My Golden Rules for Investing Part 2: Pay Attention to Key Metrics
[Did you miss the first part of Mark’s “Golden Rules of Investing” series? Click here to read part 1.]
The investment value of any business cannot easily be valued by outsiders. Every industry is unique and every business within each industry has particular aspects that make it unique, too.
I’ve often said that the challenge with buying stocks is the difficulty of understanding the particularities of individual businesses. What’s often most important in understanding the health – and predicting the future – of a business are these particularities. Because they aren’t always apparent to outsiders.
It’s difficult for me to predict the future performances of businesses I know intimately and own. It’s more difficult to do the same for a similar business in the same industry that I know only remotely. When it comes to businesses outside my experience, it’s extremely difficult to make judgements with any confidence.
But if we are to invest passively in stocks, that’s what we must do.
Toward that end, there are four metrics I look at when determining the investment value of a business, because they can, at the very least, alert me to potentially serious problems.
The Golden Rules for Investing: Metrics to Look For in Stocks
Revenues History
One of the first factors of regarding investment value for a business is seeing a steady growth in revenues (with a few exceptions). A volatile sales history makes me nervous. Especially when I can’t figure out why it’s so erratic. A steady increase in revenues is at least an indication that the people running the business understand how to make their business grow. You’d be surprised at how often this is not the case.
The rate of growth is important too. For small companies I like to see a faster growth. After the first several years I want to see significant growth – 30% to 50% a year. Then, when the business gets to the $100 million sales level, I’m happy with 20% to 30%. And when it breaks through the $500 million barrier, I’m comfortable with 10% to 20% growth.
Occasionally I make exceptions to these expectations. But only when I can clearly understand why growth was less and how it might recover. If I’m too far away from the business to understand such exceptions, I stay away from them.
History of Earnings
One of the other “golden rules of investing” that I use to determine the investment value of a business is the history of earnings. As with revenues, I want to see an upward trend. As a percentage of sales, I know that earnings will narrow as revenue grows. But I’m not very open to explanations about why earnings have flatlined or dropped if they are significant. It’s been my experience that a worrisome history of earnings is usually a predictor of worse things to come.
Again, I will make exceptions to this rule if I know the industry inside and out, and if I am familiar with the business and the people that run it. But this is rarely the case when I’m considering public companies, so I tend to shy away from any whose earnings are flat or descending.
With high tech companies, there is always the temptation to invest in companies that have no earnings. The game there is to look at market share and then calculate the potential value of the business if and then it starts to produce profits. But since I’ve never played that game with the businesses I’ve owned and worked for, I tend to pass when the companies are public.
A History of Paying Dividends
I used to be a partner in a very profitable business. Every year my partner and I would sit down and decide what percentage of the profits we would take out and what we would leave in the company.
Before being in this position, I didn’t even know this was something you did. I always assumed the shareholders took 100% of the profits each year. But in fact, that’s not possible. Businesses need cash to operate and capital to invest in new projects and products. If you take out 100% of the profits, the business has nothing to work on to grow larger.
There is no hard and fast rule for what percentage of profits you should take. It depends on a lot of things: the economics of the business itself, the requirements for future growth and — not insignificant — the desire to enrich the shareholders.
In that one business there were only two of us. And we both wanted to enrich ourselves. So we took out about 70% to 80% of the profits each year. This made us personally very wealthy, but it was a strain on the business and probably hindered its growth.
When I began working with my largest current client, I was shocked to discover that he gave the shareholders only 5% to 10% of the profits. This was in some ways very good for the company because it left so much cash in it for operating and expansion expenses, but it left the shareholders feeling a little cheated. Were it a public company, there might be some grumbling.
But there is another, more serious reason why it’s a mistake to distribute so little of the profits. It makes it too easy for the company to waste its capital resources on speculative ventures and products that have little chance of being successful.
Every business, as I said, has its own internal dynamics, so I can’t provide a blanket percentage for a healthy distribution of profits. But what I can say is this: I like companies that are committed to distributing profits to shareholders as often and as generously as they can.
It says something important about the management. It says that it is confident that it can grow the business responsibly without needing extra cash to throw at speculations.
With public companies there are basically two ways a company can distribute profits to shareholders: one is by dividends and the other is by buying back shares of the stock in the public market.
These are two events I look at when I’m looking at investing in public companies. How often does the company pay out dividends? And how much?
For reasons I’ll explain later, I like to see dividends of at least 6% and paid out on a regular basis.
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Recent Trend in Sales
The history of earnings is very important, as I said, but I also like to see how sales have been doing in the past six to twelve months. This is important for the most obvious reason: I want to make sure that something really bad hasn’t happened since the last annual report.
Recent Trend of Industry
In Delivering Happiness, Tony Hsieh compares investing in businesses to playing poker, the only casino game where the odds are not stacked against the player. The most important rule of poker, he says, is what table you are playing at.
If you choose a table that has too many players, it is difficult to win even if most of them are amateur players. If you choose a table with only a few players all of whom are experts it is difficult, too. The right table is one where your odds of winning are the best and that is a table where the expert competition is limited.
The same is true with investing. As a general rule you will do better investing in a solid but unexciting company in a fast-growing industry than you would putting your money into a business with an exciting story in an industry that is going nowhere or on the decline.
The print publishing industry is a good example. There are many large, established publishing companies you could buy that have a long-term history of profitability. But the general trend of print publishing is definitely down. I wouldn’t think of investing in any company that had too many eggs in that basket. The downside pressure against the company is simply too great.
Likewise, when industries are trending sharply up, it is possible to make a fortune investing in solid or even in mediocre business. I am certainly not recommending that. It would violate my first rule on quality. But as a short-term strategy with stop losses it can work very well.
After reading through my second “golden rule for investing” here’s what I want you to take away when it comes to investment value: Favor companies whose industries are growing strongly.