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:
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):
The next article in this series will cover a few minor tweaks to my Debt Ratio.