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Robert Abbott
Robert Abbott
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Book of Value: 3 Tests of an Investing Case

Make or break an investment case with tests of yield, stability and financial strength

March 30, 2020 | About:

Anurag Sharma has built his book, “Book of Value: The Fine Art of Investing Wisely,” around the thesis that negation and refutation are the keys to making—or breaking—a case for investment.

That runs contrary to the regular approach, which involves finding lots of evidence to make a case, which can be a never-ending quest. On the other hand, disproving or negating an investing thesis is relatively simple and straightforward. Make your best argument for buying a stock and then challenge the idea with data and disciplined thinking.

So far in the book, Sharma has approached the negation process with capitalization ratios and discounted cash flow analyses. In chapter 15, he added three more sets of tests that can be used to disprove a thesis: yield, stability and strength.

Yield

The author defines yield as the capacity to generate enough earnings to beat what investors might earn from a savings account at the bank or in bonds. Actually, that could be any kind of investment that promises future returns.

For reference, at the close of trading on Friday, March 27, 2020, the rate for U.S. 10 Year Treasury Notes was 0.683%, which means for every $1,000 you invest in them, you would receive $6.83 per year for each of the next 10 years and then get your all your capital back. The Treasury return is often considered the gold standard against which investors can compare all other investments. As you can see, as of the writing of this article, it would take very little to beat it.

Within the boundaries of yield, Sharma proposes several sub-tests:

  • The stock yield: While T-notes don’t carry a default risk, stocks do, so, therefore, stock investors need an extra amount of yield to compensate for stock and market risk.
  • Bond yields: Because T-notes do fluctuate with interest rates and investor supply and demand, especially when the markets are in turmoil (as they are in March 2020), bonds may provide better benchmarks. Sharma suggested that 10-year AAA or AA rated corporate bonds might be one such choice. In the last two weeks of March 2020, these bonds have ranged, roughly, between 2% and 4%.
  • Earnings yields: For companies paying dividends and issuing bonds, the two yields can be compared. The author offered the example of Walmart (NYSE:WMT) in 2015; its 10-year, AA bonds were yielding an average of 3.29% while its earnings per share worked out to 6.9%.
  • Dividend yields: Using the Walmart 2015 example again, the cash dividend was 2.61%.
  • Cash flow yields: The Walmart free cash flow yield (FCFY) worked out to 6.86%; a portion of the cash flow is reinvested in capital expenditures and the remainder is available for dividends and other expenditures.

Sharma concluded in the Walmart 2015 test that an investment in the company at that time would have yielded a premium that was more than double the return from investing in its bonds. Therefore, an investment in Walmart was not refuted because of yield. Of course, every investor has a different risk tolerance and at the cautious extreme, some investors might refute the investment thesis.

Stability

To test stability, an analyst will try to refute the premise that the past performance of the company was stable. In other words, if the company has a history of bumpy fundamentals, the thesis could be refuted and investing in it would not be a good idea.

The first approach in challenging the company’s stability is to review its yields over the past decade, or at least several years. Without an adequate history, this cannot be analyzed.

Sharma reported that Walmart, as of 2015, had steadily increased both its earnings and its dividends over the past 10 years. Free cash flow had nearly doubled. All of this implies the supermarket retailer enjoyed increasing earnings and larger capital expenditures each year.

This chart shows earnings, dividends, and free cash flow over the 10 years between Jan. 1, 2006 and Dec. 31, 2015:

GuruFocus Walmart EPS, Free cash flow, dividends per share

The second approach is to assess the stability of several key metrics, including the 10-year history of operating and net margins, as well as return on equity (ROE), return on capital (ROC), asset turnover (A T/O) and inventory turnover (Inv T/O). Each of these has been stable, as Sharma added that the company’s earning power had been "robust."

On overall stability, the author concluded this sub-thesis for Walmart in 2015 could not be refuted.

Financial strength

The third and final test of an investment thesis is to try to refute the premise that the company is financially strong. If it can be proven the company has financial weak spots, the thesis would be disproven and the stock would be withdrawn from consideration.

This test is made up of several parts, which Sharma calls “subtheses”. They are:

(1) coverage, which refers to holding enough cash to pay the interest on any debt,

(2) leverage, referring to the amount of debt in relation to assets, and

(3) liquidity, which is the amount of cash needed to service the debt.

The relationships between debt, equity and cash flow are captured with ratios:

  • Interest coverage is measured with a ratio by that name.
  • Leverage is measured with the Debt-Equity ratio.
  • Liquidity is measured with free cash flow (free cash flow minus capital expenditures and other essentials tells us how much money is actually available for debt servicing).

GuruFocus sums up each firm’s financial strength in a section on the Summary pages; you’ll find the first two metrics in this current table for Walmart at the close of trading on Friday, March 27, 2020:

GuruFocus Walmart financial strength

Cash flow information can be found in the cash flow section of the financial statements.

For Walmart in 2015, Sharma found that it met all the tests for financial strength—interest coverage, leverage and liquidity—and therefore the case for investing in it could not be refuted on these criteria.

He added that he might use the same criteria to invest, or not, in other companies. Regardless of the company or even the type of security, refutation or negation provides a powerful tool for ruling out potentially bad investments.

Conclusion

In chapter 15 of “Book of Value: The Fine Art of Investing Wisely,” Anurag Sharma has argued that the principle of negation or refutation can be used to qualify or disqualify a potential investment. Specifically, he showed that the yield, stability and financial strength are areas in which an investment thesis should be tested.

Yield tests involve other financial instruments, including Treasuries and bonds. Stability tests involve consistent growth of metrics such as earnings, cash flow and dividends. Financial strength tests were spread across three types of measurement: interest coverage, leverage and liquidity. A company would need to pass all three of these tests to qualify as a good investment.

Disclaimer: This review is based on the book, “Book of Value: The Fine Art of Investing Wisely”, by Anurag Sharma, and published in 2016 by Columbia Business School Publishing. Unless otherwise noted, all ideas and opinions in this review are those of the author.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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