Finding Quality in Management and Business
Nikhil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The goal of investing is to yield the maximum capital on your cash. To 'work' your money as hard as it can go without spreading itself too thin. The best way to do this? By quality businesses. The most comfortable way to do this? By management you can trust. Of course there are a number of ways in which to measure these qualities, but the metrics I have chosen here are these three:
1) Return on Equity
As I previously mentioned, you want to be working your money as hard as possible. Your money grows faster if you can use it to make more money that you use to make more money that you can use to make more.....you get my point. That's how compounding returns work, and thats the ultimate formula for riches. If you accept that fancy economic theory as true, return on equity measures the work you're getting from putting you're money into your company. The higher the return on equity, the more bang for your buck, the better the quality of your business and its management, and ultimately the faster your money will grow. That's the beauty of the formula, as it tells you a story of both the management and the company's economics at the same time while giving you a picture of the return you can expect in coming years. Of course, return is based entirely on the price you pay for a business, so this metric alone isn't the holy grail, but it's definitely up there. Return on Equity is calculated as Net Income/Shareholder's Equity. Note: If you're interested in the topic in a little more depth look up the Dupont Formula for Return on Equity, and see Return on Invested Capital for a good alternative.
2) Gross Margin
After using a metric like Return on Equity to measure the overall story of management and business quality, I use specific metrics to target each quality. I like to look at Gross Margin to see the quality of an overall business. The higher quality the business, the higher its Gross Margins. In Warren Buffett and the Interpretation of Financial Statements? by Mary Buffett and David Clark?(a book I highly recommend), it is explained that Buffett looks for Gross margins of 40% or above in his search for quality investments. Why? This literally tells you your bang for the buck. With a 40% gross margin, you get 40cents for every dollar of sales. Doesn't sound like much? Finviz.com's screener looks at almost 7000 companies, and only 1826 had gross margins above 40%. That means that 74% of businesses that Finviz screens make less than that much for every dollar of sales. I prefer Gross Margin to Net Profit Margin because Net Profit Margin can be due to exceptional issues not related to the companies operations. Gross Margin gives me an indication of the company's pricing power and the natural economics of the business. Gross Margin is calculated as Revenue/Gross Profit.
In his 120 rec article, Tom Gardner explained the merits of insider ownership in trusting a company's management. It kind of makes logical sense too though. If members of the company own the same shares you own in amounts that influence their decisions, they are being influenced to be on your side of the battle. They should be supportive of increasing shareholder value rather than increasing short term gains. Combine this with high Gross Profit margins and you should get some stellar results.
So here are 5 of my top results, companies that you can sleep well owning due to their high Returns on Equity(above 30%), high Gross Profit Margins(above 35%), and high Insider Ownership(above 30%).
First on my list would be National Beverage Corporation (NASDAQ: FIZZ). With Gross Margins coming in at 35.84% and, get this, Insider ownership of a whopping(almost scary even?) 75%, National Beverage Corporation has the business and management qualities of a winner. Of course, you need more than just a management that's on shareholders' side, you need a management that can execute. So you want execution? How about a 31.11% return on equity? and if that isn't enough, how about a more impressive metric to show company performance. In the past 4 years, earnings per share has increased at a 15.76% compounded annual rate. Of course, no investment should be made without consideration of valuation. With a P/FCF of 17.5 and a P/E of 18, FIZZ seems fairly valued, if a tad over optimisticly priced. Over a horizon of 5 or more years, investors should see a nice appreciation; However, any shorter horizon and the lack of a steep undervaluation will create risk. At fair value, price moves due to sentiment instead of value, so it's hard to tell where the stock will be.
Another quality company I found isn't even based in the US. MagicJack VocalTec (NASDAQ: CALL), formerly known as Vocaltec Communications, is a 77 employee business based in Israel. In the communication and network solutions industry, MagicJack has clearly found its own little niche, bringing in 157% ttm Return on Equity. MagicJack also has Gross margins above 55% and insider ownership above 37%. Its priced for more than this, however, at a P/E of 55.61 and a P/FCF of 20. Maybe not the most attractive buy at this point in time, but I think it might be worth looking at if it were to drop sometime in the future.
Terra Nitrogen Company (NYSE: TNH), on the other hand, is well worth looking into at today's prices. With a P/E of 14.68, TNH has a dividend of 6.7%, much higher than corporate bond yields(Note: this dividend isn't risk-free, and payments do vary significantly...even so expect the dividend to at least exceed corporate bond yields over the next year). There is quality here. Gross Margins clock in at 62%, Insider Ownership at 75%, and Return on Equity at 122%. Moreover, as a fertilizer company, there is an economic recovery investment thesis that may playout as well. In any case, as you let the business quality do the talking, it'l be nice to absorb that 6.7% dividend.
Finally, USANA Health Sciences Incorporated (NYSE: USNA) may have a lot more potential than the market implies. Vuru.com lists the company as its #2 most undervalued small cap company, indicating that according to Vuru's estimates, it should be worth between $50 and $60 per share. If this is true, this investment could turn out to be a bombshell as company quality checks out as well. USANA has no debt and management owns 53% of the company. With a 31% return on equity and 36% gross margins, USANA is poised for strong business returns in the future, and its low valuation(P/E of 11.66) might juice investor returns for the short and long term.
While these are some good ideas, make sure to do your own research before investing in any of these companies, and make sure to take valuation into consideration for shorter term security. If you're convinced that you'l never look at your stocks for the next 5 years, or that you have the heart to deal with short term risk, I don't see any problems with investing in any of these companies, except maybe MagicJack VocalTech, whose abnormally high valuation might cause losses even with a high quality business.
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