4-Steps to Make Stock Buying Like Home Buying
It’s no secret that homes in different neighborhoods cost different amounts.
A 3-bedroom house in Beverly Hills California costs much more than
the same house in Flint Michigan.
What can comparing the price of homes across the country teach us about investing in the stock market?
More than you may think.
Picking the Right Neighborhood
Here at Behind the Markets we tend to look at the S & P 500 as a collection of different neighborhoods. Instead of the neighborhoods being determined by different industry groups though, ours are determined by Return on Invested Capital (ROIC).
Because more than any other single measurement, it will tell you how much a company earns each year in relation to the amount it spends to earn that money.
For example, let’s say you invest $1,000 to start a business. This is referred to as your “Invested Capital.” Now, assume that you made $200 per year from the business without investing another dollar. That would be your “Return.”
Expressed as a percentage, your Return on Invested Capital would be
20 percent ($200/$1000).
The typical company in America averages a 12 percent ROIC each year. Using the example from above, that amount would be $120. In contrast, a truly exceptional company can have a ROIC of 40 percent ($400). A poor performing company can average in the single digits or worse.
In our S & P 500 neighborhood, a company with an ROIC of 40 percent would live in Beverly Hills while a company with an ROIC of 12 percent would live in a neighborhood similar to where I grew up in Queens, New York.
Fortunately as investors, we can choose any “neighborhood” we want to live in within the S & P 500. And while Thoreau wouldn’t approve, if you have $10,000 to invest into a stock, you might as well invest into a stock that “resides in Beverly Hills.”
Picking the Right Block to Live On
But just moving into “Beverly Hills” section of the S & P 500 alone is not enough. Now we have to find the “block” we want to live on.
Here’s how we do it:
1. Invest in companies with a debt-to-equity ratio below 25%.
Having a low debt to equity ratio has implications far across the company. The most important is that the company has an underlying business that is fundamentally strong enough not to have to borrow money.
Secondly, when a company that has a lot of debt is faced with earnings problems (remember, it happens to every company at one point or another) the stock gets hammered a lot more than a company without debt.
2. Invest in companies where capital expenses represent no more than 15% of a company’s cash flow.
I hate to pick on Intel Corp., the chip manufacturer, but for every $1 in cash that the company generates, .25 cents has to be reinvested into new plants to create more chips.
Conversely, for every $1 in Cash Coca-Cola generates, only .10 goes into new plants.
The reason? Intel operates in an industry where,to remain competitive, it has to introduce newer, faster chips every few years.
Newer, faster chips mean newer, expensive plants. New plants mean lots of capital spending. Lot’s of big spending creates lots of big risks. Especially when we know that at some point or another,an incompetent CEO will be in charge of the spending.
3. Invest in companies with consistent, predictable earnings.
Let’s compare the following to illustrate the point:
Year Company A Company B
2017 .59 .29
2016 .47 .12
2015 .38 (.29)
2014 .32 .58
2013 .26 .23
As you can see from the example above, Company A is earnings are more predictable than those of Company B.
What does this imply?
First and foremost, it suggests that it is easier to predict, and therefore to value, Company A.
In addition, it suggests that management from Company B doesn’t understand the business it is operating in.
4. Only invest in the stock at the right price.
Ok, so we know what neighborhood we want to live in and we found a block that gives us a warm and fuzzy feeling. But the most important aspect is yet to be accomplished – finding the right “home” at the right price.
Let me start with an analogy that takes us back into the real world.
If you were shopping for a home and you found a 3-bedroom house that you liked you would first have to find out what the house was selling for. If you determined that the house was worth $1 million dollars but the seller was asking $2 million you would
pass. Conversely, if the seller was distressed and was asking $500,000 you would jump at the opportunity.
The exact same rule applies when investing in a stock – the goal is to buy a
great asset at a great price.
Let’s take Company A from the example above to illustrate our point.
A quick back-of-the-napkin way to tell what you should pay for a stock is to look at the average P/E for the past five years.
Let’s say the average P/E for Company A during the past five years has been 20. Since the Company earned .59 cents in 2017, that would place a fair value of $11.80 on the stock.
That means that if the stock is selling for more than $11.80, it’s probably overpriced. If it’s selling for below $11.80 its probably underpriced.
In this example there’s a point that must be emphasized clearly: it’s critical that you separate the performance of a company with the performance of its stock price.
For example, Company A could be the best health food company on the planet. The
question is – what is it worth? As good of a company as it is, is it worth $25 per share? No.
Think of it like buying the biggest house on your block. It may be worth $1 million dollars. But would you pay $1.5 million for it? $2 million?
Of course not. That would be insane.
God bless you and your loved ones this year,
The Buck Stops Here
Behind the Markets