Many years ago while reading the Berkshire Hathaway (NYSE:BRK.A) 1986 letter to shareholders, I discovered Mr. Buffett’s ratio, which he calls "Owner Earnings". And to my amazement, in that little footnote Mr. Buffett actually explains how to use it and basically states that it is one of the key ratios that he and Charlie Munger use in analyzing stocks. In that he defined the term “owner earnings” as the cash that is generated by the business operations, regardless of the earnings the company reports to Wall Street. Mr. Buffett: “…we consider the owner earnings figure, not the GAAP [earnings] figure, to be the relevant item for valuation purposes-both for investors in buying stocks and for managers in buying entire businesses.”
“[Owner earnings] represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.”
From this I have spent the last few decades creating and back testing three ratios that incorporate owner earnings in my quantitative analysis of companies and they are:
1) Price to Owner Earnings
Price to Owner Earnings (my own version of Price to Free Cash Flow)
Price per share/(cash flow per share-capital spending per share)
I have back tested this ratio on the DJIA going back 60 years and you can find my research paper on it by going here.
I was able to determine in my back test that buying a stock selling for 15 times or less its Price to Owner Earnings, increases the probability of success dramatically in most cases.
FROIC is basically Free Cash Flow Return on Invested Capital or:
(Cash Flow - Capital Spending)/(Long Term Debt + Shareholder’s Equity)
I look for companies that achieve “Owner Earnings” returns of at least 15% on Main Street for every $1 of “Total Capital Invested”. Basically in the real world of Main Street, far from Wall Street companies that achieve 15%+ on this ratio are making a lot of money, so logically if you have a business whose cash register if overflowing continuously, there is a great probability of making some serious money someday.
The third ratio that I use to pick stocks I call “CapFlow”. CapFlow is basically:
Capital Spending/Cash Flow
This ratio allows me to identify elite management teams that achieve very low costs in relation to their cash flow. Very simply they are usually the low cost producer in their industry because of their managements great attention to detail in their cost control management. They also use things like “Economies of Scale”, where as their sales increase their cost per unit decreases.
So to summarize we search for the following ideal for each ratio;
1) CapFlow = less than 50%
2) FROIC = greater than 15%
3) Price to Owner Earnings = less than 15
We then generate a final score based on how a company performs on each of these ratios. The final scores range from zero to three.
Zero = a company that fails on each ratio
Three = a company that scores perfectly
If you can put a portfolio together with a large number of three’s in it, that will allow you to basically get a portfolio of companies that are performing very well on Main Street, but are also strong value/growth plays on Wall Street.
Here are three companies for example that currently score perfectly on my system:
Once I find a company scoring well on my system, I then go and do a Philip A. Fisher qualitative analysis. For those of you unfamiliar with Mr. Fisher here is a link that will give you an introduction to the master. FROIC and CapFlow are ratios that I designed to test management effectiveness and if you do a long term analysis of a company using my system, you can see a pattern of consistency, which was what Mr. Fisher looked for first. I can demonstrate this by giving you a long term owner earnings analysis of Apple (NASDAQ:AAPL) from 1995-2012.
As you can see from the table above that had you invested in Apple when it first hit a “three” in 2009, your return would have been excellent.
My system also works very well in analyzing entire industries or Guru's portfolios (ETF, Hedge and Mutual Funds etc..) and within minutes allows you to separate the super stocks from the dogs with fleas. Here is an analysis of the Toiletries and Cosmetics Industry:
From the data above you can see quite clearly that Regis Corp.(RGS) is the weakest player and that Estee Lauder (EL) and Nu-Skin Enterprises (NUS) are the strongest. Unfortunately Estee Lauder can hardly be considered a value play with a price to owner earnings of 25.93, but Nu-Skin sure shows promise. I can tell this by using FROIC, which is the most powerful ratio in investment analysis as far as I am concerned, as it really tells us how much in owner earnings are being created for every $1 of total capital employed. It is a real laser beam to what is really happening on Main Street. When your portfolio is full of strong FROIC's you can really amass some amazing gains on Wall Street.
Here is a long term chart of Avon Products (NYSE:AVP)
Now here is the FROIC data to help us to analyze Avon Products from 1974-2012:
As you can see from 1990 to 2008 Avon Products was an amazing performer, but like all great companies sometimes they stumble and create opportunity for value investors. In 2009 the FROIC for Avon not only fell -55.53% but it also broke below 15% as owner earnings growth also started to stumble. From 1998 to 2005 the company was just super on Main Street and that clearly showed up on Wall Street.
So if we are going to start analyzing Guru Portfolios in our GuruFocus articles, we should at least start out by analyzing the portfolio of the person who first gave us the ratio that I have built a complete system around. Here is Warren Buffett’s current portfolio analyzed using owner earnings:
As you can see from the table above that Mr. Buffett obviously still uses his owner earnings formula as his most recent purchases IBM (NYSE:IBM) and Intel (INTC) score very high on my system. You will also notice that his retail positions are not ranking very well, which may be a sign that owning that industry right now might not be the smartest thing to do. Oil companies are also not doing very well on Main Street in my research and if it wasn’t for the problems with Iran, I think oil would have been trading around $70 a barrel, as the entire industry has terrible CapFlows. CapFlow is an early indicator of problems on Main Street. When it deteriorates it does so slowly in most cases, so it gives the investor a heads up on what’s coming down the road. You will notice that I don’t include Berkshire Hathaway’s (BRK-A) financials holdings as owner earnings cannot be analyzed using it. Don’t feel bad though as this would have kept you out of Bank stocks over the last five years and you would have avoided the nightmare returns that some Gurus have, who invested heavily in them.
For those who want to analyze them just replace cash flow with earnings per share, use zero for capital spending and use ROIC instead of FROIC and PE instead of P/OE. Disclaimer: Always remember that these are the results of our research based on the methodology that I have outlined above and in other articles previously published. This research is provided as an educational tool and should not be considered investment advice, but just the results of our research. There are many ways to analyze a stock and you should never blindly follow anyone’s work without doing your own due diligence or by seeking the help of an investment advisor, if you so need one. As Registered Investment Advisors, we see it as our responsibility to advise the following: We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong. Please note, investments involve risk and unless otherwise stated, are not guaranteed. Past performance cannot be used as an indicator to determine future results. Strategies mentioned may not be suitable for everyone. We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter “Mycroft” Psaras, and should not be construed as personalized investment advice. Information expressed does not take into account your specific situation or objectives, and is not intended as recommendations appropriate for you. Before acting on any information mentioned, it is recommended to seek advice from a qualified tax or investment adviser to determine whether it is suitable for your specific situation.
About the author:
From his work on free cash flow in the investment process, Mycroft has now decided to bring his theories to the field of money management as well as work as an independent consultant for Hedge Funds, Pension Funds and ...More Institutions in general. His dream is to someday soon open a mutual fund where he can help as many people as he can benefit from what he has learned over the years.