A Matter of Quality
As many here know, I preach quality of a company above any other consideration when deciding what to trade. Timing is a different matter.
Quality is determined by an objective assessment of one company’s stock versus all others in the universe. The universe could be all the stocks that trade in the world, in a country, on an exchange, in an index, sector, industry or group. The assessment tool could be whatever criteria is of interest to you. For me I use a computer algorithm that studies many factors such as changes in enterprise values, revenue growth, earnings quality, earnings and revenue revisions, dividend yield, and analyst consensus.
Earnings quality is important because reported Earnings Per Share figures can be engineered by a company’s board of directors. Too often the sell-side of the financial services industry leads you to believe that share buy-backs are only a good thing. Nonsense. Yes EPS improves but the balance sheet quality weakens.
Here is an example from the news of the day as reported by Investopedia:
This week, SAIC (NYSE: SAIC) announced a plan to buy back as many as five million shares, representing a nearly 11% reduction of its approximately 46 million shares outstanding.
This does not guarantee the company will execute any repurchases. As SAIC confided in its announcement of the program, “whether any repurchases are made and the timing and actual number of shares repurchased will depend on a variety of factors, including price, corporate, contractual, and regulatory requirements and other market conditions.”
Indeed, SAIC approved a five million share buyback program in October 2013, but the company repurchased just 3.5 million shares of that authorization. Assuming the company proceeds at a similar pace, the program would still amount to $145 million at current price levels, amounting to an approximately 7.5% reduction in outstanding shares.
Last quarter, SAIC reported a 35% drop in quarterly profit year-over-year, despite respectable 15% revenue growth. Analysts currently predict that earnings growth for SAIC in the current constrained federal spending environment will remain slow and average just 5% annually over the next five years.
But reducing the size of SAIC’s share count by 7.5% would concentrate earnings among fewer shares remaining and improve earnings per share by more than 8%. If implemented in full, an 11% reduction in SAIC’s share count would boost earnings per share by more than 12%. Given the anemic projections for organic earnings growth, buyback-fueled growth in per share earnings could easily exceed organic earnings growth at the company — and even turn into the company’s primary driver of earnings growth going forward.
My quality rating on SAIC is 3.8 out of 10, which means that in a universe of about 5,000 US companies, I rate about 62% of the companies higher in quality than SAIC.
For interest sake, you should be aware that the Cara 300 tradeable stock universe has an average rating of 8.3 for large-cap, 7.9 for mid-cap and 9.5 for small-cap groups. The Cara 100 that I posted previously, which I carefully selected from the Cara 300 universe, has an average quality rating of 9.7.
If you can stick with the highest quality companies and hold positions on the right side of trend, I believe your portfolio will perform well.
If you stick to sell-side stories about EPS growth without looking at the quality of those earnings, you will likely be disappointed.
On a different subject altogether, I find the breaking news about massive consumer fraud by Volkswagen, and maybe other vehicle manufacturers, related to programmed algorithms designed to fool examinations by Environmental Protection Agencies to be outrageous. This is yet another example of why all governments must outlaw so-called Self-Regulatory Organizations in financial services. The bigger the business, the bigger the fraudster.
http://www.reuters.com/article/2015/09/23/us-usa-volkswagen-idUSKCN0RL0II20150923
The US EPA says the fines against Volkswagen could be in the region of $18 billion. But why penalize the consumer and the shareholder? Simply claw back the full compensation of executive management and the Board of Directors since the time this fraud began, and remove every director of the company. Hurt the perpetrators!
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