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How do I know which companies to buy?

If the current period has highlighted anything, it is that focusing exclusively on earnings (and earnings growth) has several shortcomings. The full picture needed to assess an investment opportunity must also consider the ability of a business to generate free cash flow after its investment needs have been met, and the defensibility of its capital structure.

For any business, cash is oxygen, allowing it to remain liquid and solvent.

Right now, there is an abundance of headlines to follow, but chasing data points increases the risk of missing signal for noise. In line with what I wrote last week, having a repeatable and flexible framework to apply to almost any investment opportunity is very helpful in times like these. That note focused on having a framework to assess the big picture; this note focuses in on some more company specific considerations, and presents a simplified template that may be helpful.

At a high level, I believe there are four dimensions along which to evaluate a company for potential investment:

  1. Quality
  2. Sustainability of competitive advantage
  3. Medium and long-term growth prospects
  4. Valuation

Let’s look at each of these in more detail.

1. There’s no substitute for quality

Quality has a straightforward definition in my books: is the business conservatively financed? The current crisis has bought into dramatic focus the risk of owning businesses that rely on excessive gearing to generate an acceptable return on shareholders’ equity. This doesn’t mean only owning businesses that have no gearing, but it is critical to seek out companies that have manageable debt levels and – critically – generate substantial amounts of free cash flow in order to service this debt. An assessment of management is also an indicator of quality, albeit a more subjective one to judge. Broadly, it pays to look for management teams that act rationally when it comes to allocating capital, and act candidly with shareholders about their results of doing so – both the successes and failures.

2. And now sustainability…

With regards to sustainability, I refer to businesses that have a competitive advantage that allows them to earn an economic profit over a long period of time. An economic profit is different to accounting profit, in that it measures whether the return on invested capital exceeds the cost of capital – your opportunity cost as an investor. If there is no sustainable competitive advantage, the ability to earn an economic profit will be eroded over time due to the iron law of economics: excess profits begets competition, which will see all players eventually earn the cost of capital and no more. A business that repeatedly earns an economic profit over a long period of time has to be in possession of some factor that allows it to fend off the competition, and is a very good indicator that the company likely has a moat of some sort.

The easiest way to evaluate this is by comparing the average return on invested capital (or alternatively, the return on equity) to an assumed cost of capital (or equity) over an extended period. However, keep in mind that the traditional method for calculating ROIC or ROE uses net profit/earnings, which can differ materially from cash flows. Ideally, one should use a metric that accounts for the working and fixed capital needs of the business. In a pinch, using the ‘normal’ free cash flow (cash from operations minus capital expenditures) will do, though other derivations of free cash flow (free cash flow to the firm or free cash flow to equity) will be more accurate. (Alternatively, use the ‘owners earnings’ method: net profit plus depreciation and amortization, less capital expenditures.)

Analysing this metric will impart three key pieces of information: the volatility of the return on capital over time will likely tell you how cyclical the business is, whilst the absolute level will indicate whether the business is beating its cost of capital sustainably. Finally, pay attention to the trend; a business with cash returns on invested capital trending ever closer to the cost of capital is likely facing stiff competition, or is subject to some other factor eroding its competitive advantage.

Clearly, a business with sustainably high returns on capital generates greater economic profits; when paired with a low-volatility return profile and a stable or improving trend, you have the potential makings of a great investment opportunity. Admittedly, these businesses are very rare.

3. On the topic growth…

I think in terms of both revenue and free cash flow. For the former, consider looking for businesses that can generate organic growth that consistently exceeds GDP and inflation, generally in industries that have superior growth prospects to the general economy. It is critical to understanding exactly what is driving this revenue growth (entering new markets, a secular shift, acquisitions, unit growth, pricing power, etc.) to determine the runway for future growth.

With regards to free cash flow, spending time on understanding the reinvestment requirements of the business is key. It may sound counter-intuitive, but there is absolutely such a thing as growth that destroys economic value: it occurs when the returns earned on the capital that was invested to generate said growth drop below the cost of capital.

Look for companies that can reinvest a portion – or all – of their excess economic profits back into the business, and still earn a high return on the capital invested. Over time, this is the surest way for a business to compound shareholders wealth – essentially generating more than a dollar of value for every dollar invested.

4. Finally, valuation can’t be ignored.

If you accept that earnings do not tell the full picture because it ignores the reinvestment requirement, then using a P/E ratio has limitations. Instead, consider using the free cash flow yield (free cash flow per share as a percentage of the share price), which can be compared to both other equities or long-term interest rates.

It is worth distinguishing between maintenance capital expenditure and expansionary capital expenditure at this point. The former is required to keep the business running ‘as is’; the latter is the component required for future growth and can be pulled back at the discretion of the management. Adding back this discretionary capital expenditure to free cash flow means you do not penalise companies that are investing to grow and provides a better estimate of the ‘true’ free cash flow yield on offer. This shorthand approach should be supplemented by additional valuation approaches, such as a DCF.

In distilling all the above down to the basics, this framework seeks to identify and own quality sustainable growth businesses, purchased at a margin of safety. While simplified, it is the structure I employ at my firm.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.