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Kindle Notes & Highlights
by
Pat Dorsey
But don’t overlook the power of this simple test: If you can’t understand how a dollar flows from a company’s customers back through to shareholders, something’s amiss. Either the company’s business model is too confusing or you need to do more digging before committing any of your money.
Keep an eye on the trend in accounts receivable compared with sales. If the firm is booking a large amount of revenue that hasn’t yet been paid for, this can be a sign of trouble.
You can’t just look at a series of past growth rates and assume that they’ll predict the future—if investing were that easy, money managers would be paid much less, and this book would be much shorter. It’s critical to investigate the sources of a company’s growth rate and assess the quality of the growth. High-quality growth that comes from selling more goods and entering new markets is more sustainable than low-quality growth that’s generated by cost-cutting or accounting tricks.
In the long run, sales growth drives earnings growth. Although profit growth can outpace sales growth for a while if a company is able to do an excellent job cutting costs or fiddling with the financial statements, this kind of situation simply isn’t sustainable over the long haul—there’s a limit to how much costs can be cut, and there are only so many financial tricks that companies can use to boost the bottom line.
In general, sales growth stems from one of four areas: 1. Selling more goods or services 2. Raising prices 3. Selling new goods or services 4. Buying another company
Remember, the goal of this type of analysis is simply to know why a company is growing. In Anheuser-Busch’s case, you’d want to know how much growth is coming from price increases (more expensive beer), how much is coming from volume increases (more beer drinkers), and how much is coming from market share growth (more Budweiser drinkers). Once you’re able to segment a firm’s growth rate into its components, you’ll have a much better handle on where that growth is likely to come from in the future—and when it may tap out.
From the investor’s perspective, however, the biggest reason to be leery of a growth-by-acquisition strategy is even simpler: It makes the company more difficult to understand. Acquisitive firms usually post many merger-related charges and often wind up restating their financial results, which means the results of the acquiring company can be obscured in all the merger-related confusion.
Remember, the goal of a successful investor is to buy great businesses, not successful merger and acquisition machines.
As you might have guessed, I generally view acquisitions as a very low-quality way of generating growth. Unfortunately, there are plenty of other ways of making growth look better than it really is, especially when we turn our attention to earnings growth rather than sales growth. (Sales growth is much more difficult to fake.)
Although the list of tricks that companies can use to boost earnings growth even as sales growth falters is a long one, there are a few basic areas to watch out for: Changing tax rates, changing share counts, pension gains, one-time gains (often from selling off businesses), and rampant cost cutting are among the most common.
In general, any time that earnings growth outstrips sales growth over a long period—for example, 5 to 10 years—you need to dig into the numbers to see how the company keeps squeezing out more profits from stagnant sales. A big difference between the growth rate of net income and operating income or cash flow from operations can also hint at something unsustainable.
IBM is a classic example of what I call “manufactured growth,” because it used almost all of the previously mentioned techniques to pump up its bottom line during the 1990s. As shown in Figure 6.1, Big Blue’s earnings per share growth looks pretty good since the Lou Gerstner-led turnaround began in the early 1990s—close to double digits most years, which is not bad for a company of this size. But when we look at operating income, it looks as though the company was growing much slower, while sales growth was stuck around 5 percent on average. As a double-check, take a quick look at cash flow
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So what was driving those great earnings-per-share results that Gerstner’s IBM kept turning like clockwork? A whole host of items: For one, the firm’s tax rate plunged from 46 percent in 1995 to around 30 percent by the end of the decade. For another, the firm cut overhead spending substantially during the 1990s—a laudable accomplishment, given the bureaucratic nature of the firm.
Finally, IBM bought back about a quarter of its shares during the latter half of the 1990s—fewer shares outstanding meant more earnings per share—and benefited from an overfunded pension plan that boosted earnings. As you can see, a simple comparison of IBM’s earnings per share relative to its operating income and cash flow raised many red flags—enough that any investor looking at the company in the late 1990s could have been skeptical about the quality of the firm’s earnings growth.
In general, any time you can’t pinpoint the sources of a company’s growth rate—or the reasons for a sharp divergence between the top and bottom lines, as was the case with Big Blue—you should be wary of the quality of that growth rate.
A word on cost cutting: All things equal, I’d rather own a more efficient firm—one with lower overhead costs—than a less efficient firm. However, cost cuts are not a sustainable long-term source of earnings growth, and if you’re looking at a firm that’s been slashing costs, you should be aware that at some point there won’t be any more costs to cut. Earnings growth will eventually slow unless sales growth speeds up.
At some point, a cost-cutting firm is going to find that it has become as efficient as possible, and sales and earnings growth will converge unless the firm manages to boost revenue growth. So when you see a firm with earnings gains being driven by cost cutting, make sure you think about the sustainability of those cost cuts because they won’t be around forever.
Comparing cash flow from operations to reported earnings per share is another good way to get a rough idea of a firm’s profitability because cash flow from operations represents real profits.
But neither net margin nor cash flow from operations accounts for the amount of capital that’s tied up in the business, and that’s something we can’t ignore. We need to know how much economic profit a firm is able to generate per dollar of capital employed because it will have more excess profits to reinvest, which will give it an advantage over less-efficient competitors.
In general, any nonfinancial firm that can generate consistent ROEs above 10 percent without excessive leverage is at least worth investigating. As of mid-2003, only about one-tenth of the nonfinancial firms in Morningstar’s database were able to post an ROE above 10 percent for each of the past five years, so you can see how tough it is to post this kind of performance.
We need to be able to separate out businesses that are net users of capital—ones that spend more than they take in—from businesses that are net producers of capital because it’s only that excess cash that really belongs to us as shareholders. You may sometimes see free cash flow referred to as “owner earnings,” because that’s exactly what it is: the amount of money the owner of a company could withdraw from the treasury without harming the company’s ongoing business.
A firm that generates a great deal of free cash flow can do all sorts of things with the money—save it for future investment opportunities, use it for acquisitions, buy back shares, and so forth. Free cash flow gives financial flexibility because the firm isn’t relying on the capital markets to fund its expansion. Firms that have negative free cash flow have to take out loans or sell additional shares to keep things going, and that can become a risky proposition if the market becomes unsettled at a critical time for the company.
As with ROE, it’s tough to generalize about how much free cash flow is enough. However, I think it’s reasonable to say that any firm that’s able to convert more than 5 percent of sales to free cash flow—just divide free cash flow by sales to ge...
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Moving down to the bottom right, where Lowe’s is, you see companies that are reinvesting all of their cash in expansion but are still able to generate a high return on shareholders’ money. If these firms still have profitable reinvestment opportunities, they should be spending all the cash they generate on expansion. For example, Starbucks and Home Depot posted high ROEs and negative free cash flow all through the 1990s because they were plowing every cent they earned into building more stores.
The true operating performance of a firm is best measured by return on invested capital (ROIC), which measures the return on all capital invested in the firm regardless of the source of the capital. The formula for ROIC is deceptively simple: The numerator of this equation is easy: profits after taxes, but before interest costs. The denominator is a bit trickier, and although there are many different ways to calculate it, you’ll do just fine if you use this version: You may also want to subtract goodwill if it’s a large percentage of assets.
After you’ve assessed growth, profitability, and financial health, your next task is to look at the bear case for the stock you’re analyzing. Start by listing all of the potential negatives, from the most obvious to the least likely. What could go wrong with your investment thesis? Why might someone prefer to be a seller of the stock than a buyer? Constructing a convincing bear case is especially important for those who like to buy high-quality companies that have hit temporary speed bumps, because what looks like a speed bump may very well be a roadblock on closer inspection. Equally
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My advice is to divide the management-assessment process into three parts: compensation, character, and operations.
Compensation is the easiest of the three areas to assess because the bulk of the information is contained in a single document, usually called the proxy statement.
Here’s what to look for in a company’s compensation plan. First and most important, how much does management pay itself? (This is detailed in the aptly named “summary compensation table.”) Generally, I prefer big bonuses to big base salaries and restricted stock grants to generous option packages. Bonuses mean that a good portion of the pay is at least theoretically at risk, and restricted stock means the executive loses money if the share price declines.
At least Coke’s shareholders knew what the target was, though. According to the 2001 proxy, Walt Disney’s compensation gurus decided that bonuses: may be based on one or more of the following business criteria, or on any combination thereof, on a consolidated basis: net income (or adjusted net income), return on equity (or adjusted return on equity), return on assets (or adjusted return on assets), earnings per share (diluted) (or adjusted earnings per share [diluted]). In other words, Disney’s CEO was going to get paid no matter what.
Does Management Use Stock Options Excessively? Even if they’re distributed beyond the executive suite, giving out too many options dilutes existing shareholders’ equity. If a company gives out more than 1 or 2 percent of the outstanding shares each year, they’re giving away too much of the firm’s equity every year. Conversely, it’s a great sign if the firm issues restricted stock instead of options. Restricted stock has to be counted as an expense on the income statement (options don’t, as of this writing), and restricted stock also forces the recipient to participate on the downside if the
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Do Executives Have Some Skin in the Game? That is, do they have substantial holdings of company stock, or do they tend to sell shares right after they exercise options? As a shareholder, I want management to have meaningful equity in the company. After all, selling shares in the name of “diversification” means not being exposed if the company goes downhill. Generally, I’m happier owning companies where executives own stock right alongside me because large unexercised option positions are cold comfort.
In a company’s annual 10-K filing, look for a section called “related-party transactions.” If a friend or relative of a company officer has substantial business dealings with the firm, you’ll read about it here. Often, this stuff is pretty innocuous—an ex-officer or director is paid some nominal amount each year for consulting services. As long as the firm isn’t paying out hundreds of thousands of dollars, this kind of thing doesn’t get my hackles up.
But when the firm pays substantial amounts of money to, for example, an interior-design firm run by the CEO’s wife or to a law firm in which the CFO’s son-in-law is a partner, I sit up and take notice. The key here is to make sure that (1) the firm isn’t sending a great amount of business in the direction of related parties and (2) there’s not an egregious pattern of abuse. One or two small related-party transactions aren’t a big deal, but they do cause me to raise an eyebrow because they may be signs of a deeper problem.
When you’re giving a company the once-over, there are six major red flags to watch out for.
Declining Cash Flow Even if accounting gobbledygook makes your head spin, there is one very simple thing you can do: Watch cash flow. Over time, increases in a company’s cash flow from operations should roughly track increases in net income.
If you see cash from operations decline even as net income keeps marching upward—or if cash from operations increases much more slowly than net income—watch out. This usually means that the company is generating sales without necessarily collecting the cash, and that’s a very good recipe for a blowup down the road.
If you do nothing else, watch cash flow like a hawk.
You should track how fast A/R are increasing relative to sales—the two should roughly track each other. But if sales increase by, for example, 15 percent, while A/R increases 25 percent, the company is booking sales faster than it’s receiving cash from its customers. (Remember, A/R measures goods that are sold, but not yet paid for.) As a general rule, it’s simply not possible for A/R to increase faster than sales for a long time—the company is paying out more money (as finished goods) than it’s taking in (through cash payments).
On the credit front, watch the “allowance for doubtful accounts,” which is essentially the company’s estimate of how much money it won’t be able to collect from deadbeat customers. If this amount doesn’t move up in sync with A/R, the company may be artificially boosting its results by being overly optimistic about how many of its new customers will pay their bills.
It’s reasonably common for large firms—especially in the technology sector—to make small investments in other companies. Occasionally, these investments work out well, the owner sells some of the shares, and records the capital gain as income. This is no different from the way you or I would report a capital gain as income when we’re doing our taxes every year, and it’s perfectly legal and aboveboard. An honest company breaks out these sales, however, and reports them below the “operating income” line on its income statement. The problem arises when companies try to boost their operating
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If the firm you’re analyzing is using investment gains or asset sales to boost operating income or reduce expenses, you know you’re dealing with a company that might be less than forthcoming in other areas as well.
To see whether the company has an over- or underfunded pension plan, go to the footnotes of a 10-K filing and look for the note labeled “pension and other postretirement benefits,” “employee retirement benefits,” or some variation. Then look at the line labeled “projected benefit obligation.” This is the first key number. It’s the estimated amount the company will owe to employees after they retire, and it’s based on assumptions about how long retirees will live, the rate that salary levels at the company will grow over time, and the interest rate that the company uses to discount its future
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If the benefit obligation exceeds the plan assets, the company has an underfunded pension plan and is likely to have to shovel in more money in the future, reducing profits. This can be a huge number for a large company with many retirees—General Motors, for example, had pension obligations of $80 billion at year-end 2002 versus pension assets of $61 billion. One way or another, GM will need to make up the $19 billion difference. (As recently as 2000, GM had a $1.7 billion surplus in its pension plan. When Wall Street goes south, so do pension plans—but the obligation keeps growing as
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What did this mean for GM? In 2002, the firm chucked in a whopping $4.9 billion to the plan. (You can see this in the pension footnote under “employer contributions.”) That’s almost $5 billion in cold, hard cash that an unwary shareholder might have been expecting to inc...
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However, this pension-related income is a strange kind of profit. It’s not available to pay out to shareholders—it belongs to the pension plan. And the only way to unlock that excess is to terminate the plan, which is highly unusual. But the excess does benefit shareholders: It should mean the company will have to contribute less to the pension plan in the future to keep it solvent. As a shareholder, you’d much rather have an overfunded pension plan than an underfunded one. But this income is completely dependent on the stock market, so it’s not money you want to rely on in the future. You
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There’s one important caveat to the general rule that cash flow is a number to be trusted: You can’t count on cash flow generated by employees exercising options. I mentioned this wrinkle in Chapter 5—the amount is labeled “tax benefits from employee stock plans,” or “tax benefit of stock options exercised” on the statement of cash flows. Here’s why you don’t want to count on this cash flow. When employees exercise their stock options, the amount of cash taxes that their employer has to pay declines.
As long as the firm’s stock keeps going up and it keeps giving out options, this process continues. More options are exercised, tax deductions are taken, and the firm saves cash by lowering its tax bill. But what happens if the stock takes a tumble? Many people’s options will be worthless—their exercise prices will be higher than the market price—and, consequently, fewer options will be exercised. Fewer options are now exercised, the company’s tax deduction gets smaller, and it has to pay more taxes than before, which means lower cash flow.
Therefore, when the stock price declines, the firm generates less cash than it did when the stock was flying. Sun Microsystems, for example, reported about $2.1 billion in cash flow from operations in fiscal 2001, $816 million of which resulted from this lovely tax benefit. In other words, Sun would have generated 40 percent less cash in 2001 if its employees hadn’t exercised tons of options. But the next year, when Sun’s shares plunged to below $5, this portion of cash flow dried up very fast as fewer options were exercised. In 2002, Sun’s option-related tax benefits dropped by almost 90
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If you’re analyzing a company with great cash flow that also has a highflying stock, check to see how much of that cash flow growth is coming from options-related tax benefits. Unless you think you can predict the stock ma...
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