Screening for Winners in the Equity Universe – Employing the “2-10-10” Methodology

Intro

In last week’s blog, we discussed our view of the near term outlook for oil prices. While oil, in our opinion, appears to have limited upside for the foreseeable future, there may still be ways for the investor to benefit from this volatility by owning quality companies in the oil & gas space.

This blog will introduce a few simple, yet effective concepts on how we approach our initial screening for identifying quality companies to own over the long-term, whether in the oil & gas space or others. In the following weeks, we’ll dive into some of the subsectors (drilling & services, exploration & production, refining & marketing and storage & transportation, etc.), present our short list of quality companies, explain what drives these companies’ earnings and will end on a recommendation of quality companies we’d like to own in this environment.

Screening Criteria – The “2-10-10”

There are well over 500 oil & gas companies in the stock market universe (and ostensibly infinitely more outside that space) one could choose from, but in order to narrow the scope of focus and limit our risk of absolute loss of capital, we at the Perceptive Investor like to use what we’ve dubbed the “2-10-10” criteria to filter out what could fit the bill as “best in class” companies. The 2-10-10 screening criteria can be broken down as follows:

  1. At least a mid-cap sized company (Market capitalization of USD 2 billion or greater)
  2. Historically high return on equity (ROE): 10% or greater
  3. EPS growth rate over last 5 years: 10% annually or higher

Before we dive into why the 2-10-10 is key to filtering out the best from the rest, we’d like to draw your attention to the first goal of the Perceptive Investor outlined in our initial blog (click here to read), which is to preserve and minimize the chances of complete loss of capital. As you will see shortly, by filtering out companies with these criteria we will greatly minimize the chances of choosing low quality companies that could disappear (along with your money) overnight.

Criteria 1 – Market Capitalization of at least USD 2 Billion

Market capitalization (“market cap”) is a calculation used by the investing community to understand how large a company is. It is calculated by multiplying the current price per share by the total number of shares outstanding to arrive at a dollar figure. Generally speaking there are three main classes of companies based on market cap:

  • Small-cap: anything less than USD 2 billion
  • Mid-cap: between USD 2 billion and 10 billion and
  • Large-cap: USD 10 billion and greater

You may have heard that small-cap companies can offer tremendous growth opportunities since they are generally less well known (and usually cheaper compared to larger-cap companies) and may have huge potential to grow. These “growth” opportunities, however, also come with a higher degree of risk that may not be palatable to the average investor. Some of the main risks associated with small-cap stocks and reasons why we don’t like them are:

  1. Lack of liquidity – meaning these stocks are “thinly-traded” so buying/selling at the price you want may not be as easy as a larger-cap company. Additionally, with lack of liquidity comes a higher level of volatility. Many novice investors have a tendency to watch their investments every day, which is ultimately a self-defeating endeavor. Watching these volatile investments move everyday, particularly if they are going against you, creates a sense of fear and panic that may lead the investor to make irrational trading decisions based solely on what’s happening in the moment, rather than having built sufficient confidence in their research and investment thesis. This may lead to over-trading, which not only results in excessive brokerage fees, but can also cause investors to ultimately to exit their positions too quickly or sell at loss-making prices, which just eats away at any potential profit gains. Excessive trading of such kind also defeats the purpose of investing. We are here to invest in companies for the long-term, not trade in-and-out of these positions on a short-term basis.
  1. Lack of operational history – without an established track record or reputable brand name, it will be more difficult for these companies to obtain loans for either operational expenditures or capital expenditures making it excessively difficult to survive, particularly in economic downturns or times of immense uncertainty (such as now with the so-called “Brexit”). Additionally, without a well-established brand name, consumers may be quick to substitute for cheaper alternatives, directly and negatively impacting the company’s revenue stream.
  1. Lack of transparency – the Perceptive Investor does his research based on available information and data. The larger-cap companies are covered widely by Wall Street analysts and there is typically a wealth of information about their operations available to the public through a variety of sources. Smaller companies lack this information, therefore making it more difficult for investors to arrive at sound conclusions about their business potential.

By limiting our scope of focus to only mid-cap and large-cap companies, we are making it easier for the investor to sleep at night as we are inherently reducing the risk of permanent loss of capital. Some people may argue that mid-cap and large-cap companies have limited growth in them or the average investor may not be able to “gain an edge” on these investments since they are all widely-covered and bigger institutions like banks and hedge funds will know more than them. Allow us to dissuade you otherwise. True, the big boys have a wealth of tools and information at their disposal, but they are also playing a slightly different game. They are actively managing their risk everyday by ensuring they are never over exposed to any one position, particularly in volatile times like these. This active management of positions is good in the sense it creates opportunities for average investors like ourselves who do not have the resources to actively manage large portfolios, yet are discerning enough to see through the noise and patiently wait for the right opportunities to establish positions in undervalued companies.


Brief Aside on the “Brexit”

What’s happening in Europe right now is the perfect example of market participants managing risk in their portfolios. There is a tremendous amount of uncertainty regarding the Eurozone and that uncertainty is stoking fears about the future of the global economy. This fear is resulting in sharp selling and liquidating of positions, which is reducing the market value of many quality companies for no reason other than people are simply scared. Make no mistake, there are plenty of bargains to be had in the market at the moment and this series of blogs will give you the tools you need to uncover these gems. We at the Perceptive Investor are actively dissecting the situation to help our friends navigate these uncertain times and help set you all up to benefit from this volatility. More on this coming soon.


Remember, we are not trying to trade in-and-out of these positions monthly or even quarterly. The Perceptive Investor’s goal is to exercise mental discipline and patience through diligent research and wait for the opportune time to take a position and only enter an investment at an attractive price relative to the company’s long-term prospects. The previous sentence is underlined as this is the single biggest difference between an average investor making and losing money investing in stocks. All too often, people get over excited, become impatient or simply don’t have the educational tools at their fingertips to buy at the right price. Price is everything at the end of the day and the lower the price you can purchase a stock at in relation to its growth prospects, the better off you will be. This is what’s known as margin of safety (popularized by Benjamin Graham) and will be explained in more detail in another blog.

Now that we have summarized our primary reasons for focusing on mid-cap and larger companies, we will next turn our attention to the track records of these companies. There are two notable metrics that are easy to track and screen for in nearly any brokerage account and those are return on equity and earnings per share (“ROE” and “EPS”). We like to look at how companies have performed historically to get a sense for their potential. Sure, it is true that a company’s historical performance does not guarantee continued above-average performance. After all, the only two things guaranteed in life are death and taxes. However, we do place heavy importance on a consistent track record and like to see companies with a management team who have consistently performed well over recent history. In our view, one major harbinger of success is harnessing the ability of identifying winning tactics and consistently deploying them over time. A management team that can consistently do this will also aid the investor in meeting one of his primary goals, reducing the risk of absolute loss of capital.

Criteria 2 – Historical Return on Equity of at least 10%

One of the most simple and powerful ways to evaluate the potential of a company to perform well is to understand its ROE. Though not a silver bullet for stock price evaluation, this measurement, when viewed historically, allows investors to look across three primary areas of a company’s performance: profit margin, asset management and financial leverage. ROE is calculated as annual income / annual shareholder equity, but can be further broken down into the following equation:

ROE = (annual earnings / annual sales) * (annual sales / assets) * (assets / shareholder equity)

If we break down the ratio above into its various parts, we get the following:

  • (earnings/sales) also known as Profit Margin
  • (sales/assets) also known as Asset Utilization (or Turnover)
  • (assets/shareholder equity) also known as Leverage (or Equity Multiplier)

When considering companies to invest in over the long-term, we like companies that operate at a wide profit margin and have a high amount of turnover (ie. sales). After all, business is a numbers game and the wider the margins and higher the turnover, the more profitable an organization will be.

Leverage, however, is not so straightforward. Although we prefer companies who operate with financial prudence and don’t attempt to take on more debt than they can handle, debt is, unfortunately, a necessary evil. The leverage ratio above calculates how much a company’s debt is worth compared to its shareholder equity. Let’s say XYZ company’s assets are worth $100 MM and its shareholder equity at $50 MM. This means that XYZ company had to finance the remaining $50 MM with debt, resulting in a ratio of 2. In case you’re having trouble understanding what shareholder equity exactly is, think of it as the company’s source of funding from its shareholders. Another way to view it is to think about it as the difference between a company’s total assets and total liabilities. Whatever that difference is would be what is leftover for its shareholders if the company were liquidated. While there is no hard-and-fast rule on what the ideal leverage ratio should be, when we invest in larger companies, we tend to like ones who are more conservatively leveraged, meaning they don’t take on a large amount of debt (with respect to its shareholder equity) to finance its operations and expansions. Then again, increased leverage may be OK as long as Executive Management has a track record for successfully deploying debt and/or has taken on debt at favorable terms (ie. low interest rates). We will come back to this topic another time as the details of this are out of the scope of today’s blog.

Historically speaking, companies who have a tendency to perform consistently well and consistently return an attractive percentage on equity over a long period are ones we want to consider for investment. Why? Because consistency is key to success. It can be commonly observed that any successful athlete, musician, entrepreneur, etc. is successful because they are consistent in their practice, as they know in order to get better and achieve their goals, consistent practice is key. College Football Hall of Famer (and two-time Super Bowl Champion, Heisman Trophy winner and Super Bowl MVP) quarterback Roger Staubach stresses this point best when he said:

“In any team sport, the best teams have consistency and chemistry”

This maxim also rings true in companies we look to invest in, so we want to ensure we are screening for companies returning a consistent, attractive percentage on equity. As an investor, we have a multitude of ways to invest our money and would like to see it deployed effectively. Analyzing a company’s ROE is one of many ways for shareholders to compare the value they are receiving by investing in any company as opposed to any one of alternative investments. In the past, investors typically used 15% as a minimum threshold for ROE as those were times when interest rates were much higher. Remember, a U.S. Treasury Bond (considered one of the world’s safest alternative investments) returned as much as 15% on your investment many years ago, however, in this new era of extremely low interest rates and slower global demand growth, we must temper our expectations and learn to accept a lower minimum threshold, hence the 10% minimum. Generally speaking, the higher the ROE the better. However, as noted above, if ROE’s are extremely high (perhaps due to excessive leverage), additional research must be done to figure out why this is and ensure the company isn’t taking on unnecessary risk.

Criteria 3 – Earnings per Share Annual Growth of at least 10%

EPS is likely the most widely followed metric on Wall Street and rightly so. At the end of the day, investors want to ensure that not only is the company profitable, but has also been increasing its profits year after year. The reason why EPS figures are so important for analysts is that it allows them a measurable and (mostly) transparent way to calculate the profitability of an organization. The essence of this calculation is to give the investor an idea of how much each common share (share outstanding and available to average investors like us) is worth after taking into account a company’s net income (after taxes) and dividends paid to its preferred shareholders (preferred shares are a class of shares which have a higher claim on the company’s assets and therefore will be paid out first before common shareholders are paid out). The basic EPS equation is as follows:

EPS = (net income – dividends paid on preferred shares) / average number of shares outstanding

For the same reasons mentioned above in the ROE section, it is important for the Perceptive Investor to look at the history, quality and consistency of a company’s EPS. A consistent history of positive and increasing EPS of 10% on an annual basis for at least the past five years is the minimum we expect from any well-established and healthy business. The higher the EPS and longer the time period, the better the investment, in most cases.

Though the hurdles just mentioned for EPS criteria may seem simple, one should not simply fall back and rely solely on this one metric for a number of reasons. Firstly, any EPS measurement may be subject to accounting manipulation (which is why we noted “mostly” transparent). When reviewing EPS growth over history, one should be wary of any significant deviations from recent trends in earnings, either to the upside or downside. When this occurs, investors should be careful to read the fine print of the annual or quarterly results to understand exactly why the deviation occurred. Should it have occurred for a legitimate business reason (such as bolt-on acquisition of another company), the deviation may be tolerable, however, if for any accounting reason relating to income-taxes, depreciation or other “special one-off charges”, additional due diligence will have to be conducted to ensure the deviation is acceptable. In financial statements one will see “non-diluted earnings” and “diluted earnings”. It’s usually best practice to be conservative and always base EPS estimates on diluted earnings. Diluted earnings account for the incremental amount of shares that can be issued as a result of warrants, stock options or other securities convertible into common stock. This means that at any time, new shares could be issued, diluting the shareholder percentage and, therefore should be used in order to more accurately reflect value of each share.

Summary

To summarize in the world of publicly-traded oil & gas companies, where there are well over 500 to choose from, the novice investor may feel overwhelmed and not know exactly where to begin. To provide a starting point, we have outlined three primary screening criteria (the “2-10-10”) to aid you in your search for quality companies (across any sector). These, by no means, represent a comprehensive screen nor do we suggest these are the only criteria needed to justify investment in a company, but rather, are simply meant to narrow the scope of focus and reduce the uncertainty in investing in low-quality companies, subsequently aiding the investor in mitigating the risk of massive capital losses. To reiterate the 2-10-10:

  1. At least a mid-cap sized company (Market Cap of USD 2 billion or greater)
  2. Historically high return on equity (ROE): 10% or greater
  3. EPS growth rate over last 5 years: 10% annually or higher

A screenshot from my screen using TD Ameritrade can be found below:

2-10-10 Screenshot

In the next blog we will discuss what kind of results our initial screening has yielded,  how to dive deeper into the search for value across various sub-sectors of the oil & gas industry and end with a recommendation on ways for the Perceptive Investor to set himself up for success in the oil & gas space over the long-term.

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