Investing in stocks can be just as easy as buying the right home. What neighborhood do you want to live in? Copy
What Neighborhood Do You Live In?
Itís no secret that homes in different neighborhoods cost different
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 Fallen Angel Stocks we tend to look at the S & P 500 as a
collection of different ìneighborhoods.î 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 tells an
investor how much money a company earns each year in relation to
the amount it spends to earn that money.
Letís start with a simplified but revealing example:
You invested $1000 to start your business. This is referred to as
your ìInvested Capital.î Now, assume that you made $200 per year
from your business without investing another dollar. That would be
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. A truly
exceptional company can have a ROIC of 40 percent ($400) and a
poor performer would 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 middle class neighborhood similar to where I grew
up in Queens, New York.
Fortunately as investors, we can choose any ìneighborhoodî we want
to live in within the S & P 500. And while Thoreau wouldnít approve,
if you have $10,000 to invest into a stock, you might as well invest
into a stock that lives in ìBeverly Hills.î
Picking the Right Block
But just moving into ìBeverly Hillsî section of the S & P 500 alone
is not enough. Now we have to find the ìblockî we want to live on.
Hereís how we do it:
1. We find 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. We invest in companies where capital expenses represent no more
than 15 percent of a companyís 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
Newer, faster chips mean newer, expensive plants. New plants mean
lots of capital spending. Lotís 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. We invest in companies with consistent, predictable earnings.
Letís compare the following to illustrate the point:
Year Company A Company B
1999 .18 .18
2000 .24 .12
2001 .38 (.29)
2002 .47 .58
2003 .58 .23
As you can see from the example above, Company A ís 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 doesnít understand the business itís operating in.
Finding the Right Home 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
ìhomeî at the right price.
Let me start with an analogy that takes us back into the ìreal
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
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 primary objective is to buy a
great asset at a cheap price.
Letís take Company A from the example above to illustrate our point.
Assume that Company A sells low-carb health food. The Company has
a 20 percent ROIC, a low debt/equity ratio, low capital expenses
and predictable earnings.
After doing some research you determine that Company A, fairly
valued, should trade with a P/E of 20 (which approximates its
20 percent ROIC). Since the Company earned .58 cents in 2003,
that would place a fair value of $11.60 on the stock. If the
stock were selling for $25 per share it would clearly be
overpriced; at $5 you would consider it under priced.
In this example thereís a point that must be emphasized clearly.
It is 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.
Therefore, as investors its important to note that the difference
between price and value within the S & P 500 is based on the same
principles that would apply if you were buying a home. A gorgeous
3-Bedroom house may be on the best block in Beverly Hills.
But would you pay twice its value? I hope not.
(Shameless Plug/Honest Disclaimer: When we value a company that
we recommend to you, we pore over at least a decade of financial
information. We then take this information and apply it to multiple
models to confirm and reaffirm our estimates of intrinsic value.
However, for the sake of this article, weíre using shorthand methods to
appraise Company Aís value. Keep in mind that itís the framework
we want to emphasize here, not the exact methods.
–By Dylan P. Jovine