5 Things I Look For in a Stock

The best strategy for an investor is to focus on having the best-positioned portfolio at all times. What does that mean? What does a good investment position look like? I can think of five points where an investor can have a positional advantage. If the stocks he owns score better on these five points than the average stock - he's likely to get an above average return going forward. If they don't - he is not well positioned.

The five points are: durability, quality, value, capital allocation and growth.

It's a good idea to look at any stock you're thinking about buying and see how it scores on each of these points. Is the durability of the business's cash flows below average, average or above average? Is the quality of the company - its product economics - below average, average or above average? Is the cheapness of the business at today's price - I usually focus on EV/EBITDA - below average, average or above average? Will future capital allocation be below average, average or above average? And, finally, are the prospects for future growth at the company below average, average or above average?

I would rank these points in the order I put them:

1. Durability

2. Quality

3. Value

4. Capital Allocation

5. Growth

All five are important. But you can still make money in stocks that score poorly on the last couple points. It is easiest to lose money - and lots of it - if you buy stocks that score really badly on the first few points.

Value investors tend - at most - to focus on points one through three. They always look for value. They sometimes look for quality. And they sometimes look for durability.

Let's define these five points and try to find examples of what below average, average and above average looks like. We'll start at the top: No. 1 durability.

The other day, I noticed Morningstar only gives a "wide moat" rating to one U.S. utility: Exelon ( EXC ) . Exelon owns plenty of nuclear power plants. So, I don't disagree with the company they picked as having the widest moat. But I do find it odd that they only award a wide moat to one utility.

The reason for this is clear when you realize Morningstar lumps together the ideas of business quality - in the sense of a high return on capital - and an economic moat (in the sense of barriers to entry). I think we should keep the two topics separate.

Utilities have operational durability - they can and do fail because of financial problems caused by debt - whether or not they earn high returns on capital. So, I would give Exelon and U.S. Lime and Minerals ( USLM ) and Norfolk Southern ( NSC ) and Village Supermarket ( VLGEA ) and Dole Foods ( DOLE ) and Omnicom ( OMC ) and McCormick ( MKC ) and Exponent (EXPO) and Carnival ( CCL ) an above average durability rating.

Notice these companies would get different business quality ratings. Some like McCormick and Omnicom earn high returns on capital. While a grocery store almost always earns a low return. Carnival has earned very low returns since oil prices have been high. Dole's returns are determined by commodity markets. And a railroad only earns good returns when levered. It's a mixed bag in terms of returns. But I think durability is above average at all those companies. Why?

My test of durability is whether parts of the company are likely to exist still and still be doing the same thing many years in the future. The actual quarries owned by USLM will be used by someone in 2023. Someone will be buying that limestone. The Norfolk Southern will be around regardless of who owns it. The major agencies Omnicom owns will be in business a decade or two from now.

So what does below-average durability look like? Q-Logic ( QLGC ) is a great example. It's got a moat and earns super high returns on capital. But nobody knows what storage area networks will look like in 10 or 20 years. Barnes & Noble ( BKS ) is not durable. It is - like Q-Logic - a market share leader. But we don't know what good brick and mortar shelf space will be in 10 or 20 years. Not durable. Also potentially not durable is Microsoft (MSFT) . But I don't just want to focus on technology. There are fads and fashions to consider too. Is Apple (AAPL) durable? Is Coach (COH) ? Is Abercrombie (ANF) ? Is Under Armour (UA) ? These are tricky questions because a brand can be very durable. But I can also name brands that were once much better known than they are now. A good example is Jantzen. You may know the name. But even if you do - you probably don't know that 80 years ago Jantzen would've made a world's most valuable brands list.

Even A&P - in an industry, groceries, that I said was durable - wasn't quite permanent. But the incredibly slow decline of the company and its trademark over decades makes it clear that losing ground in something like groceries is very different than losing ground in something like fashion. In fact, I think the slow decline of A&P illustrates the difference between high durability and low durability businesses.

You can sometimes make a lot of money disagreeing with the market over a company's durability. That's because the difference between a 10% equity coupon that might stop making payments in a few years and what is effectively a perpetual bond with a double-digit yield is huge. If you can look at two stocks with a P/E of 10 and you can tell which will be around and posting the same EPS or higher in 5 to 15 years, you can make a lot of money when the market starts to see that stock as a durable franchise.

I'll give one modern day example where I disagree with the market: John Wiley ( JW.A ) . I think its business is much, much more durable than other publishers. I don't think its stock is priced that way right now.

Now let's talk about business quality. There are a lot of ways to measure business quality. The recent book, "Quantitative Value Investing," suggests using gross profits to total assets. There is some logic to that approach. Of course, I'm against using intangibles in the calculation.

When I look at a company, I look at both margins and returns. I look at gross profitability (gross profit/NTA) where NTA is net tangible assets (and is basically Greenblatt's definition of invested capital). But I also look at EBITDA/NTA and EBIT/NTA.

My rule of thumb is that when EBITDA/NTA is greater than 40% you clearly have an above average business. When EBITDA/NTA is less than 20% you probably have a below average business. When EBITDA/NTA is somewhere between 20% and 40% we are talking about a roughly average business.

I'm not going to argue about leverage right now. Everybody who writes about business quality - Greenblatt, Quantitative Value Investing, etc. - shirks this issue. They simply throw out companies (financials, railroads and utilities) that use leverage.

The ability to use leverage safely has value. And the financial leverage of an insurer or bank is different than the financial leverage of an industrial. Also, most approaches to measuring business quality are too lenient on retailers and restaurants - who uses leases, etc. - and too tough on financials (who use unearned cash).

But I don't have an answer to this problem. Regardless, business quality at the extremes is easy to recognize. John Wiley and Weight Watchers ( WTW ) and Dun & Bradstreet ( DNB ) and Moody's (MCO) and Q-Logic ( QLGC ) are insanely great businesses. Two stocks I own - George Risk ( RSKIA ) and Ark Restaurants ( ARKR ) - aren't too bad either. Unless they use leverage your railroads and grocery stores, with the rare exception of something like Arden (ARDNA) , and utilities, and J&J Snack Foods (JJSF) , and so on are just okay businesses.

Business quality has two parts: competitive position and product economics. Something like a newspaper tends toward monopoly. That is the only reason newspapers earned high returns on capital in the good old days. There are other business like CARBO Ceramics (CRR) and Omnicom that earn good returns on capital because of product economics. In those businesses, there are factors that make each customer relationship likely to work out well. Some companies - like Q-Logic - combine good product economics with a strong competitive position. They have nice market share. And the product tends not to be something where price is the factor the customer cares most about. This is the best recipe for high returns on capital. However, that doesn't fix the durability question. No amount of present business quality can ensure durability far into the future.

I won't spend much time on value, because that's what value investors always talk about. I like EV/EBITDA. I like long-term averages. You can check the price ratios on the only two American stocks I own right now, George Risk and Ark Restaurants, to see what I look for. I try to discount "peak" earnings a bit. I like to buy a stock when current earnings are in the normal to low range of what the company is capable of earning. In other words, I try not to buy a restaurant, housing related stock, advertising agency, etc., at the top of the economy. I don't buy oil stocks when oil prices are high. Basically I just use EV/EBITDA, long-term averages, and common sense. Sometimes - where assets are important - I look at book value and appraised values and things like that. But usually it's EV/EBITDA.

An example of "value" would be Q-Logic or any for-profit education stock (but are they durable?) or Lexmark (LXK) or something like that. John Wiley would be an average value at best. The P/E might look low but EV/EBITDA isn't. Weight Watchers is starting to edge into expensive territory (we're above an EV/EBITDA of 9 in that case). And Buffett's recent purchase of Heinz is definitely expensive. It may be a good investment. But it wasn't a value investment. He had to be depending on other factors like durability and quality and capital allocation and growth to justify paying such a high EV/EBITDA for Heinz.

Next is capital allocation. I talked about this one a lot in a recent article on buybacks. My best advice when trying to understand what you want in capital allocation is to read the book "The Outsiders" and to read Warren Buffett 's annual letters.

I just look for free cash flow generating companies that lower their share count every year. Good examples among companies I've already mentioned in this article are Q-Logic, Weight Watchers, Dun & Bradstreet and Omnicom. Bad capital allocation is issuing stock when the price is low - like during the financial panic. Doing big, dumb acquisitions using company stock is the other big no-no. Buffett's purchase of Dexter Shoe is the classic example of terrible capital allocation.

I rank growth as the least important of the five points - maybe because I'm not much of a growth investor. I like companies that can grow at about the rate of nominal GDP. That's a huge plus. If a company can deliver earnings purely in the form of free cash flow and still grow 6% a year it's a very valuable company. Buying such companies is the Yacktman approach.

Good examples of companies I've mentioned that focus on growth are CARBO Ceramics (which historically plowed every dime back into the business, delivering almost no free cash flow) and J&J Snack Foods who reports "record" earnings every year. I think their streak of record earnings is about four decades old now. They like to buy more food companies whenever they can.

At the other extreme you have Q-Logic and Dun & Bradstreet. If either of those two companies have grown at all in the last 10 years, they've done a great job of hiding it. Their organic numbers over the last decade look like a pancake. Dun & Bradstreet is a rare example of a completely mature monopoly.

There are a few ways to look at growth. The Phil Fisher approach is to look for companies with growth in their cultural bones. The products they produce don't have to grow. They just have to keep moving into new products.

Societal trends can be another source of growth. See education and health care stocks. From the middle of the 20 th century on just about anything travel related had a similar tailwind. Video entertainment in your house - in just about any form - had three nice decades or so of ever-increasing demand.

It can be hard for investors to separate short-term shifts in perception, etc., with long-term trends. The really big trends last a long time. Things like what people eat (chicken, pork, beef, etc.), whether they have pets, if they are overweight, etc., are pretty slow moving trends. They can, however, add a couple points of real growth to a company's future for decades. That's obviously valuable. But there's the danger of paying up for a trend or confusing a short-term blip (the Atkins diet) with a long-term trend (lots more fat Americans).

The three best investors to read about for growth are: Phil Fisher, Peter Lynch and Warren Buffett . Each focused on somewhat different growth.

One problem with any of the five points is that you sometimes have to give up too much in compensation. A good example of this is the Peter Lynch approach. When Peter Lynch started investing you could find some wonderful retailers and restaurants that were strong locally and expanding at reasonably normal P/E ratios. Over time, Wall Street wised up to this and began giving astronomical P/E ratios to a hot concept that would eventually go nationwide.

But the same is true for all styles of investing. The 1970s and early 1980s were a much better time for the "consumer franchise" approach favored by Warren Buffett simply because you sometimes had really reasonably priced brands. If anything the value of brands is perhaps a little less today and yet the premium on their stocks is as high (or higher) than it was back then. Likewise, it would've been impossible to be a Phil Fisher investor in 1999. Everything in his favorite categories was so overpriced.

When looking at the five points on which you can gain an advantage over the market, it's best to start at the top and cross off stocks that clearly fail in one regard.

If a stock falls flat when it comes to durability - you may want to eliminate it right then. If it's clearly a low-quality business, you might not even need to take a hard look at the EV/EBITDA ratio. If it's trading at 30 times earnings, you don't need to worry about capital allocation or future growth. It's clearly a failure when it comes to value.

A stock that scores well enough on all five points will often make the best long-term investment. It will usually be the easiest to understand.

However, you can make money when a stock scores insanely well on one point but not well on others. In such a situation, the great advantage in one area can compensate for other flaws. A classic example - one I've invested in many times - is a negative enterprise value stock. In other words, when a consistently profitable company is selling for less than its net cash - it may not matter whether that business is especially durable, high quality, etc. It may be enough to know it's being given away for free. Especially if you can buy a basket of such stocks.

But my big advice is not to focus exclusively on one of the five points. It's especially dangerous to think a small advantage on one point - like having an EV/EBITDA of 5 - is enough to offset shortcomings in areas like durability or quality. It takes a very large advantage on a point like value to offset clear failures on key points like business quality and durability of cash flows.

I don't have a name for this five-point approach. But the idea of focusing on:

1. Durability

2. Quality

3. Value

4. Capital Allocation

5. Growth

Comes a lot closer to explaining my investment approach than the label "value" does. I think value is often the clearest point. But it's really only one-fifth of the story.

[url=mailto:[email]geoff@gannononinvesting.com[/email]]Ask Geoff a Question[/url]

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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