Motley Fool Hidden Gems subscribers had a good 2004. Over 12 months, our recommendations returned average gains of 24% against a mere 6% increase for equal amounts bought in the S&P 500. Since our service opened for business, we've outperformed proportionately, with Tom Gardner and guests racking up 39% total average returns vs. the market's 9%.
We're not at all certain that these kinds of returns are sustainable. When you consider that the average historical return from the American stock market is just 10.5%, promising continued 27% annual returns would border on hubris. That's especially true when market gurus left and right are decrying the run-up in stock prices that took place at the end of 2004, saying it's next to impossible to find bargains in common stock anymore. And we agree, it's not easy to find bargains out there anymore. But you can make the task easier by knowing where to look.
Last week, we reviewed a few very useful and easy-to-find metrics for quickly getting a handle on a company's investment potential. By running a stock through these seven steps, you can quickly get an idea of whether it merits further investigation, or whether you're better off tossing it aside and looking elsewhere. Once more, the seven metrics are:
- Market cap
- Enterprise value-to-free cash flow (EV/FCF)
- Historical and projected earnings growth
- EV/FCF/Growth
- Return on equity (ROE)
- Insider ownership
- Share dilution
The first six figures can be easily discovered with a bit of clicking around Yahoo! Finance's website. The last one, share dilution, is a little trickier, but you can work it out without too much trouble from financial statements.
Now, veteran investors may argue there are other metrics that give an even better picture of a company's financial condition. I agree completely. For instance, return on invested capital (ROIC) is a great tool, and one that becomes especially useful when you need to analyze a company with a heavy debt load. And Fool co-founder Tom Gardner emphasizes the concept of "owner earnings" for accurately gauging a small-cap company's true cash-generating power.
But while I admit that there are other, more math-intensive metrics available, to borrow a phrase from Henry David Thoreau, I prefer to "simplify, simplify." After all, there are over 8,000 small caps currently trading in the United States. The simpler and more efficient your tools, the faster you can dig through this gigantic corporate gravel pit and find the real gems. We cannot afford to get distracted by moss-bound boulders of the IBM (NYSE:IBM) variety, or to waste time picking at profitless specks of fool's gold like Ciena (NASDAQ:CIEN) -- there's real gold in them thar hills! On that note, here is my five-minute drill for quickly sizing up whether a given company is a possible gem -- or just another hunk of rock.
Market cap
Companies come in all sizes. Some are as big and beautiful as the Hope Diamond. Southwest Airlines (NYSE:LUV), for example, stands out as a jewel of large-cap land. But if you want a Hope, you have to expect a big price tag -- 46 times trailing earnings in Southwest's case. At Hidden Gems, we won't sacrifice quality, but we prefer to do our shopping on the cheap. A set of quarter-carat diamond studs from Blue Nile (NASDAQ:NILE), shipped free of charge, would do us just fine. And in fact, Blue Nile, the company, is itself the ideal size for a potential Hidden Gem: comfortably situated between our market cap limits of $100 million and $2 billion.
Enterprise value-to-free cash flow
Market cap is just one of seven factors I consider, mind you. If I find a large-cap company at a discount price, sometimes I just can't resist buying. So for instance, when last year I found mobile phone king Nokia (NYSE:NOK) selling for an EV/FCF ratio of just seven, the fact that its market cap was a scale-busting $50 billion did not stop me from buying. A bargain's a bargain, whatever the size.
And how do I define "bargain?" An EV/FCF ratio of 10 or less gets my attention real quick. Anything pricier than that, and I need to take a good hard look at the company's growth rate and EV/FCF/G ratio.
Historical and projected earnings growth rates
All I want to say about growth rates is that you should always go with your most conservative guesstimate. Because whether you are a professional analyst, a serious individual investor, or a newcomer to investing, when it comes to the future, we are really all just guessing.
So if, for example, you've noticed that a panel of anonymous "experts" thinks Applied Materials (NASDAQ:AMAT) is going to increase its earnings at a 15% per annum rate, then great. Let the experts buy it. You, on the other hand, should note the company's historic pattern of earnings declining by 20% per year over the past five years, and factor that into your equation.
EV/FCF/Growth
Picking a conservative growth rate estimate is crucial because of the huge effect it has on your EV/FCF/G calculation. An otherwise cheap company with an EV/FCF of 10 might look like a classic value play in the Benjamin Graham sense of yielding a 0.66 ratio when you use 15% as your growth estimate. But tread warily, dear Fool. If the company produces slower growth -- or worse, if earnings decline rather than grow -- you may find you have bought yourself one terribly overvalued stock.
As for the number I like to emerge from my EV/FCF/G calculation, I find a nice, round 1.0 quite appealing. On the one hand, I like the number because it offers a Graham-sized margin of safety to the market's current EV/FCF/G ratio of roughly 1.5. On the other, I like it because, in my experience, companies with ratios of 1.0 tend to double in value in relatively short order. (Sadly, they usually do this while I am still sitting on the sidelines, hoping they will get just a little bit cheaper before I buy -- a habit I am trying to break.)
Return on equity
If the uncertainty and guesswork involved in estimating a company's earnings growth potential makes you a little queasy, consider a more definite method many Fools have been experimenting with and run an EV/FCF/ROE calculation instead. The math is just as easy, and the principle is pretty much the same: You want the EV/FCF valuation to be lower than the company's return on equity -- the number that measures how efficiently the company invests in its own business. As with EV/FCF/G, the bigger the denominator (ROE), and the tinier the result of the full calculation, the better. (In other words, 1.0 is good. 1.5 or more is not as good.)
Insider ownership
This one is both straightforward and tricky. The more insider ownership, the better -- up to a certain point. If company officers, directors, etc., own a significant stake in a company, they have a strong incentive to run the it well, use funds efficiently, and keep a tight leash on share dilution. On the other hand, if insiders own too many shares, they effectively have control over the business and can run it any darn way they like. Personally, I like to see double-digit insider ownership, say at least 10%, but no more than 50%. Truth be told, one of the reasons I haven't yet invested in one of my otherwise favorite companies, The Thomson Corporation (NYSE:TOC), is precisely because it has an insider ownership of well over 50%.
Share dilution
Read my lips: no new shares. Period. I hate share dilution with a vengeance that borders on rabidity. Companies that dilute minority shareholders at double-digit rates will not receive the benefit of my investing dollars under any circumstances. Share dilution of 3% or less will win my (grudging) approval, but only if all the other numbers look good.
And there you have it, folks. My seven-step program to finding potential small-cap winners. Give it a spin yourself, and when you think you have found a winner, share the good news on the Hidden GemsStocks That Interest You board.
Speaking of which, if you sign up now for a free trial subscription to Hidden Gems, you'll receive instant access to all of our discussion boards at no extra charge, plus two official Hidden Gems recommendations vetted by Fool co-founder Tom Gardner. After the first month, you're welcome to stay for as long as you like, but if you have to leave, we'll refund the entire unused portion of your subscription fee, no questions asked, no strings attached. You have our word on it.
Fool contributor Rich Smith owns shares of Nokia, but has no position in any other company mentioned in this article. The Motley Fool is investors writing for investors.
