated elsewhere to fund the buybacks)
-Consider the present value of the investment in contrast to opportunity costs and risk free rates. What is the internal rate of return (dollar weighted average return)?
-Consider investment in equity like a bond investment – Buys equity and receives pretax earnings as coupon. Consider dividends as part of a total return also.
***** The following are for Evaluating Earnings quality: Preference items
Sales
-Premature revenue recognition (accrual basis) – typically fraud to cause 4Q spikes
-Gross vs. net basis of sales – Clearly gross sales may inflate performance
-Allowance to doubtful accounts – Possible overstatement for a fraudulent future income boost?
-Price to volume measure
-Real vs. Nominal growth – Real growth is more important (=(1+nominal rate)/(1+inflation rate))-1 = real growth rate
-Cost of Good Sold
-Cost flow assumption (LIFO/FIFO?) LIFO is inflationary, of course
-Are there base LIFO layer liquidations? Did this lead to loss recognitions on write downs of inventories? How is profit margin affected?
-Operating expenses
-Discretionary Expenses
-Depreciation
-Asset impairment and obsolescence
-Reserves (higher better)
-Warranties for debt issuance (there were very high warranty levels in 2007 signaling over-leverage
-Interest rate assumptions for pension accounts (6% is commonly considered ‘conservative’ and is a relative benchmark)
-Nonoperating revenue
-Gains on asset sales
-Interest Income
-Equity Income
-Income Taxes
-Unusual Items
-Discounted Operations
-Material Changes in shares outstanding (affects earnings per share and possibly retained earnings if there are buybacks)
Is there are material discrepancies in the above preference items year over year, you must be curious to find out why they exist. It could mean the difference between a well run company and a going concern.