I previously discussed the role fundamental business analysis plays in my style of value investing. I thought I would use a holding in both the Nintai Investments LLC and Hayashi Foundation’s portfolios – SEI Investments Co. (SEIC, Financial) - to focus on how I utilize such analysis to both reduce risk and assess growth potential for each portfolio holding. At the end of each calendar year, I complete an assessment of each holding as if it is a potential investment I might be interested in purchasing. This fresh start – so to speak – forces me to think through each component with an unjaundiced eye (hopefully). The next three parts of this series will go into detail about the three major components of fundamental business analysis.
- What story do the financials tell?
- How exactly was the moat built and maintained?
- What are characteristics and capabilities of growth?
The next three installments will delve into each of these questions, utilizing SEI Investments as a business case and walking through each component.
Corporate summary
SEI Investments is a global provider of investment processing, investment management and investment operations solutions. This includes the back-end operations of any medium to large investment firm. The company provides a platform flexible enough for family offices to large asset managers in both operations (fund administration, regulatory, etc.) and processing (by utilizing a technology platform that services clients’ sales to performance reporting). Recently, the company has moved into the investment management business itself, offering financial advice and even managing SEI funds.
What story do the financials tell?
As of the fourth quarter, in general, the financials of SEI Investments describe a company with compelling financial strength, very high liquidity, no debt, steadily decreasing share count and a management team with outstanding capital allocation skills. Diving somewhat deeper, the company has high gross (55.6%) and net margins (31.5%), significant free cash flow margins (30.0%) and high returns on invested capital (26.4%). The company has been free cash flow positive since 2003, generated 4.8% average annual revenue growth over the past 10 years as well as 10.6% earnings per share growth and 7.8% free cash flow growth over the same period. As one would expect, the company’s revenue and profits slumped during the Great Recession, though never achieved negative free cash flow during any of those years.
In the period 2008 to 2018, SEI's share price increased by a cumulative 223%. The story describes a steadily growing company (with the exception of the Great Recession) while consistently increasing revenue, earnings and free cash flow in the high single digits.
Cash flow statement
When I look at the statement of cash flows, my top priority is the overall strength of liquidity of the company. In short, what areas of distress could cause significant damage to my business case. Several modern formulas, such as the H-Score and Z-Score, can help test the company’s overall financial strength. At a high level, these scores tell the investor what areas of weakness exist in the financial model of the company.
The next area of priority is seeing a steady rise in free cash flow over a decade or two. As mentioned, SEI Investments achieved 7.8% annual growth in free cash when even including numbers during the Great Recession.
The third area of interest is the quality and clarity of the numbers themselves. For instance, is there detailed information on the relationship between free cash flow and earnings? Do the earnings growth numbers generally move in a proportional manner with free cash?
Last is the cost of stock-based compensation. Every share given out to management dilutes you as a shareholder. I cringe every time I see stock compensation numbers in the millions and dilution by 1% to 2% annually. SEI has reduced share count from 216.6 million in 2003 to 160.5 million in 2018. Clearly, management has not utilized stock options to the detriment of shareholders.
When I’m completed with my evaluation of the cash flow statement, I should have a very solid understanding of how well the company manages its cash flows, whether management are compensated in a shareholder-friendly manner and whether management is trying to fudge the earnings numbers that simply don’t map to cash flows. Dishonest managers will seek to fool shareholders. The cash flow statement will give away whether they are trying to fool themselves. Finally, I should feel a level of comfort that even the worst-case scenarios can be handled with both free cash generated from operations and the availability of debt financing if needed.
Balance sheet
The balance sheet is very different from either cash flow statements or income statements because they show the financial condition of the company at a particular moment in time rather than a set period (such as a quarter or year). Generally, this is year-end (either fiscal or calendar). The balance sheet ties into the cash flow statement in that it gives you another look at the liquidity of the company. You have both assets (what the company owns) and liabilities (what the company owes) listed on the balance sheet. The most critical aspect I look for is that the company has no (or almost no) debt. As I’ve said many times before, no company has gone bankrupt without any debt. The great news is SEI Investments has no short or long-term debt.
The second area of interest I look to evaluate is goodwill. Goodwill is the excess of purchase price over the fair market value of a company's identifiable assets. In plain English, how much did you overpay for assets that you acquired? Seeing numbers where goodwill makes up 25% to 30% of total assets can make me queasy pretty quick. Essentially, that large amount of book value can evaporate over night if an auditor decides the asset has simply been inflated in price or has become impaired. The biggest loser when this happens? You – the shareholder. Currently, goodwill makes up 3.3% of SEI Investments' total assets. That’s a great number to see as an investor.
Income statement
In the past 25 to 30 years, the income statement has become the most vital financial document for financial analysts. This is because it tells Wall Street whether the company will meet its expected quarterly earnings and whether future guidance will be in line with analysts’ estimates. If you really want to play along with Wall Street’s earnings game, then this document is for you. For those more old-fashioned value investors, this document holds far less appeal.
My first priority in this document is to make sure earnings growth or decreases generally match the free cash flow statement. The number of companies who manipulate earnings on a regular basis is truly shocking. Companies can do this in almost any conceivable manner. One is to report non-generally accepted accounting principles (GAAP) numbers such as claiming payroll really isn’t a cost. Others might claim revenues before payment is received. Another popular option is claim certain liabilities are “off-budget” and removed from the balance sheet. All sorts of techniques are used to manipulate earnings.
Second, even with all these opportunities to cheat (for that is what it really is), it’s good to see earnings increasing steadily over time (sometimes this can be lumpy, but that’s OK). Again, matching these numbers to free cash flow growth or decreases can make a big difference in your confidence of the numbers. SEI Investments grew earnings at roughly 10.6% annually from 2008 to 2018.
The third area of interest is margins (gross, net, and free cash). These should show a steady pattern of solid performance, if not slight improvement, over time.
Last – and most important – are the returns generated by the business: return on equity, return on assets and return on invested capital. In general, these tell you whether management are adequate, good or outstanding allocators of capital. In essence, are they are putting the company’s capital to work in a profitable manner that increases profits and grows the value of the business.
Conclusions
As a value investor, understanding the financial reports of your portfolio holdings is essential to achieving long-term outperformance. Basic math skills and accounting are the language of business. If you can’t speak the language, you will be blind in areas of tremendous importance to assessing value and allocating capital. One doesn’t need to be a genius in algebra or advanced mathematics to succeed. I was a straight C and even D student in math right through college, but finding a mentor and several books that work through the issues and formulas I discussed here will be essential in your growth as a value investor.
In the next installment, I will walk through how SEI Investments created, maintains and hopefully increases its competitive moat going forward. Until then, I look forward to your thoughts and comments.
Disclosure: I currently own SEI Investments in my own personal individual investment account at Nintai Investments LLC.
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