Great companies can be bad stocks.
Now, that sounds like a neat, pithy phrase to throw around (feel free to borrow it!), but it can be a lot more nuanced than you might expect. For example, if the current valuation fully reflects a company’s prospects, then there’s little opportunity to outperform even if the company is “great.” In addition, stocks move up and down 20% or more on a regular basis. Just because a stock is declining doesn’t mean the company is “bad.”
Parsing the difference between “good” and “bad” is my wheelhouse. Let me show you.
I recently updated my earnings-quality software, and I saw that one of the worst stocks in the market is regarded as a “great” company. The company is in a stodgy and stable business, has a brand name, and been in business over 100 years.
But, the numbers have deteriorated in recent quarters and the overall earnings quality score suggests that stock is one of the worst to own in the S&P 500.
Let’s take a look at the metrics that my software spat out:
Revenue Quality: F
Based on the cash-flow statement of the annual report, receivables continued to rise excluding the effect of acquisitions. Lengthening collection terms when a company is facing material slowdowns in revenue growth increases the risk that the company pulled forward future revenue into the current quarter.
Cash Flow Quality: F
Due to acquisition accounting, companies obtain a benefit to operating cash flows while the cost of the acquisition is treated as an investing cash flow. Despite this benefit, the company’s cash flow quality has deteriorated. Free cash flow has plummeted to negative levels while operating cash flow on a trailing 12-month basis is exhibiting the worst trends in years.
Earnings Quality: F
The company consistently generates negative “Cash EPS” quarter after quarter. This is my proprietary metric that measures the degree a company uses the balance sheet to influence quarterly earnings. The company scores very poor marks here. In addition, the spread between EBITDA Margins to Operating Cash Flow Margins as started to widen considerably post acquisition activity. This is a sign that profits are not translating into sustainable cash flows.
Expectations Analysis: C
The company scores in the middle of the road here. Its business doesn’t illicit a lot of excitement on the part of the investment community. Estimates have been coming down. However, earnings quality continues to deteriorate. If the company were to issue an earnings warning, there’s still significant risk of estimate reductions by Wall Street.
While the business is stodgy, it could be perceived as a “safe” stock. The stock trades at a huge premium to sustainable cash flows and about 30% higher relative to revenue than it did three years ago.
Shareholder Yield: F
Share count increases, a sub-par dividend yield, and increasing leverage all result in a poor score for shareholder yield. In addition, while its acquisitions are relatively new, the fundamentals are showing deterioration. This increases the risk that quality cash flows will not be available in future quarters to pay shareholders first.
On top of that ugly report card, the stock is already diverging from the S&P 500 index in a declining trend. This is obvious by pulling up a chart, printing it out, taping it on a wall, and standing six feet away.
But, to be more precise, the stock is trading below both the 50- and 200-day moving averages and the relative strength rating is weakening.
When the overall market is strong but a stock’s price performance is already starting to fade given the overvalued, overbought, and overly optimistic about the broader indexes, it is not a good sign. That may seem obvious to you, but making that sort of investment call in real time can be the difference between a modest gain and total bust.
Day after day, we’re bombarded with headlines and percentages. The rumor mill is always in motion, and it’s easy to be influenced by the day to day (or even hour to hour!) fluctuations that ripple through the markets. At the end of the trading day, companies can’t escape their fundamentals, and sometimes it takes work (not simply skimming a couple articles or listening to the latest talking heads) to make sense of it all.
I named my trading service Forensic Investor because that’s what I am – I’m a forensic investor, digging through the data to figure out what’s really going on in the stock market. They’re probably not going to make a TV show out of my work, but it’s pretty profitable stuff. Take a look if you’re interested.
John Del Vecchio
Editor, Hidden Profits