This is the third in a short series of blog posts covering my stock screen and investment strategy updates for 2019 and beyond.
Here’s a list of the posts so far:
- Why I’ll be looking at reported earnings instead of adjusted earnings from now on
- Why I’m measuring capital employed growth instead of earnings growth
- This post
- Factoring in the risk of excessive corporate debt
- Investing in turnarounds, recovery stocks and corporate transformations
Note: This post covers an update to my Profitability metric. If you’re not familiar with it then here’s a link to the original blog post from 2014. And here’s a link to the related and updated Company Analysis Spreadsheet (XLS).
Profitability is obviously an important characteristic; if a company never makes a profit then it’s unlikely to make a good long-term investment.
However, there are various ways to measure profitability, with each highlighting different aspects of the company in question.
So far, my preferred measure of profitability has been return on capital employed:
Return on capital employed: Measuring the returns on shareholder and debt holder capital
Specifically, I currently look at net return on capital employed (net ROCE), where:
Net ROCE = net profit / (shareholder equity + total borrowings)
I use return on capital employed because it says something about the sort of returns a company might achieve on any future earnings retained within the business.
Future returns on retained earnings are important because those earnings belong to shareholders and, rationally, you want your earnings to be invested at a good rate of return, whether that’s by you reinvesting dividends or management reinvesting retained earnings.
If a company cannot produce returns on retained earnings (or capital employed) of at least 7%, then it would probably be better if those earnings were returned to shareholders as a dividend to see if they could get a better rate of return somewhere else.
But return on capital employed is only one side of the profitability puzzle. Another equally valid angle is to look at net return on sales.
Small profit margins mean a small margin of safety
Net return on sales, or net profit margins, don’t tell you anything about the sort of returns the company can get on retained earnings, but they do tell you something about how risky those returns might be.
That’s because net profit margins are the difference between revenues and expenses, and the smaller the difference the more sensitive profits are to any changes in revenues and expenses.
In other words, the smaller the net profit margin, the smaller the company’s margin of safety becomes.
Here’s a quick example:
Imagine Company T, which generates profits of £100m on capital employed of £1 billion. That’s a 10% return on capital employed, with isn’t bad.
But what if Company T has to generates sales of £4 billion to get that £100m profit? In that case, revenues are £4 billion, expenses are £3.9 billion and net profit margins are 2.5%.
What if a new competitor (Company W) turns up which can provide the same product or service as Company T but with a 1% lower sale price?
Since Company T has no significant competitive advantages, it has to lower its prices by 1% to compete with Company W.
But a 1% decline in sales price will wipe £40 million off its revenues, and since its costs remain the same, that reduction goes straight to the bottom line, reducing profits from £100m to £60m.
In other words, Company T’s profits decline by 40% because of a 1% reduction in sales prices.
The same situation can occur when expenses increase and the increases cannot be passed onto customers in the form of price increases.
This sensitivity to income or expense pressures makes thin profit margin companies more risky than their fat profit margin peers.
And that’s the main reason I’m going to start measuring net return on sales (averaged over ten years) as well as returns on capital employed.
Thin margin companies are often poor investments
For some real world examples of the risks of thin margin companies, here are the profitability numbers for all the loss-making investments I’ve made since 2011, as they were at the time of purchase:
- Serco (outsourcing)
- 10yr average net return on sales = 3.4%
- 10yr average net return on capital employed = 8.6%
- Tesco (supermarket)
- 10yr average net return on sales = 4.2%
- 10yr average net return on capital employed = 10.1%
- Chemring (missiles, explosives, pyrotechnics)
- 10yr average net return on sales = 11.0%
- 10yr average net return on capital employed = 11.4%
- Standard Chartered (bank)
- 10yr average net return on sales = not applicable to banks
- Wm Morrison (supermarket)
- 10yr average net return on sales = 2.9%
- 10yr average net return on capital employed = 7.0%
- Braemar Shipping (shipbroker)
- 10yr average net return on sales = 9.0%
- 10yr average net return on capital employed = 17.9%
In all relevant cases (i.e. excluding Standard Chartered), return on capital employed was above my 7% lower limit, so their returns on shareholder and debt holder capital weren’t terrible.
But in half of these loss-making investments (Serco, Tesco and Wm Morrison) the ten-year average net return on sale was below 5%. This, I think, was a sign that these companies were risky and had little or no material competitive advantage.
For the two companies that did have reasonable net margins, they had separate issues; excessive debts and acquisitions in the case of Chemring and an excessive price paid for a highly cyclical company in the case of Braemar Shipping.
So while healthy profit margins don’t guarantee success, thin profit margins are highly correlated with fragile profits.
And to show you what fragile profits look like, here’s a chart showing Serco’s weak returns on sales, just before its thin profits turned into very fat losses:
Taking account of return on sales
Because of its ability to highlight potentially risky companies, I’ll be including net return on sales in my Profitability metric like so:
Profitability = 10yr average of net return on sales and net return on capital employed
This will reduce the Profitability score for low margin companies, which will give them a worse rank on my stock screen.
I also want to set a minimum standard for returns on sales, below which a company will be deemed ‘too risky’.
But what I don’t want to do is exclude large numbers of companies whose business models necessitate relatively thin margins (e.g. supermarkets or energy suppliers), so I’ve set an initially conservative minimum standard for net return on sales of 5%.
I’m also going to tweak my existing rule for return on capital employed, so that the minimum acceptable level is 10% instead of the existing 7%.
And I’m going to add a new rule, that the average of return on sales and return on capital employed is above 10% as well. That should rule out companies with marginal returns on sales and/or capital employed.
This will hopefully take me one step further away from weak value traps, without being overly restrictive and ruling out the vast majority of ‘good’ rather than ‘outstanding’ companies (as I think ‘good’ companies can be outstanding investments at the right price):
Only invest in companies where the:
- Ten-year average net return on sales is above 5%
- Ten-year average net return on capital employed is above 10%
- Ten-Year average of net return on sales and return on capital employed is above 10%
The next article in this series will cover a few minor tweaks to my Debt Ratio.
“”””But what I don’t want to do is exclude large numbers of companies whose business models necessitate relatively thin margins (e.g. supermarkets or energy suppliers), so I’ve set an initially conservative minimum standard for net return on sales of 5%.”””
John, Not sure I understand what this means – it seems, unless I’ve read it incorrectly to contradict the theme of the article.
By the very definition now, supermarkets margins have been cut so thin because of the massive growth in competition – i.e. it seems to me there are as many supermarkets and supermarket related outlets as people these days (OK slight exaggeration) — a 1-3% margin is where they all seem to be at and I don’t see that changing.
Supermarkets, outsourcing companies and most commodity companies are I’m afraid to say – are as good as gone from my watch list.
Looking also at ROCE — and this is interpreted differently in different industries as you have pointed out on occasions, of 7% seems far too low when there are so many good companies earning north of 15%.
Well I guess the newsletter from Terry Smith covers that aspect well, and the relationship with debt and interest cover in companies, and what that means to risk.
If anyone hasn’t read it and wants to it’s in this link :-
https://www.fundsmith.co.uk/docs/default-source/analysis—annual-letters/annual-letter-to-shareholders-2018.pdf?sfvrsn=8
I read it a couple of times and it’s good food for thought.
LR
Hi LR
Whether a 5% limit contradicts the gist of the article depends on your definition of low margin.
We have slightly different styles of investing, so what you think is unacceptably low (e.g. 5% net margin) is okay as far as I’m concerned, at least until proven otherwise.
And 5% isn’t that low; it pretty much rules out any outsourcing companies and supermarkets. But I’m happy to adjust that limit upwards if I have problems with companies in the 5% to 10% net margin range.
As for ROCE, 10% is about average for companies on my stock scren, so that’s a reasonable minimum. I originally went with 7% because that’s the long-run rate of return on stocks, so a 7% net ROCE (i.e. post tax, so lower than standard ROCE which uses operating profit or EBIT) will be above the company’s cost of capital and therefore acceptable.
I’m not after ‘great’ or ‘outstanding’ businesses; I’m after above average companies (even slightly above average) or better, and at below average or better prices.
And thanks for the link to Terry’s latest letter; it usually contains some good points.
John, could you please clarify exactly which earnings to use and the name in SharePad?
e.g. use EBIT for all ROCE calculations which is “ROCE lease-adjusted” in SharePad.
e.g. use post-tax earnings for all sales calculations which is “profit to turnover” in SharePad.
Hi Ken
I don’t calculate ratios in SharePad; instead I extract the data into my spreadsheets which then calculate the ratios.
So for example, ROCE is (using SharePad terminology):
Reported Earnings / (NAV + Total Borrowings)
Where NAV is net asset value. Reported Earnings are first converted from per share figures into total figures (i.e. profit after tax) using Diluted Shares (i.e. divide by 100 to turn pence into pounds and then multiply by Diluted Shares to get the total figure).
As you point out, ROCE is typically calculated using EBIT, but I use Reported Earnings (i.e. post-tax profit) because it’s simpler, it works out lower for companies with higher interest charges (which makes them look less attractive) and in most cases it doesn’t make much difference whether you use EBIT or post-tax profit anyway.
As for my return on sales (net profit margin) figure, it’s:
Reported Earnings / Turnover
Again, with Reported Earnings (per share) converted into total Post-tax profit.
So basically the only earnings figure I use is Reported Earnings, or post-tax profit, and I use that for any returns-based ratios.
Here’s a link to a snapshot of my ‘custom’ page in SharePad, showing my current setup:
SharePad custom page for Ted Baker
John, thank you for sharing the SharePad screen-shot. Should I attempt to build my own custom page or is there a free resource on your website that I can import into SharePad?
LR, thank you for recommending the Terry Smith article. It is interesting to observe the overlap with ukvalueinvestor and other strategies.
ROCE is the main quality metric. Smith also mentions: gross margin, operating margin, cash conversion and interest cover (but he allows high debt).
The value metric is “weighted average free cash flow (‘FCF’) yield (the free cash flow generated by the companies divided by their market value)”, which is 4.0% for his fund.
He mocks ‘value investors’ and the 4.0% FCF is low (median for S&P500 is 5%). This suggests he over-weights ‘quality’ and under-weights ‘value’. This is different from Greenblatt who gives both factors equal weight.
Smith omits ‘dividend yield’ as a factor (a cornerstone of ukvalueinvestor and other approaches like “Dogs of the Dow”).
I’m curious what other people think because it appears to me that Smith’s 8 years of performance success are undeniable but coincide with market conditions favourable to the glamour style. Let’s observe whether he adjusts his style in future. I admire a strategist who reflects and evolves, as John has done in this mini-series of blogs posts. I can recommend a good book to Smith that has “defensive value” in the title 😉
Hi Ken
I’m not much of a SharePad expert, so I couldn’t see how to ‘export’ its custom data page so that another user can install it.
However, it’s pretty easy to create a custom page of your own, so I’d suggest setting up your custom page by replicating the rows from my screenshot. Note that in the screenshot my custom page is missing the ‘depreciation & amortisation’ row (should be between capex and acquisitions). If you include that row then you’ll be able to copy/paste straight from SharePad into my latest Company Analysis spreadsheet (in SharePad you can export to a spreadsheet by clicking on Sharing / Export Data). If you need any help with that just send me a message via the contact page or an email.
As for Terry Smith reading my book, I think the chances of that are pretty slim!
“market conditions favourable to the glamour style”
Ken – I know where you are coming from with the sexy momentum style stocks, but Terry Smith doesn’t operate in those areas. Some of his holdings have high P/Es but most operate in particularly non sex or glamourous areas.
Estee Lauder and L’Oreal yes granted, but the vast majority of his stocks are boring old school – Microsoft, PayPal, Intertek (testing), Intercontinental Hotels, 3M, Visa, Amadeus (flight ticketing), Mastercard, Philip Morris, Diageo, Unilever, Sage, Pepsico, Johnson & Johnson, Intuit, Colgate, Novo Nordisk (Insulin), Kone (lifts), Stryker (hips and joints), etc –
His latest in roads into Facebook look like a more undervalued situation, given the emotional hammering it’s had. It’s even more undervalued now lol !
One thing that is pretty clear though is that most of the companies he invests in have strong footholds in their sphere and some dominate.
If I look at my own portfolio, I probably have about 9 of those in his Equity fund and I wonder should I have had more – certainly that’s true over the last 5 years.
Ted Baker’s glamourous, but it’s also had a few problems, but it’s darn cheap for the quality of the company and it’s consistent long term results.
Joules is a steal if you want long term glamerous from a low base and from a smaller company with less public history – I feel sure that if it had a 10 year public history with the current valuation John would have it in his top 50, but then again — maybe I’ll have to write his wife and ask her to start stocking up on English country style from Joules !!
LR – end of fashion promotion lol !!