Risk/Reward Research centers around hundreds of credit analysis ratios and techniques applied to eight quarters and fifteen years of financial statements. It provides a comprehensive assessment of the risk/reward relationship of individual publicly-traded securities, an approach sometimes referred to as "Moneyball Investing."
While there are many nuances, the analysis, at its essence, leads to a single conclusion, the risk/reward relationship expressed as both a number and phrase. Four categories of analysis underly the conclusion:
- financial statement trends: profitability, leverage, liquidity, growth (improving, neutral or deteriorating)
- financial condition (weak, mediocre or strong)
- quality of earnings (includes debt and capital expenditure growth in relation to free cash flow growth)
- price in relation to intrinsic value (undervalued, overvalued or reasonably priced)
The results of each individual analysis is compared to the financial statement trend analysis of two thousand other publicly-traded securities. While the Python software we use was created in-house, it utilizes standard credit analysis ratios employed by Moody's and Standard & Poors, with additional influences from the Piotroski F-Score, the Altman Z-Score, and Graham & Dodd's Security Analysis, but with more emphasis on trend than on current situation. The return on capital/equity DuPont model as applied by General Motors in the first half of the last century also plays a role.
The premise of this research is that growing, low-debt companies with expanding margins and improving capital turnover that sell at reasonable values in relation to free cash flow, dividend yield and long term relationship to book value, outperform no-growth or shrinking companies with lots of debt, contracting margins, declining capital turnover, and high prices in relation to intrinsic value over time. Of course in any single day or week, anything can happen.
The investment process is subject to bias, conjecture about the future — the ego-need to be proved right, to be proved exceptional, exceptionally intelligent — and in the short term security prices are often driven by hope — the hope for major gain, a process during which risk is often disregarded. On the other hand, this research too has an failure rate. It assesses probabilities. It is a valuable element in an investor's toolbox; it isn't a trouble-free path through investment life in a state of perpetual bliss.
The emphasis of our research:
- trend, as opposed to current condition, although both are considered, and in the case of companies with no trend of improvement or deterioration, the assessment focusses on current condition
- free cash flow, as opposed to reported net income
- quality of earnings (growth rate of free cash flow as compared to growth in debt, capital expenditures, receivables, inventory, payables and S,G&A). Only the highest quality companies can grow without increasing debt and minimal capital expenditures
- the intrinsic value of the company's common stock (calculated several different ways including free cash flow adjusted for growth, and historic relationships of price to free cash flow and book value per share)
- no emphasis on EBITDA because, as Buffett and Seth Klarman have repeatedly pointed out, EBITDA assumes that depreciation and amortization are not real expenses. They are. Visit here for more.
These security analysis techniques are the basis of several subscription-based publications. Each is $150 a year, is published quarterly and delivered via email.
Click on the publication title to subscribe or learn more:
- Risk/Reward Analysis: Master Investor Portfolios
- ten most interesting positions in the portfolios of the ten portfolio managers with the best ten year performance records
- Risk/Reward Analysis: Quality Small Cap
- quality companies with market caps between $5 and $200 million
- Risk/Reward Analysis: Quality Large Cap
- quality companies with market caps of over $200 million
- Risk/Reward Analysis: Growth Small Cap
- growth companies with market caps between $5 and $200 million
- Risk/Reward Analysis: Growth Large Cap
- growth companies with market caps over $200 million
- Risk/Reward Analysis: High-Yielding Non-Debt Securities
- high-yielding common stocks, preferreds, MLPs, REITs, royalty trusts
- Risk/Reward Analysis: Investment Grade Bonds
- quarterly report on five investment grade bonds with improving financial statement trends and five to avoid
- Risk/Reward Analysis: Short Sale Candidates
- overvalued stocks with declining margins and weak financial statement trends
- Risk/Reward Analysis: Value Stocks
- stocks selling at discounts to book with strong financial statement trends
- Risk/Reward Analysis: High-Yield and Convertible Bonds
- high-yield bonds and convertibles, including convertible preferreds
- Risk/Reward Analysis: Distressed Bonds
- bonds that are yielding over 10% ranked by strength (or weakness) of financial statement trend
In addition to those quarterly publications we also offer Portfolio Risk/Reward Analysis — a custom, confidential quarterly analysis of client portfolios ranking all positions in order of financial statement risk. Visit here for more information.