To Identify Resilience, Check a Company’s Vital Signs

The Motley Fool recently held its first-ever, fully virtual conference for FoolFest 2020 for subscribers of its various services, and it was awesome! While we surely missed hanging out in person with Fools (friends) from around the world, this virtual version was the next best thing, and I want to send huge props to our events team and all the Fools who helped make the digital magic happen.

A few weeks before the conference, the investing team here at The Motley Fool was asked to sign up for topics that we wanted to give a presentation on. Before I could sign up, Motley Fool Chief Investment Officer Andy Cross and Chief Operating Officer for the Investing Team Ron Gross drafted me to discuss business resilience. They know this is a topic near and dear to my heart, and the subject was also quite timely as the U.S. faces a global pandemic and economic shutdown.

For FoolFest, we were asked to keep our presentations very concise (under 20 minutes). What follows here is a longer, more complete version of that presentation.

Image source: Getty Images.

Identifying resilience begins with research

I have an investing checklist that I run through with each company I cover. For this presentation, I want to focus on three of the checks I use (but organized into four sections). Each of these checks plays a key role in pointing out long-term resilience in a company (they can also be explained well visually).

Think of these checks as the "vital signs" that help determine the health of a business. Just as a doctor or nurse usually starts a health exam by checking a patient's vital signs, I begin researching a new business by measuring its vital signs. Even after I've invested, I monitor the health of the businesses by regularly taking their vital signs each time I perform a company "checkup." This allows me to track (and chart plot) whether the company's health is improving or deteriorating over time.

These four vital signs are:

1. A strong balance sheet
2. High or increasing returns on invested capital (ROIC)
3. Growth on the top line (revenue)
4. Growth on the bottom line (earnings)

There are other important components of business resilience, including unique business models, competitive advantages (moats), excellent leadership, and a track record and culture of innovation and adaptability. But this report is focused on vital signs, so these other areas will need to be expanded on another time.

Prologue: Leadership builds great businesses

Before we dig down on vital signs, I do want to quickly make a few comments about company management.

My friend Rishi Gosalia, the managing partner of SF Value Capital, writes that he aims to invest in companies "committed to a mission that goes beyond profit maximization." The SF Value Capital website states that its goal is:

"...to invest in mission-driven companies that have ever-improving products and services and are run for the benefit of all stakeholders. Our companies are led by management teams that are dedicated to accomplishing the company's mission and consider it as their life's work."

I have since adopted Rishi's criteria for businesses committed to a mission beyond profit maximization and added it to my own checklist. Thank you, Rishi.

It's people who build great businesses. Leaders set the mission or purpose, which is the company's guiding light and reason for existing. As Rishi explains, great leaders rally and align all key stakeholders to accomplish the mission. Profits are important because they provide resilience and can help a company direct resources to its stakeholders. But profits, by themselves, are not the mission. Maximizing profits at the expense of other key stakeholders is not the reason for existing and, in fact, is a recipe for business disaster. Rather, the way to maximize long-term profits is to stay focused on the mission and to create shared value for all key stakeholders.

Brad Slingerlend and Brinton Johns at NZS Capital explain in their 2020 mid-year update:

"We believe companies that maximize non-zero-sum outcomes for all of their constituents, including employees, customers, suppliers, society, and the environment, will also maximize long-term outcomes for investors."

I couldn't agree more, and that philosophy is my guiding light as an investor.

Leaders also determine the business model. They set the strategy and pick the markets a company operates in. Leaders determine when it's appropriate to push the growth pedal to the floor and when it's appropriate to throttle growth down. Leaders determine the balance sheet strategy and choose to either pursue profitable growth or growth at any cost. Leaders build teams and allocate human and financial capital.

Great leaders build and nurture a corporate culture that is compassionate and committed to doing what's right for all key stakeholders. Great leaders make sure that a company is innovating and adapting and remaining agile in a digital world where change is constant and accelerating. Great leaders find (and even create) new avenues for growth! In other words, great leaders create a culture of adaptability and agility in order to future-proof the business, and it is this culture of adaptability that is the greatest source of competitive advantage in the rapidly changing digital world. In short, great leaders make sure that the company's products and services reflect the future rather than the past.

Please know that corporate leadership (and the cultures it builds) is the common thread that weaves and holds the resilience framework together. Businesses can't have sustainably strong vital signs without strong leadership!

Speaking again of vital signs, let's jump into the first foundational pillar of business resilience: The balance sheet.

Image source: Getty Images.

Vital sign No. 1: Strong balance sheets

The balance sheet is where the search for a resilient business starts (and ends). If the business doesn't pass this first filter, then my research stops and I move on. The balance sheet is the structural foundation of a business, and history shows that a sustainable and resilient business cannot be built atop a weak foundation.

When analyzing and stress-testing a balance sheet, I ask myself a dozen (or more) questions. These include:

1. Are the company's debt and net debt levels increasing or decreasing?
2. What is the cyclicality and capital intensity of the industry?
3. What is the company's cost of debt and its maturities on its debt?
4. What percentage of the debt is fixed-rate versus variable-rate?
5. What percentage of the debt is corporate debt versus bank debt?
6. What are the company's financial health ratios, such as net debt-to-free cash flow, debt-to-capital, and interest coverage?

But if you want to maximize resiliency, you should look for one metric on the balance sheet above all others -- net cash!

Net cash is simply total cash (and cash equivalents) minus total debt. In other words, does the company have more cash than debt? Large net cash is the ultimate measure of resiliency because it enables the company to play both defense and offense. Large net cash lets companies weather almost any financial storm (the defense), and also provides optionality by allowing a company to invest aggressively in long-term growth opportunities (at distressed prices) when most other businesses are struggling to survive (the offense). The offensive quality of net cash allows companies to not only remain resilient but also antifragile. This means that they can come out of any crisis even stronger.

Finally, large net cash positions play a significant role in equity valuation. When we build a discounted cash flow (or DCF) model, we first calculate the firm (or enterprise) value, and then we add net cash (meaning we subtract debt and add cash) to get the value of the equity.

Vital sign No. 2: High or increasing returns on invested capital (ROIC)

Return on invested capital (or ROIC) is the ultimate measure of business profitability and performance. It is calculated as net operating profit after tax (NOPAT) divided by invested capital. Here's a simple formula to show you just how powerful ROIC really is. That formula is ROIC times Reinvestment Rate equals Operating Profit Growth.

Source: Adapted from McKinsey & Co. book Valuation: Measuring and Managing the Value of Companies

The chart above is a scenario I sampled from the McKinsey & Co. book Valuation: Measuring and Managing the Value of Companies. Assume we have two companies (Company A and Company B) that aim to grow earnings at a rate of 5% per year, but Company A has a ROIC of 20% and Company B has a ROIC of only 10%. Under these parameters, Company A only has to reinvest 25% of its profits to grow earnings 5% (20% x 25% = 5%), but Company B has to reinvest 50% of its profits to grow earnings at the same 5% rate (10% x 50% = 5%).

The chart shows that Company B has half the ROIC, so its reinvestment must be double to grow at the same rate as Company A. The company with the higher ROIC has a lower reinvestment rate and will need to reinvest less capital to achieve the same level of earnings growth. And because the higher-ROIC business requires less capital (or reinvestment) to grow, it generates higher free cash flow (FCF), and free cash flow is what determines intrinsic value. Free cash flow is calculated as NOPAT less change in invested capital. (For those keeping score, both ROIC and FCF are calculated using two numbers, NOPAT and invested capital).

Mathematically, ROIC is a primary driver of both profitability (earnings) and FCF generation. Mathematically, companies with higher ROIC generate more FCF per dollar of earnings (we're assuming that both companies generate the same dollar amount of earnings, but the company with higher ROIC generates more cash flow). And mathematically, ROIC is a driver of growth.

In fact, there are research reports that explain how a company cannot grow operating profit faster than its incremental ROIC without taking on outside financing. Basically, a business that generates a ROIC of 20% can't grow operating profit faster than 20%, and to do so it must reinvest 100% of its profits (20% x 100% = 20%).

Here is where it gets really good.

Image source: Getty Images.

Because these high-ROIC businesses generate so much FCF, they can finance their growth internally, rather than relying on outside capital (other people's money) to grow. This means less debt or less equity dilution for shareholders. They can invest more in fortifying their moats. They can invest in new initiatives to build new moats and new profitable growth streams over time. They can invest in taking care of stakeholders, including employees, customers, suppliers, communities, and the planet (through green energy programs). They can set their own time frames, remain adaptable, and future-proof their businesses.

Finally, some of the excess FCF can be used to pay down existing debt, and what's left over will sit on the balance sheet to build up an even larger net cash position, which further strengthens the balance sheet and builds that optionality mentioned with vital sign No. 1.

Common terms used to describe high-ROIC businesses are "self-funding," "asset-light," "free cash flow machines," and/or "compounders." No matter what people call them, we should all love them.

ROIC is the linchpin that connects a company's profitability, free cash flow, and balance sheet.

Here's why companies that generate high ROIC outperform the market over time:

Note: R2000 = Russell 2000 Stock Index. Sources: Segall Bryant & Hamill Small Cap Team and Furey Research. Data as of Jan. 1, 2004, through June 30, 2019. Past performance is not indicative of future results.

And companies that generate rising ROIC outperform the overall market even more:

Note: R2000 = Russell 2000 stock index. Source: Segall Bryant & Hamill Small Cap Team and Furey Research. Data as of Jan. 1, 2004, through June 30, 2019. Past performance is not indicative of future results.

Companies that generate high economic value added (EVA) metrics also outperform the market over time. The "economic value-added" metric is very similar to ROIC and FCF because it is also calculated using those two all-important numbers of NOPAT and invested capital (this is not a coincidence). EVA is calculated with NOPAT, invested capital, and cost of capital. If you haven't noticed yet, I think it's really important, and even crucial, that NOPAT and invested capital are analyzed deeply and calculated correctly.

SOURCE: Data provided by ISS EVA, a division of Institutional Shareholder Services Inc. For more information please visit https://www.issgovernance.com/eva

Vital sign No. 3: Organic revenue growth powered by long-term tailwinds

"I believe that the greatest investments of our lives will be into companies with superlative top-line growth rates extended over long periods of time. Great companies foster and serve high rates of demand." -- Tom Gardner

With vital sign No. 2, I showed you that ROIC is one of the primary drivers of FCF and, ultimately, of business value. The other primary driver is revenue growth. In fact, high ROIC without revenue growth can't compete with high (or rising) ROIC with revenue growth. High (or rising) ROIC plus organic revenue growth is equal to compounding awesomeness!

When I analyze a company's top line (or revenue) growth, I'm really looking for (1) revenue growth that is organic and powered by long-term secular themes, and (2) revenue that is recurring.

In most cases, it's better if most of a company's revenue growth is organic, meaning it doesn't come from acquisitions. This is because the majority of acquisitions destroy shareholder value. But it's also because organic revenue growth is a sign that the company's investments and innovations are creating product or service relevance and demand. That's so important. An acceleration in the rate of top-line growth can be a sign that the company is taking market share and that product or service relevance and demand are increasing. It's also important that it can be sustained for a very long time.

This means we're really looking for corporate management teams committed to innovation and adaptation, and for organic revenue growth powered by long-duration secular trends. Conversely, it's equally important to avoid companies that are facing headwinds and experiencing falling product demand, falling product relevance, and therefore falling revenue.

It's much easier for a company to grow (and, importantly, to grow longer than the market expects) if it's riding a powerful wave, rather than trying to swim against the current. Growth driven by long-term tailwinds also helps insulate a company from short-term fads and cyclicality. In other words, the growth is driven by innovation and a large and growing market opportunity rather than by GDP.

As I said above, great companies find and even create new ways to grow!

Image source: Getty Images.

As for recurring revenue, it increases business resilience because it is revenue that is generated through long-term contracts, subscription services, consumables (which are use-once-and-dispose-of items), daily habits or pleasures, and/or mission-critical products and services. Revenue driven by these sources is more reliable and predictable because it is less tied to economic cycles and GDP growth. The companies with the strongest recurring revenue provide a trifecta of the best product or service, with the best customer service, and very close relationships with customers that create constant feedback and innovation. These innovating businesses live inside, and become part of the fabric of, their customers' operations, allowing them to rapidly incorporate feedback into future product development in order to avoid disruption and remain ahead of the innovation curve.

In short, recurring revenue is an indication of a loyal or captive repeat customer that provides a stable and predictable core base of business. This stable core provides resiliency in economic downturns and a launchpad for future growth coming out of the downturn.

Vital sign No. 4: Earnings growth

When discussing vital sign No. 3, we looked at the importance of organic top-line growth. Now, let's discuss the importance of the bottom-line -- or earnings -- growth. For the purpose of this section, the terms "earnings" and "profits" should be considered synonymous, and I'm referring to either GAAP net income or GAAP earnings per share (EPS).

For a company to be resilient, it must be growing and profitable. For a company to be truly great (the best of the best), it must be both growing and profitable. Many businesses are really good with one or the other of these concepts, but to be resilient, antifragile, and among the best businesses in the world, it must be able to do both.

We could debate whether GAAP net income is the best measure of profitability until we are blue in the face. Heck, there could be an entire semester-long college course on just that one topic. But the truth is that, at the best businesses run by the best management teams, GAAP earnings are a clean and highly useful measure of business quality. For all of those cash flow investors out there (like myself), earnings (in the form of NOPAT) is a primary driver of FCF.

Image source: Getty Images.

The chart below from Yardeni Research is probably the most important visual in this presentation. It shows two things:

1. Stocks go up over time. Despite all the bear markets and recessions (the gray vertical bars), every single time that the market falls from its previous peak, stocks eventually reach a new high. Not only do stocks go up over time, but they go up over 70% of the time as measured in years (they go up much more often than they go down), so you'll want to remain invested in the stock market.
2. Stocks follow earnings up over time (this is an important topic, so to read more about it, please click here, here, here, here, and here). There is a fundamental reason for this. When you buy a share of stock, you are legally buying a percentage (or an interest) in the future earnings (profits) of the business. That's what you are buying, earnings, and so earnings (or profitability) is what powers stocks higher over time. These earnings can either be paid out to shareholders (owners) as a dividend, or they can be retained, which increases shareholder's (or owner's) equity on the balance sheet. So, net income (or net profits or net earnings) goes to shareholders. These profits allow a company to reinvest in growth, but they also allow a business to properly care for its employees, suppliers, customers, communities, and the planet through various forms of relief in a time of crisis.

Source: Yardeni Research.

In summary...

This is my condensed framework for identifying high-quality, growing, resilient, adaptable businesses. It may be condensed, but I believe it is a great place to start. And remember that corporate management (and the direction and culture that it sets) is really the most important factor -- because People Build Great Businesses!

Finally, I don't personally short stocks. It doesn't sit well with my personal risk profile. But I do have a very good record of identifying winning shorts at The Motley Fool. Do you want to know my secret formula? I just focus on companies with unhealthy or deteriorating vital signs. Basically, I look for companies doing the opposite of what I discussed here. These are companies with large and growing net debt, companies with declining returns on invested capital, and companies with stagnant or declining revenue, earnings, and free cash flow.

A little reward for reaching the end

If you've read the report to this point, then you deserve a prize. Here are two lists of companies (divided up by market cap to aid in making comparisons) that have great vital signs, meaning they have net cash, high or rising ROIC, and growing revenue and earnings:

NOTES: All data as of Aug. 14, 2020. Debt includes capital leases. CAGR = Compound Annual Growth Rate; TTM = Trailing 12 Months. Revenue and net income CAGRs calculated through fiscal year-end 2019 because 2020 is a very weird year. ServiceNow and Square just turned GAAP profitable in 2019, so it hasn't been long enough to calculate a five-year CAGR. Square went public in 2015 -- not long enough to calculate a five-year CAGR. Square was calculated using a three-year CAGR for revenue and a three-year average for ROIC. Zoom Video is too new to do many of the calculations and a three-year revenue CAGR is used. Sources: S&P Global Market Intelligence and New Constructs.

NOTES: All data as of Aug. 14, 2020. Debt includes capital leases. CAGR = Compound Annual Growth Rate; TTM = Trailing 12 Months. Revenue and net income CAGRs calculated through fiscal year-end 2019 because 2020 is a very weird year. Paylocity has generated positive net income for the past three consecutive years, but not long enough to calculate a five-year CAGR. Take-Two has generated positive net income for the past four consecutive years, but not long enough to calculate a five-year CAGR. SolarEdge had a fiscal year change in 2016, which makes calculating a five-year CAGR difficult. Instead, a three-year CAGR for revenue and net income and a three-year average for ROIC was used. Sources: S&P Global Market Intelligence and New Constructs.

I consider this a high-conviction resilience stock portfolio. In the 30-stock portfolio listed above, we see:

• The average net-cash-to-total-assets ratio is 28.4%.
• The five-year revenue CAGR is 20.2%.
• The five-year net income CAGR is 31.3%.
• The five-year average ROIC is 39.9%.
• The trailing 12-month ROIC is 46.6%.

Checking the vital signs is the first step. Now you can take these lists and do further research to see if you think these companies are truly resilient and deserve a place in your portfolio.