Some Assumptions (Facts):
As we know stocks are fractional ownership stakes in businesses and as such over extended holding periods march upward, or downward, in line with the underlying business. The phrase, Extended periods, is of exceptional importance here as in the short and even mid-term a shares price can deviate widley from the fundementals. Only when viewed over a longer period does a shares price begin to more closely resemble underlying value creation or destruction taking place in the underlying business.
In order for the below information to hold weight and improve your results three assumptions were made, all are truisms:
Businesses are Ownership stakes in Businesses and their prices are merely what someone will pay today. That person might be overly pessimistic or exuberent.
The underlying value of businesses and therefore their shares are equivilant to the discounted cash that can be pulled from the business from here to kingdom come (if it could be accurately determined).
Time is the friend of the wonderful business and we are and must be longterm shareholders.
So we begin...
Firstly, this is a method for barrel selection. Meaning where to go hunting or where the good businesses are, in a broad sense. A great investment is, a good company at a good price. This takes care of the good company part of the equation above. The good price bit will be covered in other posts and in the end is up to you to determine. This just tells you where to start your hunt.
Given the three truisms above, if we are looking for a good business we must be looking for one that will maximize its capital out flows over time and with enough certainty to accurately predict. To do this a business must, over extended periods, recieve a good return on capital invested into the business, assuming it has the money to reinvest and can efficiently deploy it. We chose three metrics to represent these musts (we want all to have high values):
Return on Capitol --- ROC = (Net Income - Dividends) / (Debt + Equity), Measures the return a business gets, as a perecent, of the equity and debt put into the business.
Answers the Question: Should this business be investing cashflows back in it's operations (Business has a high return) or distributing them to shareholders (Business has a low returns)?
After Tax Operating Margin --- After Tax Operating Margin = Net Income / Sales, Measures how profitable a business is.
Answers the Question: Will this business have excess capital flows to return or invest?
Sales / Invested Capital --- Measures the Amout of sales generated per dollar of capital invested. Businesses thta can grow without capital and get high returns can best be describes as heavan.
Answers the Question: How capital intensive is the business?
Digging in...
Review the interactive representing 15 of the best industries (of 97 recorded) by each metric:
Data from: Aswath Damodaran
Top 5 Industries with the Highest ROC:
Tobacco | 80.36% |
Healthcare Support Services | 45.74% |
Retail (Building Supply) | 39.43% |
Computers/Peripherals | 37.80% |
Advertising | 31.52% |
Top 5 Industries with Highest After Tax Operating Margin:
Tobacco | 36.92% |
Oil/Gas (Production and Exploration) | 35.57% |
Oil/Gas Distribution | 34.68% |
Retail (REITs) | 34.12% |
Transportation (Railroads) | 28.91% |
Top 5 industries with Highest Sales / Invested Capital:
Healthcare Support Services | 12.88 |
Food Wholesalers | 8.02 |
Retail (Grocery and Food) | 4.76 |
Reinsurance | 4.05 |
Retail (Building Supply) | 3.64 |
Summary:
Looking over these industries all serve as a good place to fish around for your next investments. However, only three appear on more than one list.
Industry | ROC | After Tax Operating Margin | Sales / Invested capital | Industry Players |
|---|---|---|---|---|
Retail (Building Supply) | 39.43% | 10.83% | 3.64 | Home Depot, Lowes, Builder FirstSource. |
Tobacco | 80.36% | 36.92% | 2.18 | British Tobacco, Phillip Morris, Altria, Imperial Brands |
Healthcare Support Services | 45.74% | 3.55% | 12.88 | Welldoc, Tebra, SprintRay, Cerebral, Advent International |
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