Sunday, November 1, 2015

Rising Earnings Do Not Make a Growth Stock


Caltech is the origin of many new companies as well as Nobel Prizes. Each year Caltech treats its trustees at its Annual Meeting to a number of research presentations by some of its leading professors. To the extent that we can comprehend what is being said, my wife and I find these talks one of the highlights of our visits. Along with other leading research universities, Caltech is an internal tech transfer group that both licenses some of its growing intellectual properties and also occasionally invests in the pre-IPO activities. Next month I will be addressing a couple dozen CEOs who are in the process of raising public capital.

The Next to Last Ownership

Both the entrepreneurial professors and the later stage CEOs are heavily focused on the next capital raise as they should be. To the extent that they are successful and don’t lose their independence, they should start to think about developing attractive characteristics for the next to last ownership of their shares. Often when successful, the next to last owner will be established growth stock holders, most of the time found in Growth fund type vehicles. (The last owner will be the eventual buyer from the originator’s estate.)

Sustainable growth of capital is the prime objective for many of these buyers. In our context I am talking about positions in the Endowment Portfolio within the TIMESPAN L PORTFOLIOS®. Assuming no reason to sell, these positions should have a duration between six and sixteen years before some are transitioned over to the Legacy Portfolio for the benefit of future generations.

Finding Sustainable Growth

Numbers, process, and management are the clues to follow in the search to find sustainable growth. Numbers that are ratios, trends, and deviations are the easiest to appropriately identify. Good professional security analysts should have the appropriate intellectual rigor required. This process requires some depth of understanding of what the company, customers and competitors actually do and think. Someone with experience and broad business knowledge can help.

The Difficulty When Analyzing Management

Assessing management is the most difficult of the analytical tasks and requires the greatest amount of humility. From an early age successful survivors are artful in hiding both emotions and thought patterns. If it is difficult to scope-out one talented person's relations with other people (some of whom are just as bright) it is more difficult by an order of magnitude to do the same for an entire management team.

Focus on the Numbers

I will first focus on the easiest of the three clues, the numbers. As other sports followers have learned, one of the things that one becomes skilled at from “handicapping” or analyzing at the racetrack is to be suspicious of a continuation of long streaks. We know that very good performers have off days. Understanding the reasons for falling off a sustained trend line would help, but that is not always discernible. Nevertheless, I am comfortable throwing a rare mishap out in my guess as to the future. Unless something major has changed, I tend to accept an 80% compliance with a trend to be useful as an element to future predictions. Also, one of the lessons people should have learned from the Madoff scandal is that perfection is suspicious.

In viewing my comments about financial statement analysis, please bear in mind that I don’t expect every stock in a sustainable growth stock portfolio to completely mirror these filters, but the weighted average of the holdings should. I am not going to comment on every line item in the Income Statement and Balance Sheet. However, each item may color a prudent investor’s decision process much more than the press release of XX % gain in earnings per share. This is particularly the case if the GAAP accounting earnings are considerably different than the more popular non-GAAP numbers.

Operating Revenues

In the business as well as the personal worlds, without a consummated sale there is little belief. After I understand how revenue is recorded I like to see periodic growth that is faster than that experienced in the sector. A fad sales is often like a report of speed dating. While not normally reported, repeat sales demonstrate that in the eyes of the customer that the sale addresses a  customer’s problem. Repeated revenues from the same customer is showing dependency which is the goal of the drive for sustainable relations. In addition, growth in market share shows competitive strength except for the price leader which may be buying the business by educating the customer to place price over value. Often it is extremely valuable to be recognized as the low cost producer. Though it is a extremely valuable defensive weapon, it is analogous to eating one’s young. On the other hand, being acknowledged as the low cost producer can exert some price discipline on a competitor. Good analysts will markdown sales growth if returns and warranty costs are rising. (Inventory management will be discussed when balance sheet accounts are reviewed.)

Gross Margins

The direct cost to growth product companies to produce sales is often about half of the revenues received over a market cycle, producing a gross margin in the 40-60% range. Service companies, where their principal expenses are people costs, can have lower gross margins as they have materially lower plant and equipment depreciation. Many financial services companies use substantial amounts of borrowed capital (unless it is customers’ float), and have interest costs that bring margins below those of product producers. Analysts become concerned when gross margins contract because it may signal some loss of competitive standing with peers or from substitute products from outside the industry.

Operating Margins

After the cost to produce a current product or service there are other costs which include selling and general corporate administration (SG&A). In addition to research and development for new products are periodic charges that need to be absorbed as well as depreciation and other charges. Often interest expenses are included. I prefer to see a net interest item that subtracts from interest earned the interest paid/accrued. If net interest is a significant item, analysts may question whether the company has an adequate capital structure and how it will get one. Overall operating margins can be approximately 20 percentage points below gross margins.

Income Tax Rates

Analysts want to know what income taxes have been paid or accrued. Most importantly the source of the differences and the implications for the future. Wise tax management is applauded if it does not constrain the company’s future actions.

Impact of Foreign Sales and Earnings Translation

A long-term investor normally does not want to value currency translation gains and losses highly. However, hedging does tell investors what management’s is attitude toward short-term results. There are several ways to hedge. The more popular short-term approach is by entering the foreign exchange market through derivatives and/or local currencies. A longer-term approach is to balance sales and earnings from various foreign countries with the home or functional currency. One also needs to understand in which currencies the bulk of the foreign operation’s expenses are incurred. Further it is important to understand in which currency profits are measured including where and at what level taxes are paid and when.

Reporting on Industrial Conditions

Good analysts will have other sources of information as to the growth in various markets as well as significant price trends. The reporting company should be a source of these critical elements in an unbiased way. The absence of these may show a lack of serious interest in their shareholders’ welfare.

Brief Balance Sheet Concerns

Inventories - Often a firm will provide three levels of inventory: finished products, work in process, and raw materials. If inventory levels are rising faster than sales, particularly in the finished products and to a somewhat lesser extent in work in progress, it can be a tip off that the company may have to lower its selling prices or improve its terms to bring inventory levels back below the sales rate. If the build up is in the raw materials line item, the company may be speculating as to future rising prices or trying to create a shortage as a competitive device. In any case, changes in inventory levels need to be understood.

Fixed Assets -  Physical fixed assets of plant and equipment are recorded at historical cost, unless written down minus accumulated depreciation. Depending on the industry, the ratio of the remaining un-depreciated assets as a percent of the original cost of the assets compared with peers can be a useful clue as to which competitor has the newest facilities and possibly who has the lowest cost of production relative to its sales level.

Intellectual Property -  Intellectual property can be of great value to a company’s barriers to entry or moat. The size of the moat and how well it is defended can be critical in the ability of the company to resist attacks by competitors. To my mind this is of secondary importance compared with the clients’ dependency on the company’s products and services and the clients’ attitude toward that dependence.

Liabilities - Accrued but unpaid taxes, while they create valuable float, as in all liabilities need to be understood and appropriately recorded. One also needs to ensure the full extent of the retirement liability is recorded. (In terms of educational institutions rarely is there an estimate of the long-term cost of tenure.) One of the jobs of a thorough analyst is to determine the off balance sheet contingency reserves. If a company states it doesn’t have one, that can be a problem.

The Second Clue = Process

For a company to have a sustainable growth pattern it needs a well understood and hopefully written down process for most of its critical functions. A thorough research report should be able to summarize the process as well as reports to regulators and shareholders. A series of well defined processes can aid a company if critical management disappears or perhaps serve as an aid in regulatory inspections. Far too many institutional shareholders do not fully understand the critical processes. This means that when there is a market disruption investors will be flying blind until they can get a reasonably full and responsive communication with the company. Often this will lead to the sale of the position in part due to unfounded but believable rumors.
The Toughest Clue = Management

While past history is never fully complete and not exactly like the current condition, it is somewhat helpful but hardly guaranteed. In Jason Zweig’s new book “The Devil’s Financial Dictionary” he quotes Warren Buffett, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Nevertheless, we often have to make a decision as to whether the existing management can carry the company to the rosy future in which we would like to believe. The attributes that we look for are as follows:

1. Unquestioned integrity, not only in a legal sense, but also in an intellectual sense. We need to recognize that some people lie to themselves and overstate their views of the future.

2. Innovations both of product and process are critical to long term success.

3. How do the key executives as well as those at the lower level treat each other is a good clue as to how they will treat absentee owners of both debt and equity.

4. Good controls of people, finances and processes will provide the everyday discipline which is critical to the success of the enterprise.

I look forward to discussing these thoughts with you.
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