Here are the telltale signs we look for when we are searching for great businesses to invest in.
Stable or improving profit margins
Are the Gross Profit and Net Profit margins stable or improving? If we know the business consistently delivers good profit margins, than we can start to place reliance on future growth as a driver of future value. Because we know every dollar in additional revenue they generate will result in "X" cents of profit.
How do their profit margins compare to competitors? Higher, lower, or similar. Higher margins can be indicative of the existence of a moat around the business or conversely could indicate somebody is cooking the books. It is up to you to work out which. Start by reviewing our "Fraud Detection Checklist".
Consistent profit margins are more likely if the products or services provided by the company are:
- only able to be deferred for a short period of time but not forever
- not commodity products
- take commodity products and turn them into something unique
Consistent return on equity in excess of 20% p.a
- Must be consistent over the past 10 years.
- Check back and see what happened to the return on equity in the last 2 economic downturns (Watch out for cyclical stocks)
- Beware - high profit margins is a favorite tool for fraudsters and other "financial engineers" So run them through our "Fraud Detection Checklist"
- Will the business be able to sustain returns on equity in excess of 20% for the next 10 years. If so, what "moats" are they using to defend these returns from competitors and can the "moats" be breached?
- We look at standard deviation
- We compare 3 year, 5 year, and 10 year average to see if there is a trend up or down.
Excess free cash flow from operations every single year
If the company is truly generating a consistent returns on equity of more than 20% every year, than we should see those profits turning into free cash flow from operations. If not, why not?
How is the Free cash flow being used:
- Debt reduction?
- Re-investing in the business? Are those re investments generating the same high level of return on equity? If not, the Return on equity will drop going forward.
- Share buybacks - make sure these are not timed to coincide with insider selling
- Dividend payouts
Redeploying free cash flow back into business at high returns not only enables "compounding", but the improvement, expansion, and extension of the businesses competitive advantages
Little or no debt
- If the company is generating lots of free cash flow, it should have little need for debt.
- Debt reduction drives down return on equity - so it is best if there is little or no debt to reduce
- More likely to survive (and emerge stronger from) economic shocks and downturns if there is little or no debt
- Have financial strength to buy financially distressed competitors and complimentary businesses. Also better placed to take advantage of other opportunities as they arise.
- Can focus on growing the business - management is not distracted by complying with covenants and refinancing debt
- Warren Buffett says a company should be able to pay its debt off in no longer than 3 to 5 years out of operating cash flows. Of course we would prefer a strong net cash position.
If the company is consistently generating good cash flow from operations and has little or no debt, than they can continue investing through bad times to distance themselves from competitors.
WARNING: Watch out for hidden leverage (debt). For example retailers who lease all their locations have a liability for lots of rent, often long into the future. While not technically a bank loan, it might as well be because it will consume a lot of cash flow that is difficult to negate in tough times.
Real organic revenue growth - not just cyclical or by acquisition
Organic revenue growth earning the same or better profit margins is critical to most successful investments. Understand how they will achieve this:
- higher prices?
- selling to more customers?
- selling more things to the same customers?
Growth by acquisition is not the same. Lots of companies that use debt and leverage to make acquisitions or do "roll ups" flame out. Must be costs able to taken out of the combined operations that will consistently drive higher margins long into the future.
Cyclical companies, think builders, miners, energy companies, etc. If you are going to buy these, do it at the bottom of the cycle - provided you are confident they will survive - and sell towards the top of the cycle. Generally these will not be part of your long term portfolio.
Fast sustainable growth is rarely priced into the market more than a few years out. So if you can find a fast grower that you are confident can continue growing quickly for the next 10 years - the excess growth from years 3 through 10 may come very cheaply. This can be a good opportunity to buy at a price that will look cheap in retrospect. This is why P/E ratio is not a good measure of value - because it does not take account of growth.
Bottom up analysis identifies good companies and then the market trends allow the companies to keep growing a long time into the future. Do not put the cart before the horse, find the good company first than look at the market trends to see if it is likely to be able to continue growing quickly into the future.
Not Investment Advice
As always this is not investment advice. Do your own research. Consult your professional advisors.