How To Improve Probabilities In Investing

Probabilities are talked about a lot in the trading world. They also play a part in the long-term investing arena. In this series, we will go through multiple ways one can stack the probabilities in favour of the long-term investor. The two main ways to research a company are the quantitative and qualitative. Quantitative analysis is all about crunching the numbers mainly from the company´s financial statements (Balance sheet, cash-flow statement and income statement). Qualitative analysis goes more into the likes of management, the company brand, integrity, etc. This article will focus more on the quantitative side as we have seen that if a company is delivering on its numbers over a long-period of time, areas such as the integrity of management or the firm´s reputation in the market also must be in good standing.

Before we dive into the content, it is important to remember that it is practically impossible that any given stock will have all of the characteristics below at any one given time. This can be a problem many times for the investor who is too “science” related. The series will go into fundamental and technical points that you can use when picking stocks for the long-term. I believe investing is both a science and an art in equal parts. Your skill will be in identifying which stocks are likely to outperform the market. Although past numbers and trends can give us insights into a company, they do not guarantee future results. This is where you come in.

No 1 – Invest In Stocks With A Low Price To Earnings (P/E) Ratio.

The first and probably most common way we as investors can stack the odds in our favour is by buying companies with a low price to earnings ratio. For all intensive purposes, if a stock is trading at $10 and its earnings are $2 per share, then this stock has a p/e ratio of 5. The key here is to buy solid companies when their respective p/e ratios are trading well below their 5 year and even 10-year averages. Many times, the market gives you the opportunity to buy quality company at a cheap valuation. We use the p/e ratio a lot in our analysis. The premise here is that a company´s present valuation is more trustworthy than future earnings. We will always favour a low p/e stock with moderate growth over a high p/e stock with explosive growth.

The problem with the latter is that this company needs to consistently hit it out of the park with respect to its earnings growth. It needs to do this to justify its high valuation. The quarter which it fails to do this invariably results in a sharp decline in the share price. Remember, the lower the p/e ratio (compared to the company´s long-term averages), the more margin of safety in your investment. Cheap earnings though is just one part of the equation. It is also vital the other valuation metrics are in alignment.

P/E Formula

P/E ratio

No 2 – Invest In Stocks With A Low Price To Book (P/B) Ratio.

Assets are what essentially what create sales and earnings. Think of brick and Mortar stores for a retailer. Patents for a biotech company. Machinery in an auto manufacturing plant. All of these examples enable the respective companies sell their wares. We want to buy assets for as cheap as possible. Sometimes if one is lucky, one can buy a stock trading under book value. This basically means that one can buy a company (market-cap) for a lower price that the amount of assets on its balance sheet. Many times, an investment like this will end up being a good deal providing the firm is profitable and has low debt. We favour tangible or hard assets (property, plant, etc) over intangible assets such as patents and brands. The reason being is that tangible assets always hold some form of value. Intangible assets are much more difficult to put a value on.

Moreover, their values can get written down aggressively when company earnings deteriorate. Therefore, make sure that the assets a company is reporting on its balance sheet is primarily made up on tangible or hard assets such as cash and property, equipment, etc. We calculate book value by dividing the shareholder equity into the market cap of the company. For example, if the market cap of a company is $100 million and there is $140 million of book value on the balance sheet, we would determine the price to book ratio to be 100/140 = 0.7.

No 3- Invest In Stocks With A Low Price To Sales (P/S) Ratio

The price to sales ratio can vary a lot depending on which industry one is researching. In saying this, the lower the ratio, the more attractive the investment. In fact, if one can buy a stock with a p/s ratio under 1 for example, it straight away places the odds in favour of the long investor. Sales as well as assets are what essentially create earnings for a company. Furthermore, the top-line sales of a company cannot be altered as easily as earnings for example. This makes the p/s ratio a really popular metric when valuing companies.

Remember it is earnings which primarily drive stock-prices on Wall-Street. Therefore, a low price to sales ratio can boost the respective stock-price in two ways.

  1. Management can cut costs which would result in more of the firm´s top-line sales being able to fall to the bottom-line
  2. An accurate valuation metric such as the price to sales ratio (as long as there isn´t anything fundamentally awry) usually reverts to its long-term mean over time.

Sales growth is probably the most important metric we look at when researching companies. Everything starts with sales-growth. Therefore, it stands to reason that if one can pick-up these sales at a very attractive price, it usually makes for a sound investment over the long-run.

No 4- Invest In Stocks With A Low Price To Cash-Flow (P/C) Ratio

Many investors overlook this valuation metric but do so at their peril. What investors need to understand is that the net income sub-total contains many non-cash items will really have no effect on the cash running through a company. Remember it is cash which is needed to pay salaries, pay down debt and also pay the dividend. Many companies operating in bull markets can get away with having poor cash-flow because of rising earnings. However, it is when the respective firm gets thrown a curved ball, do we really see the importance of a solid price to cash-flow ratio.

In 2008, many companies lost more than half of their market caps due to lack of strong cash-flow. When companies are too ambitious, they tend to pour their resources into capital expenditure. Conservative companies prefer to conserve cash-flow which is exactly what is needed in recessions. In fact, companies like McDonald´s and Walmart were able to continue to increase their dividend pay-outs during the great recession. This was due to their strong cash-flows which heal them in good stead in that time-period.

The price to cash-flow ratio is calculated by dividing the market cap of the company by the operating cash-flow. The operating cash-flow is basically the regular amount of cash the business is able to generate over a given time-period. The lower the number, the better. Investors who want to stack the odds in their favour should seek out companies which generate high levels of operating cash-flow. This ensures the respective company will be able to withstand an unexpected event such as a sharp contraction in its earnings better than most.

No 5 – Invest In Stocks Which Pay A Growing Dividend

Investing in dividend paying companies for the long-term can really super-charge a portfolio. In fact, dividends have accounted for close to 50% of the total return of the S&P500 over the past century. Companies which are able to grow their dividends every year invariably have at least one competitive advantage. What this means is that competitors find it very difficult to eat into their respective market shares. A high dividend yield is important but growth is what really signals out a healthy stock. Dividend growth protects the investment from rising inflation. Furthermore, sustained dividend growth means earnings growth also should be happening.

There are many metrics to study when researching a company´s dividend. Free cash-flow and the pay-out ratio and more importantly their trends are usually the go-to metrics in this area. To get an insight into the level of forward-looking growth rates, we look at the debt to equity ratio, interest coverage ratio and projected earnings growth. These metrics cover the state of the income statement and balance sheet which is important.

When quality companies drop to below average valuations, long-term investors are usually very quick to buy. The reason being is that dividend growth stocks with proven records rarely sell on the cheap. In fact, many dividend growth investors only invest in the “dividend aristocrats”. This group of stocks are companies which have raised their dividends every year for the past 25+ years at a minimum. Suffice it to say, a quality dividend growth stock trading at the right valuation straight way stacks the odds in favour of the long-term investor.

No 6 – Invest In Stocks With Low Debt

Debt or too much leverage is by far the most common reason why businesses go bankrupt. When companies have too much leverage, the element of time comes into the equation. When debt is increasing substantially at a firm, earnings growth really needs to take place rather quickly to avoid future problems. Furthermore, many investors only look at the company´s interest bearing debt. However, many times, companies have other large liabilities such as pension obligations, accounts payable, etc. Therefore, when researching the balance sheet, we like to compare shareholder equity to all of the respective liabilities the firm has. This gives us a better read on how solvent the company really is.

Easier To Grow Assets

Many of the companies we invest in are slow-growing firms with minimal debt. These types of companies can best withstand any type of curved ball which comes their way.  Earnings growth is what primarily moves stocks on wall-street. Growing earnings though usually comes from sales and asset growth. Companies with low debt have more statistical probability of growing their asset-base if they have low-debt. This stands to reason.

It really all boils down to this. Being in this industry a while, we have seen companies being able to growth their earnings substantially year after year. Obviously, wall-street rewarded this record. A lot of this growth though was financed by leverage. Now this never gets noticed on the way up. The way-up is all about the rally and that EPS growth. To investors, it is the defining number.

It is when growth comes to a halt is when momentum investors decide to research the balance sheet. This is when it is seen that the capital is not there to be able to recover the situation equitably. This goes for a household, a small business, a fortune 500 company or even a country. The ability to foster restraint in an environment of abundance.

This piece is in no way taking away from all of the excellent leveraged growth stocks out there. We though always aim to protect our capital in every way possible. Suffice it to say investing in firms with low debt once more stacks the odds in favour of the long-term investor.

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