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LOWELL, BLAKE & ASSOCIATES INCORPORATED
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COOLIDGE'S ANALYTICAL MARKERSThere are a number of key markers that we use in analyzing stocks. The purpose of this memo is to highlight the most important of them in each of three principal categories, balance sheet, income account and vital relationships. Balance Sheet
We start with the balance sheet because it is particularly valuable as a screening device. A company with a poor one rarely, if ever, can qualify as a suitable holding for a fiduciary. We particularly abhor heavy debt, which we view as a severe competitive handicap, especially in a weak economic environment. Generally, we get uncomfortable when long-term debt is much more than one-third of the capitalization. Short-term debt also must be scrutinized because it is frequently large relative to the capitalization and may have to be refinanced soon, possibly on unfavorable terms. Goodwill is another element we dislike because it is an intangible accounting entry reflecting the excess of the purchase price over the value of assets acquired. It may not be an asset at all (is not accepted as such under conventional accounting principles) and yet it frequently represents a major portion of a company’s stated net worth. Management is required to write off acquisition-related intangibles when it determines that carrying values may not be recoverable, thereby causing an abrupt and possibly substantial reduction in shareholders’ equity. Working capital sufficiency obviously has a bearing on a company’s dividend paying ability, which is of fundamental importance since dividend growth is essential if clients hope to keep pace with the inexorable rise in living costs. The availability of ample liquid assets also enhances management’s ability to act quickly as opportunities arise. Generally, we avoid capital intensive businesses because they tend to have more volatile earnings and less dividend paying ability. The size and age of a company’s plant and equipment as indicated in the property account give clues to future capital demands which, of course, influence dividend policy. Changes in the common capitalization are important for their impact on per share results. For example, a stock buyback program can both enhance earnings per share and provide support for the stock price. However, the success of any such program depends on the source of the funds used and the prices paid for the stock. We deplore the use of debt to buy back stock and the payment of prices representing excessive premiums to book value. Income Statements – Annual and Quarterly
Unlike a balance sheet, which provides a financial picture as of a specific date, an income statement covers a period of time such as three months or a year. Thus we pay a lot of attention to trends and whether they are accelerating or decelerating. Particularly noteworthy is the change in the direction of a trend, because that can be extremely rewarding for those who detect it and act on it at any early stage. Taken by itself, a company’s performance tells only part of the story, since the real test is how its results compare with those of its competitors and others in similar businesses. It is critical, for example, to know whether a company is gaining or losing market share. If one company’s experience in sales and profitability is significantly inferior or superior to that of its peers, we have some indication of the opportunity or vulnerability it faces. Sales are obviously the lifeblood of any enterprise. They are made up of three principal elements, physical volume, sales mix and selling price. To the extent possible, we try to determine the contribution of each of these elements, since sales gains from price inflation are fundamentally less creditable than those from physical volume. The short-term impact on profits may be as good or even better, but the sustainability of growth through significant price increases is ultimately questionable. The gross margin and operating margin are simply measures of the relationships between production costs and total operating costs (including selling, administration, R&D expense, etc.) and sales. They are a good measure of how well management is running the business both absolutely and relative to competitors. The tax rate needs to be calculated to determine whether earnings over the short term are being temporarily inflated or penalized by some non-recurring tax factor. Cash flow, the sum of net income, depreciation and amortization charges, is the amount the business is generating for management to reinvest, service debt and pay out dividends. Its usefulness is in helping appraise a company’s ability to provide its own capital requirements while maintaining a desirable dividend record without resorting to outside capital (borrowing or sale of additional stock). Key Relationships
Return on capital employed in the business is really the most revealing measure of the worth of any enterprise. This single relationship tells us a great deal about a company’s ability to compete, to pay dividends and to meet its future needs for capital. As always, we are interested not only in just the figure itself but, most important, whether it is improving or deteriorating and how it compares with others in similar businesses. Taking that a step further is the return on capital after dividends have been paid, or the relationship of earnings being reinvested in the business to capital employed. This is a fundamental measure of a company’s ability to grow without bringing in additional capital. However, that indicator is valid only if the company is able to earn as good a return on capital from its ongoing reinvested earnings as from its overall capital. The proportion of cash flow committed to debt service and required for expenditures on plant and equipment is obviously important because what is left, known as free cash flow, is the prime measure of dividend paying ability. It also is a measure of management’s flexibility in taking advantage of opportunities which may arise unexpectedly such as an acquisition or a chance to buy back stock at an attractive price. These issues bring us back to our aversion to heavy debt expressed at the outset. At the very least, debt represents a management constraint and resultant competitive disadvantage compared to the debt free company. If the returns contemplated when the debt was incurred fail to materialize, a company’s ability to pay dividends and ultimately even its survival may come into question. The valuation aspect of investment decision making is also subjective and deserves greater elaboration than we can give here. Clearly, investors are prone to following herd instincts and to carrying both optimism and pessimism to extremes. We accordingly are careful not to chase stocks when they are in vogue and selling near the high end of their range of recent years. Nor are we willing to sell stocks of good companies when they fall out of favor except for tax reasons or in cases where there has been a significant change in the basic outlook for the business. Thus we are contrarian in approach in the conviction that a DISCIPLINE OF BUYING LOW AND SELLING HIGH is the surest approach to consistent good investment performance.
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