Investing can be tough, as many people let emotions and outside opinions steer their decisions. There are so many ads now that make timing the market seem easy and tell you that trading is the best way to make a profit. This causes investors to be shortsighted and impatient. Many famous investors, such as Warren Buffett, Benjamin Graham and David Dreman, made their fortunes not by jumping in and out of stocks, but by looking at the value of a business and where it will be years down the road. The key distinction between these successful investors and many unsuccessful traders is they are not focused on returns over a few days; they are focused on the value of owning a business long-term.
At our firm, as long as the businesses remain strong and the stock prices remain reasonable, we will not sell out of our companies. To judge a business’ fundamental strength, we examine its balance sheet to ensure the company can endure any potential major downturn. A company with a weak balance sheet that faces tough economic challenges runs the risk of bankruptcy. For this reason, if the company shows one or two of these three warning signs, we will further analyze whether we should sell:
Warning Sign No. 1:
If a company has a debt/equity ratio over 150%.
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Debt/equity is a great measure to show if a company is over leveraged. As an example, to better explain debt/equity, we tell people it is great if you own a $1 million home, but if you owe $1.5 million on that home then it’s not so great. There are some accounting policies that may negatively affect the appearance of the debt/equity ratio, but if the debt burden appears to be a large risk after analyzing the cash flow and equity of a company, we will sell at that point.
Warning Sign No. 2:
If a company has a current ratio below 0.6.
The current ratio shows the liquidity for a company and, more specifically, looks at 12 months of assets divided by 12 months of liabilities. If the current ratio is low, the company could be at risk of not being able to pay its current bills. Like debt/equity, there are some accounting policies that may negatively affect the appearance of the ratio, but if the company is in jeopardy of not being able to pay those bills, we will sell.
Warning Sign No. 3:
If the forward P-E multiple on GAAP earnings per share hits 16.5.
The only other time we will regularly sell out of a stock is if the future earnings of the company have become too expensive. The forward multiple is calculated by taking the current price divided by the estimated GAAP earnings per share. When that calculation hits 16.5, we sell.
We use GAAP, or Generally Accepted Accounting Principles, because this is the standard to which all companies must comply. If using non-GAAP EPS, there can be discrepancies between different companies and their earnings as some may choose to back out stock-based compensation, fluctuations in currencies or other expenses, while others may not. By using GAAP EPS we can ensure the playing field is level for all companies and we are comparing on an apple-to-apples basis. We use a multiple of 16.5, because that is the 40-year average for equities. Even dating back to the late 1800s, the forward EPS multiple was approximately 16. By using 16.5 as our forward multiple we can ensure we are not overpaying for a company’s earnings.
Maintaining discipline and having a company that trades at low valuations is important to long-term success. Over the course of history, results from value investing have been superior to those of growth investing. From 1926 through 2015 large-cap value stocks produced an average annual return of 11.2%, vs. 9.4% for growth stocks.
Throughout history we have seen time and time again that buying good quality companies at reasonable valuations will lead to strong returns over the longer term. Do not fall into the hype of Wall Street and let your emotions ruin your investment decisions.
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