Our Investment Process
Owning Good Companies
We are only interested in owning good companies, but we can turn a good company into a bad investment if we pay too much for it. We use a business-like evaluation of each company designed to identify what a company is worth as a business.
Return on Equity and Price per Earnings
Since World War II the average return on corporate shareholder equity has been about 14%. We like better than average companies, so we look for companies with ROE over 14%. In a climate of 2 1/2% inflation and 4-5% interest rates we need to see a P/E less than or equal to the ROE to consider purchasing the company. By contrast, in a climate of 9% inflation and 12% interest rates (during the 1970s) we were screening for a P/E less than half the ROE. We are always looking for good companies, but the price we are willing to pay for those companies changes as inflation and interest rates change.
Fundamental Analysis
Once we have identified companies meeting our ROE and P/E criteria, we begin our fundamental analysis. We dig into the numbers to learn how they achieved that ROE, and whether it is sustainable. We look at growth, profits, financial strength, labor relations and management teams.
Growth.
The relationship between growth and ROE is an important consideration. If ROE is higher than the growth rate, the company is probably generating free cash flow, which puts a company in control of its own destiny. Growth rates higher than the ROE are not sustainable without additional debt or equity financing. We prefer companies with ROE that can comfortably fund growth. We like to see revenue driven growth and not just cost cutting or accounting “sleights of hand.” Revenue tells us if the public is buying the company’s product and should be near the level of earnings growth. Both earnings and revenues growth should exceed the industry medians.
Profits.
Profits are another critical factor. The way to make profits is cost control, and we look for companies whose profit margins exceed the industry median.
Financial Strength.
Clean balance sheets are important but can be more or less critical depending on the business and the stage of the economic cycle we are in at the time. Use of debt can help boost ROE when the company is performing strongly, but it can hurt the company when business slows down and the company still has to meet their interest payments. We look for companies with a percentage of liabilities to assets lower than industry medians, and then look for free cash flow.
Labor Relations and Management Teams.
Labor relations and management teams are harder to quantify. The quality of the management team is all we have, but we don’t know a better way of measuring them than by how well they have done the job historically. The quality of the management teams usually becomes clear in the fundamental analysis that we perform.
The opinions expressed are those of Tony Muhlenkamp of Muhlenkamp and Company and are not intended to forecast future events, guarantee future results, or offer investment advice.
