Institute for Individual Investors

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For those about to trade - we SALUTE YOU

Wednesday, August 22, 2007 | Dylan Jovine


I'm in a bit of a competition with Chris Rowe here.

Indeed, after reading his article from last week, how can I not be?  Wasn't that one of the most informative articles you've ever read on seasonality?  I know it was great for me.

But today I'd like to add something to your investing toolbox.  Hopefully, I can expand on what my good friend so brilliantly explained last week.

Here we go ...

There are some investors who like to sit in front of a screen all day sipping Red Bull and nervously fidgeting around their screens, searching and searching.

I am not that kind of guy.

It's not because I don't think you can make money trading for pennies here and points there.  I know for a fact you can if you have a large enough stake.

So the reason I don't invest that way is not because I don't think it can work.  The reason I don't invest that way is because it doesn't fit my emotional disposition.

One of the GREATEST lessons you can learn as an investor is to know yourself well enough to know what INVESTING STYLE best suits the way you are as a person.

Do you love staring at the monitor all day long, filled with energy and excitement?  Then you're probably a natural day trader.

Conversely, if you're comfortable sitting on the sidelines 90% of the time and only jumping into the market two or three times EACH DECADE, then you're probably made of the same stuff I'm made of.

So before you force a style upon yourself, pick a style that feels intuitively correct to you.  Just like a martial artist would choose Karate or Tae Kwon Do if he or she liked to punch and kick, while another one would choose JUDO if he liked to wrestle.

Keep in mind while you're listening to each of the writers here at Tycoon that picking the right style is HALF the battle.

I’ve always liked individual company analysis because the variables are far, far fewer to analyze and understand.  Instead of trying to understand whether or not the Saudis are re-funneling their gas money to the U.S. to buy bonds, you can study a company’s debt-to-equity ratio; instead of watching to see if Japan is going to raise rates ¼ point or ½ point, you can see what the company generates each month in cash flow.

Many of you may be thinking to yourselves that I’m oversimplifying how easy it is to pick stocks.  I’m not.  I just think that trying to predict the economy is much, much harder.  Simply by having fewer variables to analyze, your risk is lowered.

Let's use investing in housing as an analogy to investing in the stock market.

It’s no secret that homes in different neighborhoods cost different amounts; a 3-bedroom house in Beverly Hills, California costs much more than the same house in Flint, Michigan.  So what can comparing the price of homes across the country teach us about investing in the stock market?   More than you may think.

In my Fallen Angel Stocks service, we tend to look at the S&P 500 as a collection of different “neighborhoods.”  But instead of the neighborhoods being determined by different industry groups, our neighborhoods are determined solely by Return on Invested Capital (ROIC).

Why ROIC?  Because more than any other microeconomic measurement, it tells how much money a company earns each year in relation to the amount it spends to earn that money.

Let’s start with a simplified but revealing example:  Let’s say you start a business called XYZ Shoes.  You end up spending $100,000 on retail space, inventory and a fax machine.  The $100,000 you’ve invested into the business is referred to as your invested capital.

Now, let’s assume that you make $20,000 each year, after expenses, from your business without investing another dollar.  That would be your return.  Expressed as a percentage, your return-on-invested-capital would be 20% ($20,000/$100,000).    

For the past one hundred years, the average company in America has averaged a 12% ROIC each year.  Using the example from above, that amount would be $12,000.  A truly exceptional company can have a ROIC of 40 percent ($40,000) and a poor performer would average in the single digits or worse.

In our S&P 500 neighborhood, a company with an ROIC of 40 percent would live in Beverly Hills, while a company with an ROIC of 12 percent would live in a middle class neighborhood similar to where I grew up in Queens, New York.

Why “Maximizing Shareholder Value” is Wrong

Most managers today are worried about “maximizing shareholder value” through increased earnings.  That is dead wrong.  Anybody can make a stupid acquisition and increase earnings which, by default, would increase the stock price.  Or anybody can lower prices so dramatically that revenue explodes.  However, as the internet companies found out, revenue without profit is called charity.

The greatest leap made in the field of security analysis during the past quarter century (thanks again, Buffett) was in studying the relationship between return-on-invested-capital and stock prices.  This point is so critical to your investment success that I want to take an additional moment to explain this.

What Buffett realized was that companies that earn a high return-on-invested-capital increase shareholder value at a far faster rate than companies that don’t.

For example, every time a company with a 40% return-on-invested-capital brings in $1 per share in earnings, it can gain $7 in stock market value.  In contrast, companies with a 12% return on capital may only add $1 in shareholder value for every $1 in earnings.

(The reasons for this require us to delve much deeper into the very nature of microeconomics.  For those of you who are interested in learning more, I’d be more than willing to share more with you if you write in and ask.)

Picking the Right Block

But just moving into the “Beverly Hills” section of the S&P 500 alone is not enough.  Now we have to find the “block” we want to live on.  Here’s how you do it:   

1.    Find companies with a debt to equity ratio below 25%.  Having a low debt to equity ratio has implications far across the company.  The most important is that the company has an underlying business that is fundamentally strong enough not to have to borrow money.  Secondly, when a company that has a lot of debt is faced with earnings problems (remember, it happens to every company at one point or another), the stock gets hammered a lot more than a company without debt.  Although this is not a hard and fast rule (different types of companies can support different capital structures), it is a good one.  

2.    Invest in companies where capital expenses represent no more than 15 percent of a company’s cash flow.  I hate to pick on Intel Corp., the chip manufacturer, but for every $1 in cash that the company generates, 25 cents has to be reinvested into new plants to create more chips.  Conversely, for every $1 in cash Coca-Cola generates, only 10 cents goes into new plants.  The reason?  Intel operates in an industry in which, to remain competitive, it has to introduce newer, faster chips every few years.  Newer, faster chips mean newer, expensive plants.  New plants mean lots of capital spending.  Lots of big spending creates lots of big risks.  Especially when we know that at some point or another, an incompetent CEO will be in charge of the spending.  

3.    Invest in companies with consistent, predictable earnings.  Let’s use the following comparison to illustrate the point:

Year            Company A           Company B
2003                .18                       .18
2004                .24                       .12
2005                .38                       (.29)
2006                .47                       .58
2007                .58                       .23                    

As you can see, Company A’s earnings are more predictable than those of Company B.  What does this imply?  First and foremost, it suggests that it is easier to predict, and therefore to value, Company A.  In addition, it suggests that management from Company B doesn’t understand the business it’s operating in.

Finding the Right Home … at the Right Price

OK, so we know what neighborhood we want to live in, and we found a block that gives us a warm and fuzzy feeling.  But the most important aspect is yet to be accomplished - finding the right “home” at the right price.

Let me start with an analogy that takes us back into the “real world”.  If you were shopping for a home, and you found a 3-bedroom house that you liked, you would first have to find out what the house was selling for.  If you determined that the house was worth 1 million dollars, but the seller was asking $2 million, you would pass.  Conversely, if the seller was distressed and was asking $500,000 you would jump at the opportunity.  The exact same rule applies when investing in a stock - the primary objective is to buy a great asset at a cheap price.

Let’s take Company A from the example above to illustrate our point.  Assume that Company A sells low-carb health food.  The Company has a 20 percent ROIC, a low debt/equity ratio, low capital expenses and predictable earnings.

After doing some research, you determine that Company A, fairly valued, should trade with a P/E of 20 (which approximates its 20 percent ROIC).  Since the Company earned 58 cents in 2003, that would place a fair value of $11.60 on the stock.  If the stock were selling for $25 per share, it would clearly be overpriced; at $5 you would consider it underpriced.

In this example, there’s a point that must be emphasized clearly:  It is critical that you separate the performance of a company with the performance of its stock price.  For example, Company A could be the best health food company on the planet.  The question is - what is it worth?  As good a company as it is, is it worth $25 per share?  No.

Therefore, as investors, it's important to note that the difference between price and value within the S&P 500 is based on the same principles that would apply if you were buying a home.  A gorgeous 3-bedroom house may be on the best block in Beverly Hills.  But would you pay twice its value?  I hope not.

If you consider yourself a student of investing, re-read this article several times.  Learn it, memorize it.  I am being serious … it will give you x-ray investing vision.  

Enjoy the rest of August!  The dog days of summer are almost over!
Dylan Jovine signature
Dylan Jovine
CEO, Founder & Director of Editorial Content
The Tycoon Report
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