A great way to find ideas is to use the selection checklist of gurus. There is one by Benjamin Graham that not too many people know about. A couple of readers have been kind enough to provide the selection criteria and papers testing the process which I will go into detail here.

Graham’s Stock Selection Criteria

• Forum link to the discussion of Graham’s stock selection criteria.
• Test of Graham’s stock selection criteria on industrial shares traded on the JSE (pdf)

There are 10 criteria in total.

The first 5 criteria measure ‘reward’ and is sensitive to price and earnings changes. The focus in this group of five criteria is on stock price, earnings and dividends.

The second group of 5 offers a measure of ‘risk’ and does not change rapidly with changes in price and earnings. Criteria number 6,7 and 8 represent the financial soundness of companies.

Selection, by using the criteria, is based on the concept of maximising the ‘reward’ to ‘risk’ ratio of stock selected.

One thing I want to point out is that the reward-risk philosophy is backward. Personally, after chasing reward to risk much often and taking the damage, I have found it much better to chase after low risk to reward ratios. It may sound like the same thing, but determining low risk followed by reward is much different to finding reward and then performing the risk analysis.

List of 10 Stock Selection Criteria by Benjamin Graham

1. An earnings-to-price yield at least twice the AAA bond rate

2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years

3. Dividend yield of at least 2/3 the AAA bond yield

4. Stock price below 2/3 of tangible book value per share

5. Stock price below 2/3 of Net Current Asset Value (NCAV)

6. Total debt less than book value

7. Current ratio great than 2

8. Total debt less than 2 times Net Current Asset Value (NCAV)

9. Earnings growth of prior 10 years at least at a 7% annual compound rate

10. Stability of growth of earnings in that no more than 2 declines of 5% or more in year end earnings in the prior 10 years are permissible.

Test Combination of Criteria

Not a single stock will be able to pass this filter today. When the screen reaches no. 3, only around 30 stocks make it. When you hit the fourth condition, the list becomes 0.

So to make this exercise worthwhile, I would have to run the criteria in combination with each other but not all at the same time.

The table below is from the paper with the test performed from 1977 to 1995, a span of 18 years.

Keep in mind that back in the days of Graham, most companies were industrial and the stock universe was much smaller then as well.

In order to clean up the results, I left out financial stocks, OTC stocks and ADR’s.

I do not have access to historical AAA bond yield data so I applied a static 4.5% as the AAA bond yield for all screens for all periods.

Still, it results in plenty of pickings. The additional condition that I applied was (7) Current ratio great than 2.

I also tested one that included (8) Total debt less than 2 times Net Current Asset Value (NCAV). The number of results were reduced but the screen did not perform any better so I left it out.

Graham Stock Selection Criteria Results

With the limited amount of data that I have access to, 20 years of back testing is out of the question. 20 year tests also do not serve much purpose. Such tests, I find to be distorted due to it being unrealistic. You might as well do the test for 100 years and conclude it kills the market.

I chose the period from 2004 end of August 2010 to test the results.

Why 2004?

I didn’t want to apply the test in 2001-2003 because of the dot com bust. By 2004, the recession was over, markets have stabilized and “ordinary” people would have gotten back into the market. Not quite Nobel prize worthy, but realistic.

The conditions I applied to all screens are as follows:

• ignore financial companies, OTC and ADR’s
• AAA bond yield was kept at 4.5%
• max 20 stocks held
• 1 year holding period

I would say a 6 year period is long enough to say that this strategy would beat the indexes over the long run. With $100, the screen depicted by the orange line would have netted $193.

Individual year performance will vary and fluctuate and you won’t beat the market every year, but Graham’s simple selections looks to be solid for the passive investor as well as being a good source of ideas for the enterprising.

10 Stocks that Graham Would Choose

Applying the (1),(3),(6) & (7) conditions, here is a list of stocks that even Graham would be interested in if he were alive.

Disclosure

None

Old School Value Stock Portfolio Performance

Time sure does fly. August ends with the Old School Value portfolio down -0.56% and down -14% for the year. The large cash position of 30% cushioned the fall in August while the S&P dropped -4.5%. When including cash, the equivalent performance for the S&P500 is -3.12% at the end of August 31, 2010.

August Transactions

The only transaction during August was the successful tender offer for FIS.

I originally bought 99 shares of FIS @ $27.94 which was successfully tendered at $29. The price of $29 was the low end of the possible scenarios but it still netted a gain of $101 or 3.67% over a 3 week period. Not bad for about 30 minutes of work.

No other transactions took place in August.

Gravity Co (GRVY)

The 2nd quarter results announced by GRVY on Aug 19 was nothing to get excited about. There was only a slight increase in royalties and licensing compared to the 1st quarter. Compared to the previous year, the royalties as well as subscription revenue is down with the trend looking to continue as gamers decay out of the Ragnarok cycle.

The balance statement still remains strong with plenty of cash. Although the top line shows declines in business, cash is being managed well. You tend to see lots of cash burn in micro cap companies with slowing businesses but GRVY looks to be in good hands.

Also, in case you missed the news, GRVY has just started its closed beta testing on August 31 for RO2: Legend of the Second (RO2:LotS). Remember this is where the original RO2 failed due to the horrible gameplay and server issues.

It has taken over 3 years for the company to completely redesign the game and to get back to where it is.

From this point, the closed beta tests will determine the outcome of RO2 and my decision to keep GRVY as an investment.

Here is a good interview with the CTO of Gravity on RO2:LotS and this link is of a Ragnarok blog posting feedback, gameplay and general discussions of the game itself.

Looking at valuation, GRVY is currently valued for no growth with a bleak outcome. With over 3 years of delays, I don’t blame the market for being pessimistic. However, based upon different outcomes of RO2, these are my valuations.

• Game failure: $1.20 (market wont care that GRVY NCAV is closer to $2)
• Mild success: $3-4
• Above average success: $4-5
• Huge success: $7-10

The valuation range is quite large but keep in mind that this is just a quick estimate. I’m not going to try and predict cents here. What I do know is that if GRVY even surprises by a little bit, expect liftoff.

Insmed (INSM)

INSM sure likes to take its time with taking the company forward. $125m in cash with the market cap at $93m, no debt, no operations. Still no word on the outcome for a strategic review. Makes you wonder whether there ever will be. With all the cash on hand, NNWC is $0.94. From the current price of $0.71, there is a 24% upside to reach liquidation value.

Mastech Holdings (MHH)

Worst performer YTD. Down -32.98% this year. Although the stock price has been dropping, there is still nothing that adversely changes the thesis of the investment. I still see a well managed company worth at least $6 based on 0% growth, 15% discount rate and low ball FCF figures.

What is interesting is that MHH tends to stay still while the rest of the staffing industry rise dramatically on good economic news. TBI and VOLT may be worth another look to play the employment sector.

Disclosure

Long GRVY, INSM, MHH

With the Dow hovering around 10,000 again, you  may be interested in what I have on my watch list.

Medtronic (MDT)

A leader in the industry of medical equipment yet is trading at 1998 prices. Became interested after reading Vitaly Katsenelson’s latest article rebutting Barron’s. I was very close to buying a position this morning but had to wait to go through some finer details.

Typical of medical instrument companies, MDT has huge margins. Gross margin is over 80%, operating margin is still maintained at 30% and the net margin is just under 20% with the average net margin over 10 years being 19%.

Barron’s sees MDT’s debt as a problem, and to be honest, it has been rising. The TTM debt to equity is at 96% which means for every $1 of equity there is $1 of debt. However, FCF to total debt is about 26% TTM, FCF to short term debt is 135% and FCF to long term debt is 50%. In other words, MDT generates plenty of FCF to cover all of its debt without having to take any loans.

MDT is trading at a multiple of 10 but should really be trading at about 13-14 compared to its peers. This puts the estimated value in the range of $40-44. DCF also comes out to around $45-50.  Historical consistency makes it easier to value and the Benjamin Graham formula gives a value of around $45 as well.

John B Sanfilippo & Son (JBSS)

A company that came up in one of my value screens. JBSS is a commodity business selling nuts and a net margin of 1.2% last year reflects the competitiveness of the industry. What makes JBSS worth keeping on the watchlist is that the company has been focusing on reducing debt and driving profitability to the bottom line.

There was a period from 2006 to 2009 where short term debt had doubled but the company has been aggressively paying back both short term and long term debt to reduce interest expense and strengthening its balance sheet. This has helped the company go from negative owner earnings to positive territory again.

You can see the improvement in operations by following each criteria of the Piotroski score. The current TTM Piotroski F score stands at 8.

Valuation wise, JBSS isn’t exactly in value territory. With a 0% growth rate and 12% discount rate, the DCF based on an owner earnings of $16.7m  comes out to be $12.

Food Technology Service (VIFL)

Value Uncovered beat me in writing about VIFL and since VIFL is still a stock on my watchlist, I will direct you to the VIFL analysis.

Duckwall Alco Stores (DUCK)

Duckwall Alco is a small company operating small retail stores in towns. The company has very low volume and fits the NCAV category of investments. I.e. its current assets are greater than its total liabilities. DUCK, being a store operator, expect a lot of its assets to be in inventory. The NCAV comes out to be around $18 and the current price of just under $14 offers about a 25% margin of safety.

Although DUCK is a net net, it doesn’t have a consistent history of losses. Capex was higher than normal during 2009, but it was due to a growth strategy of new store openings. I still don’t expect much in the way of growth and it is likely that DUCK will  stay in the NCAV category without much recognition or exposure. As much as I would like to apply a DCF valuation, the FCF numbers are inconsistent so it would be best to rely on valuation based on assets.

Sales is consistent which shows that if management can get costs down and operate the company smoothly, DUCK has a chance of breaking out of the NCAV region. The only problem is that most companies can’t do this.

Disclosure

No positions. Not a recommendation to buy or sell any stocks mentioned.

This is part three of Identifying Durable Competitive Advantages by Analyzing Financial Statements.

Part one: Finding Durable Competitive Advantages by Analyzing the Income Statement

Part two: Finding Durable Competitive Advantages through the Balance Sheet

Part three: Finding Durable Competitive Advantages through the Cash Flow Statement

The information provided in this article can be found in the book Warren Buffett and the Interpretation of Financial Statements.

Before you proceed, you may be interested in a primer on analyzing the cash flow statement.

How to Identify Competitive Advantage through the Cash Flow Statement

Capital Expenditures

• Never invest in telephone companies because of big capital outlays

Rule: company with durable competitive advantage uses a smaller portion of earnings for capital expenditure for continuing operations than those without.

• To compare capex to net earnings, add up total cap exp for ten-yr period and compare with total net earnings over the same period

Rule: if historically using less than 50%, then good place to look for durable competitive advantage. If less than 25%, probably has a competitive advantage.

Stock Buybacks

• Buyback increases EPS even though actual net earnings do not. More shares outstanding = lower EPS. Buybacks increase shareholder wealth without taxes.
• To assess: look at cash from investment activities. “Issuance (Retirement) of Stock, Net”
• If buying back consistently, the company has a competitive advantage because it is generating lots of cash

Rule: history of repurchasing/retiring shares is an indicator of competitive advantage

Valuing the Company With Durable Competitive Advantage

Equtiy Bond Idea

• A company with competitive advantage shows great strength and predictability in earnings growth, that growth turns the shares into a kind of equity bond, with an ever-increasing coupon/interest payment. (Bond=shares/equity. Coupon/interest payment = pretax earnings)
• e.g. In 1980 Buffett bought Coke for $6.50 a share against pre-tax earnings of $.70 a share = after-tax $.46. Historical earnings growth = 15%
• Buffett argues that he got a Coke bond paying initial pretax interest rate 10.7% on a $6.50 investment, with yield increasing at 15% annually.

Durable Competitive Advantage Summary

To all premium spreadsheet users, I’ve just released a new version using a new data source for the financial statements. Other upgrades include the ability to edit a yearly growth rate for the DCF and more.

Check your email and remember not to enter the incorrect password 5 times.

This is part two of Identifying Durable Competitive Advantages by Analyzing Financial Statements.

Part one: Finding Durable Competitive Advantages by Analyzing the Income Statement

Part two: Finding Durable Competitive Advantages through the Balance Sheet

Part three: Finding Durable Competitive Advantages through the Cash Flow Statement

The information provided in this article can be found in the book Warren Buffett and the Interpretation of Financial Statements.

Before you proceed, you may be interested in a primer on analyzing the balance sheet.

How to Identify Competitive Advantage through the Balance Sheet

Assets

Current Asset Cycle: Cash – Inventory – Accounts Receivable – Cash

Cash and Equivalents: Cash is king.

A high number means either:

1) The company has competitive advantage generating lots of cash

2) Just sold a business or bonds (not necessarily good)

A low stockpile of cash usually means poor to mediocre economics. There are 3 ways to create large cash reserve.

1) Sell new bonds or equity to public

2) Sell business or asset

3) It has an ongoing business generating more cash than it burns (usually means durable competitive advantage)

When a company is suffering a short term problem, Buffett looks at cash or marketable securities to see whether it has the financial strength to ride it out.

Rule: Lots of cash and marketable securities + little debt = good chance that the business will sail on through tough times.

• Test to see what is creating cash by looking at past 7 yrs of balance sheets. This will reveal which way it was created.

Inventory

• Some companies have the risk of inventory becoming obsolete
• Manufacturers with durable competitive advantage have the advantage that the products they sell do not change, and therefore will never become obsolete. Buffett likes this advantage.
• When identifying manufacturers with durable competitive advantage, look for inventory and net earnings that rise correspondingly. This indicates that the company is finding profitable ways to increase sales which called for an increase in inventory.
• Manufacturers with inventories that spike up and down are indicative of competitive industries subject to boom and bust.

Net Receivables

Net receivables tells us a great deal about the different competitors in the same industry. In competitive industries, some attempt to gain advantage by offering better credit terms, causing increase in sales and receivables.

If company consistently shows lower % Net receivables to gross sales than competitors, then it usually has some kind of competitive advantage which requires further digging.

Total Current Assets & Current Ratio

• Current ratio greater than 1 = good
• Current ratio less than 1 = bad
• However, a lot of companies with durable competitive competitive advantages have a current ratio less than 1 (e.g. PG = 0.77). For companies with moats, their earnings power is so strong they can easily cover current liabilities. These companies also have no problem securing cheap short term commercial paper if needed.
• Another reason for the low current ratio is that these companies also pay big dividends  and repurchase stock thus diminishing cash reserves
• Current ratio is useless in identifying durable competitive advantage.

Property, Plant & Equipment

A company with durable competitive advantage doesn’t need to constantly upgrade its equipment to stay competitive. The company replaces when it wears out. On the other hand, a company without any advantages must replace to keep pace.

Difference between a company with a moat and one without is that the company with the competitive advantage finances new equipment through internal cash flows, whereas the no advantage company requires debt to finance.

Producing a consistent product that doesn’t change equates to consistent profits. There is no need to upgrade plants which frees up cash for other ventures. Think Coca Cola, Johnson & Johnson etc.

Goodwill

Whenever you see an increase in goodwill over a number of years, you can assume it’s because the company is out buying other businesses above book value. GOOD if buying businesses with durable competitive advantage.

If goodwill stays the same, the company when acquiring other companies is either paying less than book value or not acquiring. Businesses with moats never sell for less than book value.

Intangible Assets

• Intangibles acquired are on balance sheet at fair value.
• Internally developed brand names (Coke, Wrigleys, Band-Aid) however are not reflected on the balance sheet.
• One of the reasons competitive advantage power can remain hidden for so long.

Long Term Investments

Long term investments are carried on books at the lower of cost/market price. This means a company can have valuable assets on its books at a valuation below its market price.

It can tell us about the investment mindset of management. i.e. do they invest in durable competitive advantages or those in highly competitive markets.

Other Long Term Assets

Doesn’t tell us anything e.g. Pre paid expenses, tax recoveries

Total Assets & Return on Total Assets

• Measure efficiency using ROA
• Capital is barrier to entry. One of things that make a competitive advantage durable is the cost of assets needed to get in. This is why we calculate the Asset Reproduction Value along with the EPV.
• Many analysts argue the higher return the better. Buffett states that really high ROA may indicate vulnerability in the durability of the competitive advantage.
• E.g. Raising $43b to take on KO is impossible, but $1.7b to take on Moody’s is. Although Moody’s ROA and underlying economics is far superior to Coca Cola, the durability is far weaker because of lower entry cost.

Current Liabilities

Includes accounts payable, accrued expenses, other current liabilities and short term debt.

• Stay away from companies that ‘roll over the debt’ e.g. Bear Stearns

When investing in financial institutions, Buffett shies from those who are bigger borrowers of short term than long term debt.

• His favorite ‘Wells Fargo’ has 57 cents short term debt for every dollar of long term
• Aggressive banks (like Bank of America) has $2.09 short term for every dollar long term

Durability equates to the stability of being conservative.

Long Term Debt coming Due

Some companies lump their yearly long term debt due with short term debt on the balance sheet. This makes it seem like there is more short term debt than the real amount.

Rule: Companies with durable comparable advantages need little or no LT debt to maintain operations.

Too much debt coming due in a single year spooks investors and can offer attractive entry points.

However, a mediocre company in problems with too much debt due leads to cash flow problems and certain bankruptcy.

Total Current Liabilities & Current Ratio

• The higher the ratio, the more liquid. The greater its ability to pay current liabilities when due.
• Useful in determining liquidity in average business
• Durable competitive advantages do not require ‘liquidity cushion’ so the ratio may be less than 1.

Long Term Debt

Buffett says that durable competitive advantages carry little to no LT debt because the company is so profitable that even expansions or acquisitions are self financed.

We are interested in long term debt load for the last ten years. If the ten yrs of operation show little to no long term debt, then the company has some kind of strong competitive advantage.

Buffett’s historic purchases indicate that on any given year, the company should have sufficient yearly net earnings to pay all long term within 3 or 4 year earnings period. (e.g. Coke + Moody’s = 1yr)

Companies with enough earning power to pay long term debt in less than 3 or 4 years is a good candidate in our search for long term competitive advantage.

• BUT, these companies are targets for leveraged buy outs, which saddles the business with long term debt
• If all else indicates the company has a moat, but it has ton of debt, a leveraged buyout may have created the debt. In these cases the company’s bonds offer the better bet, in that the company’s earnings power is focused on paying off the debt and not growth.

Rule: little or no long term debt often means a Good Long Term Bet

Deferred Income Tax, Minority Interest, Other Liabilities

• No help in search for durable competitive advantage

Total Liabilities & Debt to Shareholders Equity Ratio

• Debt to shareholders equity ratio helps identify whether the company uses debt or equity (includes retained earnings) to finance operations.
• Company with a moat uses earning power and should show higher levels of equity and lower level of liabilities.
• Debt to Shareholders Equity Ratio : Total Liabilities / Shareholders Equity
• Problem with using as identifier is that economics of companies with durable competitive advantages are so great they don’t need large amount of equity or retained earnings on the balance sheet to get the job done.

Treasury Share Adjusted Debt to Shareholder Equity Ratio

• Wrigley 0.68, Goodyear 4.35, Ford 38.0

Financial institutions like banks, have a much higher ratio. This is why Buffett says they are highly leveraged operations. Exception is M&T (his favorite) is 7.7

Rule: if the Treasury Share Adjusted Debt to Shareholder Equity Ratio is less than 0.8, the company has a durable competitive advantage.

Shareholder Equity & Book Value

• Net worth = Book Value = Shareholders Equity
• Shareholder equity is under the heading capital stock, which includes preferred and common stock, paid in capital, and retained earnings.

Preferred + Common Stock: Additional Paid in Capital

In search for durable competitive advantage, we look for absence of preferred stock in the capital structure.

Retain Earnings: Buffett’s Secret

Net earnings can be paid out as dividends, used to buy back shares or retained for growth. To find net earnings to be added back we take after-tax net earnings and deduct dividends and stock buy back.

If the company loses more than it has accumulated, retained earnings is negative.

One of the most important indicators of durable competitive advantage

• If a company isn’t adding to its retained earnings, it isn’t growing its net worth.
• Rate of growth of retained earnings is good indicator whether it’s benefiting from a competitive advantage.
• Mergers pool earnings together
• Microsoft is negative because it chose to buyback stock and pay dividends
• The more earnings retained, the faster it grows and increases growth rate for future earnings.

Treasure Stock

• Carried on the balance sheet as a negative value because it represents a reduction in shareholders equity.
• Companies with moats have free cash, so treasury shares are hallmark of durable competitive advantages.
• When shares are bought back and held as treasury stock, it is effectively decreasing the company equity. This increases return on shareholders equity.
• High return is a sign of competitive advantage. It’s good to know if it’s generated by financial engineering or exceptional business economics or combination.
• To see which is which, convert negative value of treasury shares into a positive and add it to shareholders equity. Then divide net earnings by new shareholders equity. This will give the return on equity minus effects of window dressing.

Rule: presence of treasury shares and a history of buyback are good indicators that company has competitive advantage

Return on Shareholders Equity

Net earnings / Shareholders Equity = Return on Shareholders Equity

• Companies moats show higher than average returns on shareholders equity (Coke 30%) (AA 4%)
• High returns on equity means company is making good use of retained earnings.
• This will add up and increase the underlying value, which will eventually be reflected in the stock price.
• Note: some companies are so profitable they don’t need to retain any earnings, so they pay them all out to shareholders. This sometimes shows up as negative equity. Danger is that insolvent companies also show negative equity.
• If the company shows a history of strong net earnings, but shows negative shareholders equity, there is a durable competitive advantage.

Leverage

Leverage can make the company appear to have some kind of competitive advantage when just using debt. Avoid businesses that use a lot of leverage to generate earnings.

Next in the Series

Cash Flow Statement and the set of criteria to determine durable competitive advantage.

Isn’t it awesome how the internet has evolved so that your web of connections can expand although you’ve never met the person?

It’s fantastic how people email me with a common interest in investing and we can immediately pick up a conversation like we’ve been friends for ages.

Frank recently emailed me with some comments and we got to discussing about investing, BOLT, his take on valuation methods and also has graciously allowed me to edit his notes on Durable Competitive Advantages (DCA) and the set of criteria he uses to identify companies with durable competitive advantages.

Part one: Finding Durable Competitive Advantages by Analyzing the Income Statement

Part two: Finding Durable Competitive Advantages through the Balance Sheet

Part three: Finding Durable Competitive Advantages through the Cash Flow Statement

Finding Durable Competitive Advantages

The concepts that you find in this article is from the book Warren Buffett and the Interpretation of Financial Statements and addresses Warren Buffett type investing ideas and methodology.

This is not a book review, but notes from the book to discussing and identify durable competitive advantages.

The Exceptional Company

The exceptional company has a durable competitive advantage differentiated by the following:

• Unique product/service
• Low cost buyer AND seller of a product which public needs consistently

The exceptional company has durability.

• Consistency in product = consistent profits
• Consistent: high gross margins / low debt / low R&D exp. /strong earnings / earning growth

Analyzing the Income Statement

When it comes to analyzing the income statement, it is important to investigate further and drill down to detect what the quality of earnings are made up of and what the numbers interpret.

Revenue: Analyze expenses

Cost of Goods Sold:  investigate what the company includes

Gross Profit Margin: firms with excellent long term economics tend to have consistently higher margins

• Durable competitive advantage creates  a high margin because of the freedom to price in excess of cost
• Greater than 40% = Durable competitive advantage
• Less than 40% = competition eroding margins
• Less than 20% = no sustainable competitive advantage
• CONSISTENCY is KEY

SG&A: Consistency is key.

Companies with no durable competitive advantage show wild variation in SG&A as % of gross profit

• Less than 30% is fantastic
• Nearing 100% is in highly competitive industry

R&D: if competitive advantage is created by a patent or tech advantage, at some point it will disappear.

• High R&D usually dictates high SG&A which threatens the competitive advantage

Depreciation: Using EBITDA as a measure of cash flow is very misleading

• Companies with durable competitive advantages tend to have lower depreciation costs as a % of gross profit

Interest Expenses: Companies with high interest expenses relative to operating income tend to be either:

1) in fiercely competitive industry where large capital expenditure required to stay competitive

2) company with excellent business economics that acquired debt in leveraged buyout

• Companies with durable competitive advantages often carry little or no interest expense.
• Warren’s favorites in the consumer products category all have less than 15% of operating income.
• Interest expenses varies widely between industries.
• Interest ratios can be very informative of level of economic danger.

Rule: In any industry, the company with the lowest ratio of interest to Operating Income is usually the one with the competitive advantage.

Gain (Loss) Sale Assets and “Other”: For non-recurring income or losses, remove from calculations of net earnings

Income Before Tax: Buffett uses this number when calculating his return. It allows for comparison with other investments types. E.g. Equity and bonds.

Income Taxes Paid: Helps figure out who’s window dressing

• Check SEC docs and see what they are paying in income tax.
• Take pre-tax operating income and deduct tax rate (USA 35%)
• Compare with reported income tax paid

Net Earnings

• Look for consistency and upward long term trend.
• Because of share repurchase its possible for net earnings trend to differ from EPS trend.
• Preferred over EPS
• Durable competitive advantage companies report higher % net earnings to total revenues.

Rule: If a company is showing net earnings history greater than 20% on total revenues, it is probably benefiting from a long term competitive advantage.

• If less than 10%, likely to be in a highly competitive business
• Exception – Banks and financial companies where abnormally high ratio of net earnings to total revenues usually means poor risk management.

Earnings Per Share (EPS)

• Look for at least ten-year period showing consistency and an upward trend.
• Consistent earnings is usually a sign that the company sells products that doesn’t need to go through costly process of change.
• Upward trend reflects the company is strong enough to allow it to make expenditures to increase market share through advertising and expansion.
• Or a company could use financial engineering like stock buybacks to increase EPS
• Avoid erratic earnings pictures

Next in the Series

Part two: Finding Durable Competitive Advantages through the Balance Sheet

Thanks to a reader, I realized I’ve been making a mistake on how I read the SEC insider transaction Form 4.

How to Read SEC Form 4

The example above is the latest form 4 for Dilliards (DDS).

Overall, the form is very easy to understand. You have the filing person, the date of transaction, the type of security, codes for the type of transaction, the price paid for the security and comments down the bottom.

In the image above, I placed a star next to the transaction code.

My mistake was that I thought “A” stood for “Acquired”, which I also thought to be direct open market purchases. Oops.

Better a slice of humble pie now than later.

So for those unsure of what each transaction code stands for, the official code list from the SEC is below.

Transaction Code Definitions

General Transaction Codes

• P – Open market or private purchase of securities
• S – Open market or private sale of securities
• V – Transaction voluntarily reported earlier than required

Rule 16b-3 Transaction Codes

• A – Grant, award, or other acquisition
• D – Sale (or disposition) back to the issuer of the securities
• F – Payment of exercise price or tax liability by delivering or withholding securities
• I – Discretionary transaction, which is an order to the broker to execute the transaction at the best possible price
• M – Exercise of conversion of derivative security

Derivative Securities Codes

• C – Conversion of derivative security (usually options)
• E – Expiration of short derivative position (usually options)
• H – Expiration (or cancellation) of long derivative position with value received (usually options)
• O – Exercise of out-of-the-money derivative securities (usually options)
• X – Exercise of in-the-money or at-the-money derivatives securities (usually options)

Other Sections 16b Exempt Transactions and Small Acquisition Codes

• G – Bona fide gift
• L – Small Acquisition
• W – Acquisition or disposition by will or laws of descent and distribution
• Z – Deposit into or withdrawal from voting trust

Other Transaction Codes

• J – Other acquisition or disposition (transaction described in footnotes)
• K – Transaction in equity swap or similar instrument
• U – Disposition due to a tender of shares in a change of control transaction

This is a continuation of the first post on the performances of the value stock screens.

Value Stock Screen Performances 2010 YTD

CROIC Screen

I created this screen to identify potential turnarounds or companies that have already changed the direction of  the company.

A company that is able create positive returns from invested capital is a good find. But a company able to create positive, increasing cash returns from invested capital is a great find.

CROIC stands for Cash Return on Invested Capital and for those new to the concept, F Wall Street has great explanations and examples of this metric.

In short, below is the formula for CROIC.

CROIC = FCF/Invested Capital

Invested Capital = Total Equity + Total Liabilities – Current Liabilities  – Excess Cash

Excess Cash = Total Cash – MAX(0,Current Liabilities-Current Assets)

With a return of +5% YTD, this screen is meeting my expectations of screening for great opportunities.

Best 5 Performers

• MIND C.T.I. (MNDO) : +104%
• MTR Gaming Group (MNTG) : 72%
• X-Rite (XRIT) : 68%
• Key Tronic Corporation (KTCC) : 35%
• EasyLink Services International (ESIC) : 32%

Worst 5 Performers

• Kindred Healthcare (KND) : -29%
• NovaMed (NOVA) : -29%
• Apogee Enterprises (APOG) : -25%
• Spartan Motors (SPAR) : -21%
• Cross Country Healthcare (CCRN) : -16%

Altman Z Screen

The Altman Z score is to predict companies that are likely to go bankrupt within the next year or so, selecting a group of companies where the Altman Z score is above 3 should gather a list of fundamentally strong companies.

Z = 1.2*X1 + 1.4*X2 + 3.3*X3 + 0.6*X4 + 1.0*X5

When Z is 3.0 or more, the firm is most likely safe based on the financial data. However, be careful to double check as fraud, economic downturns and other factors could cause unexpected reversals.

When Z is 2.7 to 3.0, the company is probably safe from bankruptcy, but this is in the grey area and caution should be taken.

When Z is 1.8 to 2.7, the company is likely to be bankrupt within 2 years. This is the lower portion of the grey area and a dramatic turnaround of the company is needed.

When Z is below 1.8, the company is highly likely to be bankrupt. If a company is generating lower than 1.8, serious studies must be performed to ensure the company can survive.

Best 5 Performers

• Dialysis Corporation of Ameri* (DCAI) : 57%
• UFP Technologies, Inc. (UFPT) : 53%
• Dorman Products Inc. (DORM) : 51%
• TESSCO Technologies, Inc. (TESS) : 33%
• Dollar Tree, Inc. (DLTR) : 30%

Worst 5 Performers

• Corinthian Colleges, Inc. (COCO) : -42%
• Lincoln Educational Services  (LINC) : -30%
• Big 5 Sporting Goods Corporat (BGFV) : -26%
• Walgreen Company (WAG) : -24%
• Tech Data Corporation (TECD) : -13%

Free Cash Flow Cow

Given that the purpose of this FCF screen is to identify cash cows, I believe it is doing a fine job despite under performing by couple percentage points. I would have expected the overall performance to be better since the listed companies have proven free cash flow with cheap valuations.

One anti thesis that I thought of was that companies, no matter how big or small, that starts to accumulate FCF is a sign that the company is not investing in growth which the market does not care for.

Best 5 Performers

• Triumph Group (TGI) : 50%
• Key Tronic Corporation (KTCC) : 35%
• CIRCOR International (CIR) : 28%
• SFN Group (SFN) : 27.%
• Ceradyne (CRDN) : 26%

Worst 5 Performers

• Willbros Group (WG) : -50%
• Sterling Construction Company (STRL) : -37%
• Apogee Enterprises (APOG) : -25%
• La-Z-Boy (LZB) : -16%
• Century Casinos (CNTY) : -15%

Graham’s Net Net Working Capital Screen

One thing that I’ve realized for sure is that investing is a game of adjustments. You think you have a strategy that will consistently beat the market, but situations change and the strategy is no longer as effective.

Investing is all about the company valuation, whether your purchase price will reward you for the risk you are taking, which is dictated by the market valuation.

In 2009, when the broad markets were statistically cheap, these Net Net stocks were high flyers. In a fairly to overvalued market, the same set of companies can be a killer.

However, the -17% performance is an exaggeration because many of these stocks are less than $1 and with the proper allocation, I’m sure the result could have ended up positive.

• Forward Industries, Inc. (FORD) : 66%
• Leadis Technology, Inc. (LDIS) : 40%
• Heelys, Inc. (HLYS) : 25%
• Sycamore Networks, Inc. (SCMR) : 11%
• New Dragon Asia Corp. (NWD) : -37%
• Tegal Corporation (TGAL) : -50%
• China 3C Group (CHCG) : -50%
• China Crescent Enterprises, I (CCTR) : -64%
• NewMarket Technology, Inc. (NWMT) : -96%

Graham’s Net Current Asset Value Screen

NCAV companies do not get any prettier. With only 6 stocks that made the list at the beginning of the year, things were bound to be tough for Graham this year.

• Parlux Fragrances (PARL) : 6.8%
• Qiao Xing Universal Resources (XING) : -25%
• Qiao Xing Mobile Communicatio (QXM) : -29%
• InfoSonics Corporation (IFON) : -41%
• Tegal Corporation (TGAL) : -50%
• Orsus Xelent Technologies (ORS) : -61%

Disclosure

None

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