There have been many people who have impacted me positively ever since I started managing my own investment in September 2014- Robert Kiyosaki, Warren Buffett, Peter Lynch, Joel Greenblatt, Stephen Jarislowsky, etc. Through the journey, I had switched my investing styles from mutual funds investing to index investing to dividend growth investing and value investing to finally GARP investing. Thanks to all the people who positively impacted me, I have been able to beat the markets.
One of the people who impacted me positively is Robin Speziale. I got to know Robin about 3 years ago when he published his bestseller Market Master. If you have not read the book, check out his book as well as his blog. Robin has been doing amazingly well in growing his portfolio and I have no doubt that he will do very well going forward. Robin recently contacted me for content submission that gets to be featured in his sequel of the Capital Compounder eBook, so this post is dedicated to it.
Developing Personal Investor’s Edge
When you read Peter Lynch`s books, he often talks about identifying and developing personal investor’s edge. Almost everyone has an edge. A person who works in an innovative tech company. A person who works in a company that just won a major deal to supply important parts to a much larger company. Or even being a parent who have kids that are so addicted to watching Spin Master’s Paw Patrol every day.
My edge? I used to be an auditor and am an accountant, so I know how to find info and interpret financial statements and know some of accounting tricks that can be pulled off by some companies. I am sure Robin and other investors will share key metrics and ideas for successful investing such as revenue, earning, cash flow growth, ROE, ROIC, avoiding mining, gold, resources companies, penny stocks etc.… through his book so let me talk about some of the other areas that investors often overlook but certainly help to boost investing performance.
1. CEO compensation test
Finding great ethical CEO is half the battle when it comes to investing (at least for me). If they are ethical, then they will shape every little aspect of running company towards increasing shareholder values. Google ‘SEDAR’ with the name of the company and look for a document called “Management Information Circular” (For American investors, you should google EDGAR and look for DEF 14A Proxy Statements) where you can see how much salary the top executives have received in cash, stocks, stock options, bonus, pension and other benefits such as car allowance for last 3 years.
The below shows MTY Management Information Circular.
Considering the company made close to $90M in free cash flow in 2017 fiscal year, Stanley Ma’s $450K is less than 0.5%. That’s a great indicator that the CEO cares about growing the company than their paycheque. You see $3M stock options issued to Eric, but you may be interpreting it as ok as he will be the successor of Stanley Ma this year.
You can of course compare that to other companies in similar industry and size that you may be interested in. For example, Concordia International where the company lost $10M of cash flow in 2017 but the former and current CEO’s 2016 salary combined was close to $10M. Its market cap used to be around $3B but it is only $18M now. The company has lost 99.85% of its value last 3 years. You know why.
If you find something stinks, go find better opportunities elsewhere. There are many companies with ethical and competent CEOs that pay themselves reasonable salaries thus everything they do with the company would likely be shareholder oriented.
2. Insiders ownership test
The Management Information Circular also shows insiders ownership.
I have been always thinking that owner/manager’s substantial interest of the business they run is extremely important as they are aligned to the interest of the shareholders. But if the ownership is too high, let’s say 50-60% then stock price may get impacted negatively when the insiders want to diversify by selling their ownership through a bought deal offering at a lower price than market price. That happened to Spin Master and Stella Jones recently and the value of the shares dropped to the level of the bought deal offering where a discount had to be given to get the deal closed. Just a temporary downside you need to keep an eye on. You could see it as an opportunity to buy more as long as fundamentals of the company remains intact.
It also shows directors’ ages and background and how long they have been working as a director.
You can also see how many options at what prices were given to all insiders. The best of the best but extremely rare founder run companies don’t issue free options or free shares to the insiders because he/she would hate dilution. When you find companies like that, take a close look and you may want to put some money in if everything else checks out. Compare number of options issued to the insiders to total outstanding number of shares to measure greed of the insiders.
3. Cash flow test
I can’t emphasize enough on this. I know several dozen ways of manipulating revenue, net income and expenses. Name a few? Aggressive capitalization of PPE, intangibles, financing fees and others, loose impairment policy of assets combined with aggressive forecasts, less accrual of expenses and liabilities, Overstating revenue by recording returns of the inventory as resell revenue, overstating revenue with higher charge off expenses, overstating revenue by aggressively recognizing deferred revenue etc. I can go on all day.
However, I can only think of a few ways of manipulating cash flows which is simply delaying the expenses and collect aggressively before cut off date. That being said, it can’t be manipulated for more than 1 year.
Businesses do not run on earnings and revenues but cash flows. So, when net income and revenue look great but actual cash flow looks bad then you gotta throw a red flag and watch it very carefully.
Supplement return on equity and earnings multiples metrics with return on cash flows and cashflow multiples. Cash flow growth is also a very good indicator that the business is doing great.
4. Debt to Free cash flow (or cash flow) test
Simple but very effective when you want to quickly measure the financial health of company. No one can bankrupt the company except creditors with covenants. Just find out how much debt the company has and how long it would take for the company to pay off assuming the company is using 100% of the free cash flow to pay off the debt. MTY’s debt was around $220M and its free cash flow was around $90M in 2017 so it would take less than 3 years to pay off. If it is more than 5- 7 years, I would be cautious. If it is more than 10 years, I would stay away in general.
This criterion is extremely important when you look at turnaround situations. You got to look for broken stocks and stay away from broken companies when looking at turnaround situations. I have witnessed very closely how high debt load and covenant breaches kill companies. It starts with creditors imposing more cash restrictions then the managers of the creditors are forced to send out very expensive consultants who monitor the company (otherwise the managers may lose their jobs). The scavengers mostly think about their own pockets rather than helping the company turnaround. Slow and painful death awaits. So, make sure to test debt to free cash flow when trading or investing turnaround stocks.
5. Short test
Like environmental activists balancing out growth-oriented businesses and government policies, short sellers balance out the investing community. Listen to well-known short sellers’ thesis (I am not gonna name them here but typically simple google away) and think carefully about what they are saying. Often, they do extreme amount of research, so it would likely be worth it. When well known short sellers start talking about accounting inconsistency, abrupt departure of CFO or Chief Accounting Officer, you better listen. Accounting scandals end badly most of the time. When something stinks, take your profit or loss and run. Jim Cramer often says, “Bulls make money. Bears make money. Pigs get slaughtered” You don’t want to be the pigs!
Bonus content- Dividend myth buster
I have seen tones of people or bloggers investing in companies that are heavily leaned towards dividends. I would say if you are around 20-40 (or even 50 as people live longer lately) then I would put very little to none emphasis on dividend investing. I don’t blame you as I was one of them. It blinded my eyes for a while. It probably has been blinding your eyes. Time to open your eyes. If you are investing in companies that are paying more than 50% of earnings or cash flows as dividends, you are missing out on growth. Some companies are just so great in allocating capitals and with the scales they have, they can use the money in better ways than paying out as dividends. Dividends should not have any material impact when it comes to your investing decisions unless you are semi-retired or retired and look for dividend cheques to supplement your other income streams. I am not saying dividend paying companies aren`t great investments but just saying there are so many other important metrics that people overlook because of they are fixated on dividends.
At the end of the day, what really counts is not how much dividends you have gotten but how much total returns you have made during the year. If you have been fixated on dividend investing, time to compare your total returns including dividends to the returns of the ETFs that you can invest to. After all investing in well diversified ETFs are relatively cheap and takes no efforts at all. You will save tones of time and stress of managing individual stocks of portolio while generating comparable returns.
The below shows simple exercise I performed just to get my point across. I compared top 10 dividend growers of Canadian public companies’ total returns to with some vanguard ETFs. The dividend growers are not too bad but not great for all the efforts you put in.
Have you noticed? All of the above companies are well known blue chip companies that I have trouble associating with innovation. I see 3 utilities companies, 1 second tier bank, 2 grocery, 1 railway, 2 oil and gas and 1 old media. Don’t get me wrong. All of them are good companies and I personally really like a few of them. They have great scales, solid business structures and relatively strong moats that they have built over a long period of time but growth and innovation don’t often go with their names. Have you worked in a government or had to deal with gigantic companies in your job? How was your experience?
That’s it from me. Keep learning, watch your eggs, get rid of weed, find investing style that fits you, save, invest and rinse and repeat until you reach your goals. I will end this post with my one of favorite quotes. Forgot who said this but I can’t agree enough with what he is saying.
I love temporary problems because they typically provide the greatest buying opportunities. Half-seriously, I think that one of the best investment strategies could be to seek out great companies and then wish real hard that something bad happens to them – something temporarily bad, of course. When problems raise their head, Wall Street can be depended on to put a company on skewers and hold it over the fire, regardless of whether the problem is temporary or permanent.