I pick stocks using rules that select for companies that have a low levels of debt, that have a trusted CEO and are priced at a level that is cheap relative to how much cash they generate. The lower I feel the price is, the more money I invest. Lastly, I stick with my bets by buying and holding, which reduces the tax penalty of selling/buying. I’ll cover these last two points in Part 3. My strategy is more an exploration and learning process than a refined process and I expect will continue to evolve.
I don’t want to lose money. I especially don’t want to lose money when most people and businesses are losing money. To the extent I can lose less money than the average person during a downturn, I can take advantage of lower prices when others are selling. Mark Spitznagel provides mathematical reasons why losing money is bad, not just in itself, but also for average returns. I think about protecting the downside in buying stocks as well as finding good upside for the long run.
Companies with high debt tend to have stock prices that fall drastically if the economy takes a downturn. Debt seems sustainable when the market is doing well – in such times the market often values companies based on profits or even just revenue. In bad times, companies with high debt struggle. Compare Exxon Mobil and Occidental Petroleum – both hit by the recent market and oil price falls. The two companies have different market exposures, but a big cause of Occidental’s stock price is – in my opinion – the high level of debt that Occidental has (as a result of its recent acquisition of Anadarko). Occidental’s level of long term debt was about $39B at the end of 2019. The combined revenue of Occidental and Anadarko for 2019 was about $29B. For comparison, Exxon had about $26B in debt (less than Occidental) at the end of 2019, but is a company with revenue of $256B (almost ten times the size of Occidental).
Picking an “acceptable” level of debt is subjective. I screen out any companies that have a ratio of long term debt to adjusted cash-flow that is below five. In simple terms, if a company doesn’t generate enough cash annually to pay off it’s debt in five years (without compromising on necessary capital investment), I don’t want it. I find the long term debt on the company’s balance sheet. I calculate adjusted cash-flow by looking at cash flow from operations (on the statement of cash flows) and subtracting off depreciation (on the P&L or statement of cash flows). For software companies like Google, there isn’t much depreciation. For industrial companies, depreciation is a real cost because companies need to invest capital into equipment/land/assets in order to generate that operating cash flow. In other words, a portion of the operating cash flow is needed to pay for new equipment just to keep the business going as is, so I have to make an estimate of how to subtract that out. Note: I could subtract out capital spending, but that tends to fluctuate more year on year. Also, if the company is growing, capital spending will outstrip depreciation – so I would be subtracting out too much. Mature companies that are growing more slowly will have annual capital spending and depreciation that are closer in value – compare Southwest airlines with comparable capital spending and depreciation to Ryanair (more growth and more capital spending in 2019).
Of course, there is subjectivity in how you pick the adjusted cash flow and how many years you want to average over. Some companies that I considered passing this screen at the end of 2019 were: Ryanair, Southwest, Berkshire Hathaway, Amazon, Apple, Facebook, Google, Spotify, JetBlue.
My heuristic for a trusted CEO is simple. Either the CEO has to have a majority of their net worth in stock of the company (not options) OR Warren Buffet has to have invested in the company. This is a strict rule, but I think a good one to ensure alignment with stockholders. Of the list above this would leave the following as qualifying: Ryanair, Southwest (via Berkshire), Berkshire Hathaway, Amazon, Apple (via Berkshire), Facebook Spotify, (I include JetBlue as well because I think Buffett would own it but the market cap is too small for him to be able to invest).
There are other companies that could be in there, but I haven’t had enough time to read the annual reports of a lot more qualifying companies. I prefer to learn about a few companies at a time even if it limits me on the pool I’m picking from.
Low price relative to cash generated
Over the long run, I believe that cash generation matters. Quite simply, if a company is generating cashflow from operations, they can fund growth without having to issues shares or debt. If they are generating a lot of cash, they can either support fast growth, or they can distribute that cash (via dividends or stock buybacks). The decision of what is done with the cash is important, which is why a trusted CEO is important. The level of cash generated is also important.
For mature companies (with less than 20% year on year revenue growth), I screen for companies that have adjusted cash flow (see above) equaling 10% or more of the stock price. For example, if a stock is $50 per share, I want to see $5 per share of adjusted free cash flow. For growth companies (ones growing revenue by 20%+ per year), I screen for companies with adjusted free cash flow equaling about 7% or more of the stock price.
Note: This cash flow based screening is just one approach and it misses a lot of companies that could be good. For example – Amazon is at a high price relative to its cash flow, but could still be a good investment. I haven’t figured out a strategy for low cashflow companies that I’m comfortable with.
Summary and stock holdings
As of now (April 2020) the main stock holdings I have are Berkshire (10% of total assets), Southwest (5%), Ryanair (5%), Facebook (3.5%), JetBlue (2%). I have been holding Berkshire, Southwest and Ryanair for quite some time, and picked up Facebook and JetBlue recently as their prices fell. I’m not confident that aviation will come out well out of this (although low fuel prices and reduced competition due to bankruptcies may help), but I am staying the course. For clarity, this is about 25% in stocks at present. 6% gold index. 6% Bitcoin. The rest (63%) I hold in cash (since TBills went to zero).
Note on Berkshire Hathaway. It is a bit of work to figure out cash flow for Berkshire because it owns significant stakes in other companies whose cashflows are not reported in Berkshire’s consolidated financials. I have to go in to those companies (Apple, American Express, etc.) and figure out what share of cashflow can be attributed to Berkshire.