Introduction
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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Michael Lipper, C.F.A.,
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