The Future Is Now
Alexandria, VA (Aug. 25, 1998) -- In this week of Cash-King reports, I'd like to direct your attention toward measuring business momentum in a company's financial statements. (Don't worry, it won't be that boring!) In much of our work together, we've studied snapshots of a public company, scanning for the qualities of Cash-King: high gross margins, high net margins, loads of cash, little debt, and signs of a natural monopoly in a low Flow Ratio.
We typed in numbers, clicked a button, and a photograph emerged.
But you know, and we know, that flat screening only gets us part of the way toward market-beating results. There's more. The direction of a business is even more important than its present location. Here, think of Muhammad Ali's 1974 bout with George Foreman in Zaire. For a handful of rounds, the 25-year-old Foreman pounded his elder into the ropes. The judges marked up Big George's performance, minute after minute, one punch at a time. In business terms, Foreman was posting high margins, no debts, and a mixture of great product sales (overhand rights on offense) and excellent financial management (forearm blocks on defense).
Foreman was making all the rules in the early rounds of the fight. He looked like a King. But then the momentum began shifting. Ali -- from whose book of thoughts Microsoft tore a page -- had been sitting back, taking harsh punishment from his competitor, but ultimately encouraging the younger fighter to punch himself tired. And then Ali began wearing down Foreman, relentlessly banging at his crown. By the eighth round, Foreman was down, and out. It took more than four rounds of physical and psychological endurance before Ali could change the dynamics of the fight, bring a King to his knees, and alter boxing history.
There are plenty of other examples of major momentum changes beyond the world of boxing. Cash-King manager Phil Weiss, a huge Duke basketball fan, was visited by an unhappy directional shift in the NCAA Basketball Tournament last year, when Duke relinquished a 22-point first-half lead to Kentucky, losing 86-84. Other great non-sports momentum turns in late-20th-century history include the smashing popularity and near-immediate demise of Jordache Jeans, Gary Hart's front-running race for the White House ending in his lap as a mariner aboard the boat Monkey Business, the rise and fall then rise of Apple Computer, and the first time I beat my older brother in a best-of-seven series in ping pong.
Andrew Grove, chairman of Intel, explains it thus: The world came upon an inflection point, and everything changed. William Butler Yeats described the end of kingdoms in "Second Coming," noting that with things falling apart, the center cannot hold. For investors, locating and classifying those turns in momentum is critical. For your investment portfolio, it can mean the substantial difference between quickly selling a laggard and holding it forever into oblivion. It can lead you to add new money to an existing position or to take your money elsewhere. Following momentum as investors reminds us that the direction of objects is often more important than their present location.
As you might expect, here in the land of Cash-Kings, we don't concentrate on following the motions of a stock price. And we don't place heavy emphasis on the latest news of oncoming product killers -- tales of oncoming momentum without numerical support. Nope. Instead, we pay attention to the direction of the financial statements, from one quarter to the next, asking ourselves: Is our company driving more profitable sales today than it did last year? Is management aggressively pursuing new opportunities while prudently allocating capital? Is this business gaining in efficiency and power, or losing?
This doesn't mean we don't study a business' location. We narrow the universe of 9,000 public companies down to a few dozen by carrying out the simple screens outlined in our 11 Steps to Cash King Investing (gross margins above 50%, net margins above 7%, cash equal to or greater than 1.5x long-term debt, a Flow Ratio below 1.25, et al.). But the next level of the analysis is to look at the historical information, comparing this quarter's performance to last, this year's to last, even this year's to those five or ten years past, as we've done in our buy reports. The reason is obvious -- net margins of 14% down from 16% are not as attractive as net margins of 14% up from 12%, even though both meet our Cash-King screening criteria.
The beauty of moving beyond a flat screen and working these two studies together (screening and historical comparison) is that we narrow down our list of potential investments even more tightly to those companies in excellent shape today whose operational momentum is improving. That's doubly powerful and difficult to compete with. History shows that no unseen hand can destroy these sorts of kingdoms overnight. The Internet, for example, has not killed the Windows platform. Nielsen Media Research reported that 70.5 million American adults are using the Internet today, four times more than in 1995, yet Microsoft continues to sell upgrades to its operating systems and applications.
We think similar scenarios will play out for the significant majority of our Cash-Kings in the years ahead. There will be no David to strike our Goliaths down with a single stone. Momentum won't shift in a single collision, in a loud bang, with a puff of smoke. Most of our companies have a worldwide base of repeat customers and hundreds of millions or billions of dollars to defend their positions. This doesn't mean they're invincible. But it does mean they live in a world where the only revolution is evolution, a series of transitions, a gradually altered course. The challenge of our monster businesses -- from Gap to Coca-Cola, from Microsoft to American Express, from Pfizer next door to Schering-Plough -- is to stay awake at the wheel and to steer their operations to match the winding roads of commerce.
And we face the same challenge with our portfolio of investments, to float our lodestones across the water and follow the direction of things. Because we're invested in Cash-Kings, we don't have to obsessively watch for the next press release to hit the wires or care about the latest 5% drop in the value of our portfolio. Instead, we can practice training our eyes on the quarterly earnings reports and training our minds to sort through them purposefully and efficiently.
We can dig out answers to questions like: Are things getting better at Gap after its latest report or are they slackening off? What sort of business downturn would cause us not to add new money to this position? What might force us to sell? And, more likely, what developments will have us salivating to add more savings to it? If you take a gander at Gap's last earnings report, released on August 13th, here's what you'll find in comparing this quarter to the same period in 1997:
Gross Margins: +17% (from 34.4% to 40.4%)
Net Margins: +38% (from 5.2% to 7.2%)
Cash-to-Debt: -BIG (to 1.07x from no long-term debt)
The Flow Ratio: +16% (from 1.21 down to 1.02)
By looking at those five simple metrics, you can get a pretty good sense of what's going on at Gap Headquarters. The company has blasted ahead its sales, dramatically improved its margins, strengthened its power position in the industry, yet done so by assuming a load of long-term debt. In September 1997, Gap borrowed $499 million in ten-year notes carrying an interest rate of 6.9%.
The company has used that cash to accelerate advertising and store expansion. The question for investors is, "Will today's momentum carry Gap through to repayment of those notes by 2007, and will it put our company in the driver's seat for casual clothing over that period?" Our answer today is yes. But our pencils and scorecards are ready for the next quarterly report due out in the middle of November. We'll have another chance to study then whether or not competition or shifts in consumer preference or a slowing economy have weakened our denim dealer.
Tomorrow, I'm going to walk through seven financial criteria I use to measure whether a business is weakening, stable, or strengthening from one quarter to the next, year after year. Until then, please post any queries to the Cash-King Strategies Folder linked below. Fool on!
Stock Change Bid AXP - 5/16 96.88 CHV - 1/2 78.19 CSCO + 15/16 103.94 KO + 1/2 80.13 GPS -1 15/16 64.00 EK - 1/8 85.50 XON - 3/16 70.38 GM + 7/8 64.50 INTC - 13/64 84.42 MSFT +2 3/8 112.75 PFE +1 3/8 106.50 SGP +1 7/8 102.13 TROW + 7/16 36.00
Day Month Year History C-K 0.43% 0.34% 15.97% 15.97% S&P 500 0.43% (2.49%) 8.63% 8.63% Nasdaq 0.39% (3.98%) 7.89% 7.89% Cash-King Stocks Rec'd # Security In At Now Change 2/3/98 24 Microsoft 78.27 112.75 44.05% 2/3/98 22 Pfizer 82.30 106.50 29.41% 5/1/98 37 Gap Inc. 51.09 64.00 25.27% 6/23/98 23 Cisco Syst 86.35 103.94 20.37% 2/27/98 27 Coca-Cola 69.11 80.13 15.94% 2/6/98 56 T. Rowe Pr 33.67 36.00 6.91% 8/21/98 22 Schering P 95.99 102.13 6.40% 2/13/98 22 Intel 84.67 84.42 -0.30% 5/26/98 18 AmExpress 104.07 96.88 -6.91% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Eastman Ko 63.15 85.50 35.40% 3/12/98 20 Exxon 64.34 70.38 9.39% 3/12/98 15 Chevron 83.34 78.19 -6.19% 3/12/98 17 General Mo 72.41 64.50 -10.92% Cash-King Stocks Rec'd # Security In At Value Change 2/3/98 24 Microsoft 1878.45 2706.00 $827.55 2/3/98 22 Pfizer 1810.58 2343.00 $532.42 5/1/98 37 Gap Inc. 1890.33 2368.00 $477.67 6/23/98 23 Cisco Syst 1985.95 2390.56 $404.61 2/27/98 27 Coca-Cola 1865.89 2163.38 $297.49 8/21/98 22 Schering P 2111.7 2246.75 $135.05 2/6/98 56 T. Rowe Pr 1885.70 2016.00 $130.30 2/13/98 22 Intel 1862.83 1857.28 -$5.55 5/26/98 18 AmExpress 1873.20 1743.75 -$129.45 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Eastman Ko 1262.95 1710.00 $447.05 3/12/98 20 Exxon 1286.70 1407.50 $120.80 3/12/98 15 Chevron 1250.14 1172.81 -$77.33 3/12/98 17 General Mo 1230.89 1096.50 -$134.39 CASH $48.07 TOTAL $25269.60 *Please note: On 8/4/98 $2,000 cash was added to the
portfolio for future investment. This will be reflected
in the numbers as soon as possible.
*The year for the S&P and Nasdaq will be as of 02/03/98