How to identify outstanding companies

A manual for the intelligent investor

HOW TO IDENTIFY OUTSTANDING COMPANIES

First I will introduce you to the 3 categories of companies. Then I will show you how to identify the most successful companies. Afterwards I will give you the tools to identify the right time to buy these businesses.

PART 1: THE 3 CATEGORIES OF COMPANIES

Stocks can be sorted in roughly 3 categories based on their earnings (EPS) development: the earnings over time are shown by the straight
line. Green areas are defined as good buying opportunities, red ones as bad buying opportunities.

Price follows earnings

I. Growing: These are the companies we are looking for: Constant earnings growth. In the ideal case we identify times of relative undervaluation and are able to buy the company when it is trading at a discount to its inner value (point 3&4). The beauty of buying outstanding businesses is: Even when you are buying at times when the stock is relatively expensive (point 1&2) you will still make profit over time. As Warren Buffest said: “Time is the friend of the wonderful company”

II. Sideways: These companies are not or just barely growing their EPS. Although it can be profitable to buy these companies at times of undervaluation (green areas) it is best to not buy them at all and stick with Stock from category I.

III. Falling: These companies are in decline. Even at times of relative undervaluation (point 3&4) these companies are not attractive.

To illustrate my point with real-life examples look at these charts which are from Fastgraphs. The orange line represents the development of the EPS.

Category I company: Adobe

Take Adobe (ADBE) as a prime example of a category I company. Outstanding EPS growth.

All EPS Graphs are from https://fastgraphs.com/

The next chart is the same as above, but this time I have included the stock price development of Adobe. Again: Price follows earnings.

Even when you buy a company like Adobe above its historical valuation (point 1 and 2), you can still get amazing results. Adobe is growing so fast, that the fundamentals caught up with the price.

Price fluctuates around the earnings

Another example for a category I company is Altria (MO). Over the years, Altria has shown impressive EPS growth (orange line). At the same time the stock price fluctuated a lot. If you bought Altria at times of relative undervaluation (points 1, 2 and 4) you were doing a lot better, than if you would have bought Altria at times of relative overvaluation (point 3).

Why timing matters:

Microsoft (MSFT) is one of the most successful companies. Nevertheless, it is important when to buy category I stocks because excessive overvaluation can lead to many years of underperformance. If you bought Microsoft in the early 2000s at very high valuations (point 1) you did not see any capital appreciation for many years. At the same time Microsoft was growing the underlying business at a strong pace. Over time the stock became eventually undervalued (point 2) before the stock price caught up with the strong business development.

Category II company: AT&T

AT&T’s (T) earnings have been mostly going sideways over the last years. Since price follows earnings, the stock price barely moved in all these years.  The only way to ensure capital gains is to buy at times of relative undervaluation (green areas in the chart for category II stocks). For AT&T this would have been at point 1 in the chart. Since it is a lot easier to profit from exceptional companies, we will stick to category I stocks.

Category III company: Bed Bath & Beyond:

Bed Bath & Beyond (BBBY) has been in a major decline since 2016. The EPS are falling off a cliff and so does the stock price. Even though the stock might seem cheap, we will not buy these companies and focus on category I companies instead.

Conclusion:

We are looking for category I companies and buy them at times of relative low valuations (point 3 and 4). Even if we are buying too early (point 1), the stock price will eventually follow the increasing EPS. It is a lot easier to hold onto a category I stock at times of declining prices than it is to hold onto category II or category III stocks.

PART 2: IDENTIFYING CATEGORY I COMPANIES

The goal of each investment is to be a long-term owner of the business. The goal is not be a short-term trader by speculating on short swings in stocks.

Each investment will be bought based on outstanding underlying fundamentals. By creating tough hurdles for companies to be considered for the portfolio, we free ourselves from looking at the majority of listed stocks. This narrow focus provides us the time to research outstanding companies in more depth.

To be eligible for the portfolio a company has to show a strong track record in the following fundamentals:

Profit and Loss (P&L) statement metrics:

·         Revenue: Revenue has to grow steadily. Revenue is the fuel to any business. As the topline of the P&L the whole enterprise is relying on sales. By consistently increasing the revenues above inflation the company proves that it brings value to the customer

·         Gross Margin: A steady or even increasing gross margin is the requirement to turn all the additional revenue into profit. Declining gross profits are a warning sign

·         Net Income: Net Income must show an upward trend. Fluctuating net income can be neglected if the free cashflow numbers are steadily growing.

·         Number of shares: In the best case they are constantly decreasing. A lower number of outstanting shares means that the percentage of our ownership in the company is increasing. Young or fast-growing companies can be the exception. As long as the issuing of new shares is used to grow the company at a faster pace than the dilution, it is a valid way to collect capital.

·         Earnings per shares (EPS). The quotient of the two metrics above. Higher EPS are a good indicator of an outstanding company. Be careful however, if the EPS are only rising due to decreasing number of shares

Cashflow statement metrics:

·         Operating Cashflow (OCF). The amount of cash the business generates by doing business. OCF and FCF are better indicators than earnings, since the cash statements are a lot harder to manipulate (or in business terms “adjust”) than earnings. Especially for young and fast growing companies the OCF numbers are a good indicator if the company is going in the right direction.

·         Free Cash Flow (FCF). The most important metric for established companies. In short: how much more cash does the company have at the end of the period compared to the start.

Balance statement metrics:

·         Cash/Liquidity: The more the merrier. Cash provides the company with the option to return it to shareholders though dividends or share buybacks, buy other companies or repay debt

·         Long Term Debt: Too much debt can easily kill a company when the economic outlook turns dark. High debt in absolute terms can be ok, if the company has the ability to pay it back within a reasonably timeframe. High debt, paired with weak OCF is a red flag.

·         Net Debt = Long term Debt – Liquidity

By only investing in companies which have a past of strong fundamentals we are on the way to long-term success. If we want to increase the chance of strong returns even further, we will buy these companies in times of relative undervaluation. To identify these times, we need the tools from Part 3.

PART 3: VALUATION IS THE KEY FOR BIG RETURNS

The following valuation metrics are tools to compare different stocks to their peers. All of these metrics must be considered before buying a stake in a company. These tools help us to identify attractive buying opportunities (point 3 & 4) in the picture.

Starting with the multiples which apply mostly to young/fast growing companies to metrics which are more relevant to mature companies.

·         Price to Sales (P/S). The market capitalization of the company divided by its revenue. Most commonly used for fast growing (software) companies which are not earnings or cashflow positive

·         Price to earnings (P/E). The most common metric. A good first indicator but not sufficient as a standalone metric.

·         Price to OCF (P/OCF). The Marketcap dividend by the OCF.

·         Price to FCF (P/FCF). The Marketcap dividend by the FCF. A better indicator than the P/E ratio.

·         Enterprise Value / Free Cashflow (EV/FCF). The enterprise value of a company is the Marketcap – cash. It defines how many years of FCF it takes to gain the overall enterprise value of the company.

To sum it all up: Stick to Category I companies and buy them at times of relative undervaluation (Point 3 & 4)