Creating an Investment Framework
The purpose of this blog is to share an investment framework by which one can find new stocks, systematically research them, and model future performance. Once the initial research has been done, periodic follow-up due diligence should be done to update the model and assumptions.
I like to look for stocks trading at low multiples of earnings or at a discount to net assets. Assuming no growth, my ideal company is still a bargain based on current earnings. If it's a high growth company, I like paying a reasonable price. In short, I like value and GARP.
Finding New Stocks:
- A general screen might include a mixture of growth, profitability, financial health, and valuation. An example might be: revenue/earnings growth, ROE, current ratio, LT debt-to-equity, and low PE/PB.
- Let's say I'm targeting financials. I might go with a low PE, low PB, and high ROE. Book value's a lot more important with banks and insurance companies, and a high ROE with a low PB is a nice combination of cheap valuation and profitability.
Response to macroeconomic events:
- I still point to my example of the 35 day slump in the BDI, which made me very interested in dry bulk shippers.
- After the gulf oil spill, oil drillers, explorers, and other oil-related companies fell a lot. Some of them barely even had exposure to the Gulf of Mexico. I took this opportunity to pick up some drillers in real life.
Scanning the daily list of losers:
- While the market might not be doing much of anything, there are still stocks making new highs and new lows. It's good to run screens regularly and to check the headlines for which stocks dropped the most. Our CAPS homepage has a nice list of the 5 top gainers and losers for each day.
- Four times a year, earnings seasons provide healthy doses of companies whose shares plummet because of slight misses on revenue or EPS. I make a lot of my moves around earnings seasons, scooping up stocks where 5% drops in guidance often lead to 15% or 20% drops in share prices.
Read and Understand the Financial Statements
In general, I check the company's last 4 or 5 quarterly and annual financial statements.
- The income statement looks at a firm's financial performance over a set period of time, usually a quarter or a year.
- Look for sales, gross profits, operating profits, and net income. Also look at the gross margins, operating margins, and net margins.
- Is the company growing? Are margins stable or increasing? Are there any red flags?
- The balance sheet is a snapshot of a firm's financial position at a certain time. It tells about a firm's liquidity and solvency.
- First, check for adequate liquidity through the current and quick ratios. It's most important for the company to be able to meet current liabilities, or liabilities due within 12 months.
- Also look at long-term and overall debt levels. Long-term debt maturity schedules can be found in the company's latest 10-K filing.
- Check for growing equity as a whole and on a per-share basis. Make sure management doesn't dilute the stock too much.
- Check for red flags, such as rapidly increasing receivables that grow faster than sales. This may indicate overly aggressive revenue recognition, which means the firm may be counting revenue befire it ships the goods instead of adding unearned revenue to the liabilities.
Cash Flow Statement:
- The cash flow statement shows the actual movement of cash. In general, we want the majority of cash inflows coming from operating activities.
- Are operating cash flows generally higher than net income? Starting with net income, adding depreciation and amortization alone should take operating cash flow higher than net income. A notable exception is a company in the very early stages of growth. This company may have more financing cash inflows than operating cash inflows for a while.
- If this company is growing, do capital expenditures outpace depreciation? Note that capital expenditures should outpace depreciation even for companies maintaining status quo, since replacement cost is likely higher than historical cost.
It should not take long to see if the per-share numbers of various ratios look good. They should already be acceptable if this stock was found through screening. Make a mental note of red flags, such as cash flows not coming from operating activities, runaway receivables, and rapidly decreasing margins.
Read Annual and Quarterly Filings
After a quick run through the financial statements, I have a general idea how this company is performing. If I don't know how the industry operates, I take the time to learn. I like to learn how companies make money in this industry and about supply and demand side fundamentals. Check here for sample due diligence on supply and demand side fundamentals for the dry bulk industry. The information was gleaned from companies' filings, investor presentations, and some personal knowledge about the steel industry. Anyway, check for risk factors and pending lawsuits and be sure to pay special attention to management discussion and analysis.
After reading several reports for a company, I have a decent understanding of how a company makes money, the status of its PP&E, past performance, recent acquisitions, and future growth opportunities.
Pay special attention to footnotes to the financial statements, as they contain a lot of important information that you won't see on quarterly or annual financial statements at your favorite finance hub. They include a lot of useful information such as assumptions or estimates used and how management chose to account for certain items under its discretion.
If the company has long-term debts, they'll often be listed under "contractual obligations" or "long-term debts." Be sure to check these as they can provide guidelines for modeling future years and can warn of upcoming maturities of bonds or credit facilities.
One interesting thing to do is to read a few annual reports from several years back. One can see if management follows through on past promises or says one thing and does another.
Listen to Earnings Calls
Your typical earnings call will contain a disclosure from a legal representative, a business update for the last quarter, financial performance for the last quarter, and a question and answer section. These earnings calls provide additional information about the business along with valuable commentary from management. Analysts' questions tend to have pretty good follow-up questions to clarify past events, ask when recent acquisitions might become fully accretive to earnings, and other questions on how to model upcoming quarters in terms of revenues, G&A, R&D, margins, and other important items.
I've found that earnings calls are more interesting than reading hundreds of pages of text and provide a nice change of pace. It's also nice to actually hear management share their thoughts on the industry and past and future events. Nobody knows as much about these industries as the people actually working in them, so I appreciate the additional information.
I try to listen to at least the last 3 or 4 earnings calls if they're available. Many companies will archive them on their websites.
If you're feeling ambitious, you can create a model of upcoming quarters and actually calculate a future EPS figure. A good place to start is management's guidance on revenue and net income. If you've been listening to the earnings calls, you should also have a good idea how to model G&A and R&D as a percentage of sales and how gross margins are going to look. Some companies even tell you what tax rate to use in modeling upcoming quarters. In many cases, one can use historical trends to fill in many of the blanks such as depreciation and amortization.
When modeling, there are many things to find in the financial statements and company filings such as seasonality of the industry, macroeconomic developments, company-specific assumptions, and product mix.
In retail, Q4 is always the biggest quarter. If you're modeling Q1, you cannot extrapolate numbers from Q4 of the previous year or you will likely come up with an overly optimistic estimate of future earnings. One should knwo which quarter is the biggest for a company by looking at past quarterly financial statements.
A sample macroeconomic event is the wildfire incidents in Russia. As a result, Russia imposed a ban on grain exports. This increases exports from North American grain exporters. It would also potentially increase ton-miles for dry bulk shippers for the portion of grains headed towards China. Since the distance from North America to China is way greater than that of Russia to China, dry bulk shippers would potentially benefit from Russia's grain export ban.
A very important factor is GDP growth, since it will tend to help most companies. A company that can maintain market share during periods of growing GDP will increase sales simply because companies are sharing a bigger pie. Keep in mind that some sectors' movements are decoupled from overall GDP movements and will expand and contract on their own.
Different products produce different gross margins. Hardware will tend to be lower margin than software or services. Keep in mind the product mix typical for the upcoming quarter or if an analyst has asked management what kind of product mix to expect in upcoming quarters. Gross margins may have to be revised up or down as a result.
For a company that ships goods out of factories, one can use factory utilization and price per ton to calculate sales. For example, one can model a steel company by looking at the ISM index and steel industry utilization rates, along with prices on hot band and other finished products. Again, knowing supply and demand side fundamentals is pretty important for modeling future quarters.
If you've ever wondered about forward PE and analysts' estimates, they come from financial models. Obviously, the models must use certain forward-looking assumptions and sometimes continue past trends. Like I mentioned earlier, management guidance provides a good starting point. A diligent investor can then fill in the blanks and revise the guidance up or down based on his due diligence.
Here's a sample model from CAPS user wax, who posted a worksheet at the bottom of this blog post.
Rinse and Repeat
Every quarter, there will be a new 10-Q or 10-K, new financial statements, and a new earnings call. One should review what's happened in the latest quarter, learn about any new upcoming developments, and adjust the model as necessary. It's a lot easier once the initial legwork's been done, but the upkeep takes a bit of work as well. For every company one chooses to follow, additional research should be done regularly. It's a good idea to read new press releases on your companies through the companies' websites or through a watch list that provides news headlines on all of your watched stocks.
Doing comprehensive research is very time-consuming, but very rewarding. I've found that I sleep a lot better at night when I've done comprehensive research on my holdings. Many companies will not make it past your initial screening or financial statement readings, so don't worry about doing this for hundreds of companies (which, by the way, is not possible due to time contraints).
As always, I look forward to your comments. Entire books can and have been written on certain sections, such as financial statement analysis. I tried to touch up on some main points, but I do understand I may have missed certain important ratios or factors in my write-up.