Stock Selection Shorthand

I’m going to lean more toward the ‘capitalist’ spectrum in this post, which hopefully will be a welcome change to many people. This post is again going to be pretty lengthy, and I apologize for that, as I have promised shorter posts. I guess what I am discovering is that if I care enough about a subject to actually write about it, I generally have a lot to say. My guess is as I more thoroughly lay out my point of view to you, these posts will tend to get shorter.


Throughout my career, I have worn many hats as a professional in the financial services industry. During much of that time, my family and many of my non-financial friends have had little to no idea what I actually did for a living. However, over the years many have asked me how I go about picking stocks, so I figured I would pass along the five general things I look at and what levels I am trying to find before becoming interested in a stock.

My wife is a lawyer and she has urged me to include what is called ‘a hedge clause’ at the top of this post, so here goes. I am not telling you to buy or to sell a stock or group of investments in the following post. I am not saying that this is the best way to go about picking stocks. Indeed, more than likely, it will turn out that I am completely full of crap, and I have the tax loss carry-forwards to prove it. The following post is just my opinion as to what is a good way to approach the stock market. Nuff said.

Today, a massive amount of capital is locked up in state-of-the-art technology running state-of-the –art software churning through massive amounts of market data to determine when to buy and when to sell stocks. I don’t have a PhD in physics and I don’t know how to program in C++, so I can’t select stocks that way. Since a very young age (i.e. 5 years old) I wanted to work in the stock market, so like an idiot, I earned Bachelors and Masters Degrees in Finance. Had I known physics would have provided a more direct route to wealth in the stock market, I would have studied that instead. Because of my education, I tend to follow a fairly conventional approach to choosing stocks. I believe I am a better than average student in economics and finance so I first employ a top-down strategy, which means I have a view of our current macroeconomic environment and a view of how this environment will change over the next 12-24 months. In that respect, I have a view of which industries should outperform the stock market given those circumstances, which allows me to narrow my field of concentration. From there, I follow the following five heuristics on a company’s financial statements to narrow the field further to get to the 20 or so stocks that I really like. If you have any questions about any part of this post, please feel free to leave a comment, and I will answer it to the best of my ability.

I. Credit Statistics: My preference on strong vs. weak credits changes with my economic view. For example, if I think we are going to have a significant economic recovery, then I want to buy the stocks of companies with the crappiest credit statistics in the most economically cyclical sectors. For example, from the market bottom in March of 2009 until April of 2010, you could have made 6X your investment in Ford Motor Co. (ticker: F) stock. Even though F is the only domestic car-maker that didn't file Chap 11, it continues to be a horrible credit, and there is nothing more cyclical than the auto biz. In that rally, it was the crappiest companies whose stocks performed the best.

As a point of further illustration for this phenomenon, let us analyze the aluminum manufacture industry. Alcoa (ticker: AA) is a dominant player in this industry and Century Aluminum (ticker: CENX), to put it charitably, is a marginal one. These two companies compete directly in many instances in the aluminum market. One of the most significant differences between these two companies, from a financial perspective, is that AA has an investment grade credit rating (i.e. BBB- by S&P) and CENX has a junk rating (i.e. Caa3 by Moody’s). Had you invested in AA from March 2009 to April 2010, you would have nearly tripled your money; had you invested in CENX over the same period, you would have made 16X your money. This is what is called 'the dash for trash'. There are several reasons why these divergent returns make sense, but that is the subject of another post.

But I digress. Since I believe we are looking at a sub-par economic recovery with credit already starting to tighten, then you really want to invest in companies with strong credit statistics. There are innumerable metrics to look at, but the three that I rely on the most and the levels I like to see are the following: Total debt should be less than 50% of total capitalization—total capitalization meaning stock price x total shares outstanding + total debt outstanding. Cash flow as measured by EBITDA (earnings before interest, taxes, depreciation and amortization) should cover your interest expense by at least 4 times. The total Debt to EBITDA ratio should be around 3 or less. These are the main credit statistics I follow. The good news is there is a multitude of stocks that easily surpass these credit thresholds, but the bad news is you need more filters to get down to fewer stocks.

II. Liquidity: Liquidity is very important in the current market, given the credit access difficulties. One of the main things I learned from the dot-com crash and credit debacle of the early 2000s is that there is no substitute for a mountain of cash on a balance sheet. While it is also nice to have a large, untapped credit facility, cash as always is king. Many large cap companies now have mountains of cash sitting on their balance sheets-- Apple has $40 billion, Cisco has $30 billion, Google has $28 billion and so on. Having a net cash position (i.e. total cash - total debt= positive cash balance) is a fantastic way to navigate this stock market. However, not every business or industry can afford this luxury. Many companies have tremendous capital requirements to effectively operate in their industries and it would be irresponsible of them NOT to finance some of these assets with debt. Typically good, solid credit companies are those borrowers without overly complex corporate structures (i.e. many divisions, or matrix lines of authority), or overly complex debt instruments. Good credits typically pay-off a bond or refinance a bank facility well before its maturity. A good relationship with the credit markets is worth its weight in gold for a company in a capital intensive industry.

One additional consideration that I lump in with liquidity is the term structure of a company's debt. The question being, does a company have any significant debt maturities over the next 2 years. For example, if my company has $1 billion in cash and a $1 billion untapped credit facility; but has a capital expenditure budget (capex) of $1 billion per year and a $500 million bond issue maturing in 18 months, then my business better be generating some significant cash flow otherwise I am going to have trouble refinancing that bond next year. I always look out 2 years to make sure that a company has enough liquidity to comfortably pay-down any bond maturities with existing cash and borrowing facilities. Credit events move slower than equity events, so I think 2 years is plenty of visibility for credit purposes.

III. Is the business self-financing: Ideally, you want your business to be able to comfortably pay for itself (i.e. recapitalize) on a continuous basis. What most disinterested stock market bystanders and Democrats (redundant?) don't understand about corporate profits is that profits are generated to attract capital such that the business can continue as a going concern. While early stage companies consume enormous amounts capital, their returns on capital are required to be high (i.e. 25-30%+) to attract enough capital to keep the business running and growing. There is a place in every portfolio for stocks in companies that consume large amounts of capital in an expectation of very high returns. However, your capital investment in these kinds of companies also demands a substantial amount of your time to analyze the business, the industry, and the correct macroeconomic circumstances under which this stock will flourish. Most people do not have this kind of time. A short cut to getting involved in this kind of company is investing in an intriguing stock within your own industry of employment. You would naturally know a lot of things about the industry and the company that most of the people on Wall Street would not know, that would at least give you a fighting chance at beating them in the investment arena on this stock. If you try to invest in a company outside of your innate industry area, be prepared to spend more than a few long nights studying up on the industry, the company and analyzing its financials, because there are super smart hedge fund guys out there who are highly incentivized to beat your brains out on the trading of these kinds of stocks.

The way you determine if a business is self-financing is by looking at about 4 or 5 years of annual cash flow statements. The first third of the statement is called cash flow from operating activities—this conveys to you how much cash the business generates. To get a more precise idea of the long-term cash generating capability of the company, you want to look at this number excluding changes in working capital (e.g. accounts receivable, inventory, etc.) that usually appear at the bottom of this part of the statement. Working capital changes can be manipulated for the end of year closing of the books to a much greater degree than any of the other numbers and can fluctuate wildly from year-to-year, so you want to net those out. What you are left with is FFO (funds from operations)--this is basically net income plus depreciation plus deferred taxes. This is a fairly realistic estimation of the cash generating ability of the enterprise.

The second third of the cash flow statement is the cash used in investing activities. The numbers you want to pay attention to here are capital expenditure items only. If you want to get technical, you may want to look into the SEC filing to see if they disclose maintenance capex as a subset of total capex. Over the 5 year period, does FFO consistently cover total capex? If it does, then your business is solidly self-financing, and therefore would not be required to go to the capital markets for money during tough times. If not, does it cover maintenance capex? If it doesn't then I believe you should exclude this company from your investment universe and move to the next one.

The other thing to look for is whether capex is greater than depreciation consistently. If it is, then that means the company is continuing to grow and build the business. If it is not, then there are one of three possible activities going on here: (1.) management is slowly liquidating the business, (2.) management is intentionally underinvesting in the business because the company is in distress and is in severe cash conservation mode, (3.) management is neglecting the business and may come back one day with some massive future capex budget. In certain cases, the first scenario can still be lucrative to stockholders, but the other two are usually bad scenarios for stockholders.

IV. PEG ratio: This is a fairly well covered ratio on the Street. You take the price-earnings ratio of the stock and divide it by its growth rate, meaning the year-to-year growth of earnings per share. Some people look for a mulit-year growth rate, but I don't because equity analyst growth rates are crap after one fiscal year into the future. So I look at the one year out estimates (e.g. 2011) and compare that to the current year to determine the growth rate. Then I look at how EPS has grown year-to-year over the prior 4 to 5 years. In most cases, that average growth rate should be less than the forecast growth rate. In this stock market environment, the PEG ratio should be close to 1 or less for a stock with a P/E greater than the market’s P/E (typically about 15x). In all cases it should be less than 2 for a stock you are going to buy. For mature companies that pay decent dividends and with P/E ratios below the market's, I would pay more than a PEG of 1. In robust economies, this rule changes. You still want to pay less than 2 for everything, but would pay around 2 for fast growing companies, and 1 or less for mature companies with good dividends.

V. Better Than Expected: These are the three sweetest words on Wall Street during earnings season (the 3 week period every quarter when most companies report earnings--begins the second week of January, April, July, October; and ends the first week of March, May, August and November). You want your company to report earnings above Wall Street consensus earnings estimates (and in most cases, you want its revenues to exceed consensus as well). To improve your chances beyond the probability of a coin toss of picking a stock that beats the number, look at the prior 4 quarters of reported earnings to see if they beat Wall Street's numbers. If they have done so at least 3 of those times, then you have a pretty good shot of having a company that will beat them again. Management generally has a good idea of what the number is going to look like about a month before they report. A company that routinely beats Wall Street consensus is very good at managing expectations, which is really what you want from management most of the time anyway. Another way to get a better idea of how the company is going to report is to look at EPS estimate revisions on Wall Street. I know that WSJ.com has a feature like this for most stocks. It will tell you the stock's current consensus quarterly and annual earnings estimates, what they were a month ago, and what they were 3 months ago. If the number 3 months ago is lower than the current number, then obviously business conditions are improving and you probably have a stock that will beat its number come reporting time.

Using these rules of thumb and incorporating your own ideas about the character of the economy, you should wind up with about two dozen stocks. Then the fun begins in analyzing the companies and their industries. By following these guidelines, you should be able to construct a portfolio of solid companies that will perform well over at least a two year holding period. Most investment professionals will tell you the hardest part of the investment business is knowing when to sell a stock, but that is the subject of a future post.

If this post is as clear as mud, then I feel I have done my job. If you have any questions, please leave a comment and I will answer as quickly and thoroughly as I can.

Happy stock hunting!