BUYING A COMPANY WITH A TWENTY-YEAR TIME HORIZON, PART TWO
ALEXANDRIA, VA (August 8, 1997) -- Today, in our quest to outline the kind of companies we will be looking to add to the Drip Portfolio, we turn to sustainable growth, strong balance sheet and excellent management. In conjunction with the criteria outlined yesterday, these will be the factors we look at when we are analyzing whether or not to purchase a company for this portfolio.
o History of sustained revenue and earnings growth over five years or more
- OR -
o Darn good evidence that past shoddy earnings growth no longer applies
Sustained Revenue and Earnings Growth. While normally we equally rate growth, underlying quality, and value when making investment decisions, for a DRP purchase we want two portions of growth, two portions of underlying quality and only one portion value. We measure growth by increases in revenue and earnings, quality by looking at asset utilization and return on assets, and value by looking at the current price of the company relative to the business fundamentals.
Why do we focus more on revenue and earnings? Long-term price appreciation is driven by earnings growth and multiple expansion. This means stocks rise in price because earnings grow and the multiple of those earnings to the stock price (the P/E multiple) expands. As it is difficult to expand the multiple endlessly, particularly here in late 1997, we want to look more intently for sustainable revenue and earnings growth and less for value, which is determined using multiples to earnings and sales among other financial criteria.
The thesis here is that although the initial purchases might be at a premium to the underlying asset value, the company's earnings growth will make up the difference within five years and the power of that earnings growth will create a market beating return over the next twenty years. Compounding earnings growth over a few decades can make it almost irrelevant whether you buy the company at 42 times earnings or 21 times earnings today.
Darn Good Evidence Shoddy Numbers Are Over. Although earnings growth is more important than underlying value for a DRP investor, if we can find a company that has regained quality and stands in a position to drastically improve earnings growth going forward from prior levels, we may occasionally choose to discount poor past history -- particularly if this history was driven by extreme events that are no longer in play. While in the end the multiple will stop expanding and earnings growth will carry the show, if you get a low multiple to start with it can make for a nice kick to your twenty-year annualized returns if it does go up to a more reasonable level.
o Stable balance sheet with solid or improvement asset utilization
When you are investing money over twenty-year periods, you want to do as much as possible to be sure that the company will not get into financial trouble if business is weak for a short period of time. This means looking at the balance sheet and making sure you are buying a company that knows how to manage its assets. We will spend a lot more time detailing what this means as we continue to look at more individual companies, but for now, Liquid: A Journey Through The Balance Sheet and Return on Equity are good places for readers to starting looking in order to bone up on the terminology. If you get one thing out of reading the Drip Portfolio reports, it is our aim to turn interested readers into veritable financial analysts in these matters -- Foolishly. One of the things beginning investors do not pay enough attention to is asset utilization and return on assets.
o History of attracting and retaining excellent management
Although this is hard to quantify, this is absolutely key. The biggest winners over the past decades have been companies with visionary managements that have been able to train and retain the next generation of leaders. At the very least you should be familiar with the key management at any firm you invest in, but for DRPs, knowing who might be the next generation of management and knowing how they are currently being seasoned is crucial. The best way to examine this is to become a historian of the companies you purchase.
Have a Foolish weekend!
--Randy Befumo, Fool
(Please see the left navigation bar for information on this new portfolio.)
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