How to Use New Constructs' Stock Ratings: Part 1

post it again on our investment research section of our website. If you can just go ahead and search webinar here, you can find the last one we did. This one's a little bit longer, but all the webinars will be posted on our website for you to view at any time, or in case you miss one on any given week. So that'll be available to you hopefully tomorrow afternoon. And then one other thing I want to touch on before we get started, just one last thing here. We recently put up this education section of our site, and I'm going to be talking throughout the course of this webinar about a lot of different metrics and a lot of different ideas and a little bit of theory here. And if you want to touch back on any of that theory or understand any of the metrics I'm talking about, you can go here to the education section of our website. Here's some of the theory behind what we do. Here's how we apply value investing. And then there's also definitions of all of our metrics here. You can get definitions. So for example, if you hear me say NOPAT, all that means is net operating profit after tax. And you can go to this page right here and it gives you the formula and the explanation, everything. So if at any point during the webinar you don't understand something, this is the place to go. So today, like I mentioned earlier, we're going to be talking about our stock ratings. Now we also apply ratings to our ETFs and mutual funds, but today for the purpose of clarity, we're just going to be talking about our stock ratings. And you can find that here on the ratings page, or if you're a Gold subscriber, you can go into a report which I'll show you in a moment. So for any given ticker here, let's enter Walmart. You get an overall risk-reward rating, and that rating ranges from very attractive to attractive to neutral all the way down to very dangerous. And that's— and this is sort of contrary to what a lot of Wall Street does. A lot of Wall Street has buy, hold, sell, overweight ratings, things like that. Our ratings are a little bit different. They are overall risk-reward ratings. And this risk-reward rating is based on 5 criteria that we think are the most important for assessing the risk in a stock versus the potential for reward. And those 5 criteria, which are detailed here, you have economic versus reported EPS all the way down to growth appreciation period. These 5 criteria are further broken down into 2 subcategories. You have quality of earnings, which is right here, And then you have valuation, which is right here. So what we're doing is we're really applying the philosophy of value investing. So we want to know how good is the company behind the security that we're buying versus how expensive is that security. We always like to buy great things at cheap prices, and we tend to avoid sort of lousy things at expensive prices. So the quality of earnings is not strictly EPS rising. It's the quality of the economic earnings of the company and the strength of the business model of the company. And that's measured by a metric called economic earnings and a metric called return on invested capital. Now, economic earnings versus— this here is actually the economic earnings versus the reported earnings. That's per share, on a per-share basis. And that measures how the company's reported accounting income, which is what most investors are seeing and which is what the company is reporting in its earnings reports, compares to the actual economic reality of the company. And return on invested capital measures the aggregate cash-on-cash returns of the company. So that's how much money did the company— how much cash did the company generate in a given year relative to how much cash has gone into that company over its lifetime. And in general, with a company that's attractive like Walmart, we like to see return on invested capital that is, you know, high or rising. And this is relative to every other company. So when we say return on invested capital is in the 2nd quintile, so Walmart's return on invested capital is 11%, and that's in the 2nd quintile of all the companies we cover, that means it's just in the top 40%. of all the companies we cover. There's no real— it's not quite cut and dry where there's sort of a good ROIC below 8% and— or excuse me, a good ROIC above 8% and a bad one below 8%. There's no cutoff there. It's all relative to other companies in the market and in the industry. And Walmart performs pretty well when it comes to other companies in the industry— in the market, excuse me. And then we also like to see Economic earnings— I might use the term cash flows here interchangeably— economic earnings that are positive, or even better, they're rising. So each of these metrics here, we assign a grade to. And for the purpose of this podcast, I'm only going to be talking about the quality of earnings portion here, just for the sake of brevity. Next week, we'll be talking a little bit more about valuation, but today I'm going to be talking mostly about economic Earnings per share and return on invested capital. So each of these metrics here we assign a numerical grade to. And so the best here being 1, which is rising economic earnings and a top quintile return on invested capital, and 5, which is the worst. And so that in that case, it would be a misleading trend in economic earnings or a bottom quintile return on invested capital. So that would be a return on invested capital of maybe 3% or 2% or something like that. And we average out all of these, all of these factors across the company. So we have 5 factors here, and each of them is graded on a scale from 1 to 5. And if a company receives an average of under— or of a 1.4 and under, we consider it to be very attractive. Whereas if a company receives an average of 4 4.25, I believe, or over, we consider that company to be very dangerous. And there's all sort of cutoffs in between where we get attractive, neutral, and dangerous stocks. But that's sort of the calculation behind our risk-reward ratings. And then on the flip side, when we don't like a company, we tend to see bottom quintile returns on invested capital, so very low returns on capital that are invested into the business, or we see a misleading trend in economic earnings. Which I'll talk about in just a second. So the key, we think, to investment strategy, and this is sort of the philosophy behind our ratings, is maximizing upside potential and minimizing downside potential for every one of your investment decisions. Because the future is inherently unpredictable. While you might be very good at predicting the future, there's no real sure way. If you're playing a clean game, there's no real sure way to predict the future with any, any kind of degree of certainty there. So when battling against an uncertain future, we like to maximize our odds of success, and that means maximizing our upside potential while minimizing our downside potential for every single investment decision. So we want to be long stocks that have an attractive risk-reward proposition, and we want to sell or short stocks that have a very bad risk-reward proposition. So, and that comes down to measuring and knowing about whether a company has a good risk-reward proposition knows or requires us knowing the quality of the company's earnings. And that can only be measured by using something called economic earnings. Now, economic earnings is kind of a catch-all term. When I refer to economic earnings per share, that's actually a mathematical calculation that we do. But economic earnings are metrics that help us measure the actual cash that a business is generating. Accounting data by itself is actually not meant for equity investors. It's meant for debt investors. And so by itself, accounting data that you might find in an annual report is inadequate, we think, for making responsible investment decisions. You can think of accounting data as sort of the words that are used in the language of finance or the language of investing. So they can be sort of arranged to convey any kind of meaning you want, but if you arrange them properly, they can communicate a message about what's actually going on in the company. Now for us, the first stop on that trip is calculating return on invested capital, which we calculate as net operating profit after tax, or NOPAT, over invested capital. And all that's doing is that's measuring the the cash return, the cash profit a business has generated in a given time period versus all of the cash that has gone into that company over its lifetime. So if we go to the screener here, we can look at a company and sort by return on invested capital, and we can look at a company like the St. Joe Company. So that company is generating 67 cents for every single— in 2014, that company generated 67 cents for every dollar that has gone into that business over its lifetime, and that's very good. That's very high. Now, to calculate economic earnings, let's go back here. Let's type in Walmart once more. To calculate economic earnings, we are really concerned with How much real cash flow the business generates relative to how much capital has gone into that business over its lifetime. And when we calculate economic earnings, that means calculating the cash a business is generating at that moment versus the cash going out of that company at that moment. Economic earnings are based on the complete set of financial information available. So calculating economic earnings requires going into the financial statements like a 10-K And reading every single page and understanding how much real cash flow has that business generated relative to how much capital has gone into that business over its lifetime. And that requires looking at something like net income and then applying all— and then adding and subtracting all kinds of things that we consider to be non-cash charges or is actually not a cash charge that's included in net income and things like that to calculate NOPAT, which is the actual— Net operating income. cash generated by that business in that time period. And then, in a similar way, the numbers you're seeing on the balance sheet aren't really representative of the amount of cash that has gone into that business over its lifetime, because companies can do things like write off assets, and therefore those assets aren't going to appear on the balance sheet going forward, and it's sort of forgotten to accounting history. But if we're thinking— if we're looking at economic history, we really need to take into account all of the cash, even if it's been written off the balance sheet, that company has put into its operations over its lifetime. Now, to calculate economic earnings, we take return on invested capital again, which is the amount of money that— excuse me, the return the business is generating on its— on the amount of money that's gone into over its lifetime versus the cost of that money. And we do that by calculating WACC, which is the weighted average cost of capital. So in other words, if a company is earning economic earnings above— or excuse me, if the company is earning return on invested capital above its weighted average cost of capital, that means the company is generating real value above the cost of the capital that it's using to generate that value. So it's actually generating value for its shareholders. On the opposite side, you have something that happens when you have a return on invested capital, let's say it's 11% here, versus a weighted average cost of capital that's 13%, which is abnormally high, but sort of for the sake of example, just kind of roll with me here. If the weighted average cost of capital in Walmart's case was 13%, the company, sure, it's generating a return on invested capital that's 11%, But that doesn't matter because the cost to utilize that capital is 13%. So it's actually— so cash is actually flowing out of the business rather than flowing into the business. Now, in Walmart's case, the WACC is somewhere likely around 8% or something like that. So Walmart is actually generating positive economic earnings, as we can see here by the economic earnings per share rating. And actually, so let's go into Let's look at a company like Goodyear Tire. Now Goodyear Tire, it's rated a 1 across all these categories here, and it gets a 3 in return on invested capital. So return on invested capital is just okay. But in terms of economic versus reported earnings per share, it has rising economic earnings. Let's go ahead and enter the report here and see what that actually means. So all of you, all of you have access to these things, which are our company reports. And in each of the company reports, you have this ratings table right here. And this is just the same thing we were looking at over here on the ratings page, which some of you don't have access to. But all of you have access to the same ratings table, and this is all the same information. Now, if we scroll down into the report here, we can see The break— a visual breakdown between reported earnings per share and economic earnings per share. So this is Goodyear Tire again. Goodyear Tire's reported earnings per share went way up in 2014. They've been rising for quite some time, but they went way up in 2014. But the good news is that the company's economic earnings per share, which tend to be a lot less volatile because it's based on a larger set of historical financial information, the economic earnings per share is actually also rising. So that's good. That means the company is— and it's positive here as well. So that means the company is actually generating value for its investors, and it's generating an increasing amount of value for its investors over time. Now let's go back to our ratings page here. Let's look at a company where that's not the case. Let's look at something like Yahoo, for example. So Yahoo gets our worst ratings across the board in terms of all of our economic earnings drivers here. It's got a misleading trend. In its economic versus reported EPS, which I'll show you visually. It's got a bottom quintile return on invested capital, so that's 4%. So that's in the very bottom 20% of all the companies in the market, and that's particularly bad for technology companies. Let's go look at the report here. And again, you have the same sort of information here that we were just looking at on the ratings page. Now here's the visual breakdown for Yahoo, which looks A little bit different because while you have reported earnings per share, and again in 2014 here reported earnings per share went way up. They had a great year according to their accountants in 2014. But if you look at the company's economic earnings per share, which again measures the company's return on invested capital, which you can see down here in this table, their return on invested capital fell to 4% in 2014. This measures the company's return on invested capital versus— The market. The cost of that capital. And so the company is actually right now, it's earning a return on invested capital under its cost of capital. Let's see if we can actually see that numerically broken down here, if I can pinpoint that for you. Return on invested capital. I'm not sure if it's in here or not, but this shows you that the company's return on invested capital is below its cost of capital. However, I mean, again, if you're looking at its accounting statements, you wouldn't know that. You would think that Yahoo had a great year and it was generating record earnings per share and things like that. But in reality, the company is earning less and less of a return on the capital that's been put into the business over its lifetime. And now it's actually destroying value for its shareholders. And especially for a company in the tech industry, that's a little— I'm not gonna say unusual, but it's particularly poor because tech companies tend to earn much higher returns on invested capital. That's a conversation for another day. That, I think, sort of covers the basics here. If any of you have questions, I know that was a little quick. I tried to keep it short for the sake of all of you. I know all of you are very busy. But if you have any questions about what I just went over, we're gonna go ahead and take questions right now. You can go ahead and type it into the question box in your little webinar window here, and I'll try to answer any questions about the quality of earnings portion here of any of the companies I just talked about or about that information in general. So we just got a question here. I'm gonna read it out. And the question reads, for reported versus economic earnings per share, is a misleading trend A series of false positives, or how would you define a false positive? So a false positive would mean that the company's economic earnings per share are negative. They might not necessarily be declining, or— Exactly, actually. They might not necessarily be declining, which again is the worst here. So economic earnings, or if earnings per share were rising and economic earnings per share were falling, That's a misleading trend. If economic earnings are negative but not necessarily rising or falling, that's a false positive, and that occurs when earnings per share are positive but economic earnings per share are negative. That's a great question. We just got a question about the recorded version of the webinar. Yes, there's gonna be a recorded version of this webinar. Everything I just went over, we're gonna post on the website tomorrow, either morning or afternoon. And that'll be in the investment research section of our website. I'll just go back over one more time. You'll be able to find it right here. It'll be one of the most recent posts tomorrow afternoon, and that'll be a video. Let me show you the example of one we did last time. You'll be able to go into the post here and you'll be able to look at the YouTube video right there. So all the things I just covered will be available. And then again, for those joining late, if any of you were confused about anything I talked about or were curious about any of the theory or just needed a quick checkup on any of the definitions of the things I talked about, we have this education section of our site here. You can go right into the metrics definitions page and you can look at all of the definitions of all of the words I used here. And again, if you're curious about the formulas and things like that, those are also available as well. Great. If you, if you have a question, would you mind clicking the raise your hand button as well? So I know that we might still be waiting on people who are asking questions or might want to ask a question shortly. We got another question here. How do you choose the most attractive? So for those of you that don't know, every month we put out a report called the Most Attractive List, and you can find that here on our investment research section of our website. If you go to the Most Attractive Stocks category, you can look at April's Most Attractive Stocks available to members today, and that's available in a PDF, and that's available to our paying subscribers. And that's a list of the 20 large and small-cap stocks that we consider to be the most attractive stocks in the market that month. And again, that's available at the beginning of every month. And Kyle, actually, who's on this call, puts that report together, so he might be a little bit of a better person to answer that question, and maybe he can correct me if I'm wrong here or give you a little bit more detail in a in an email. But the most attractive stocks are generally almost always— they're almost always very attractively rated. So we only rarely see attractive-rated stocks. And those stocks have— so we weigh things a little bit more differently. They have extremely high free cash flow yields, which means they have a great free cash flow available to each share that they've issued. And they are, in general, below priced economic book values. of, I think, 1.2, maybe 1.4, 1.3. They almost never have price-to-economic book value ratios above 1.2. So even though a stock might earn a price-to-economic book value here of 2, and it might earn a risk-reward rating of very attractive, we think the most attractive investment prospects only come at price-to-economic book values around 1.2, maybe 1.3 if we're feeling generous. That's something I talked about in the last call as well. And again, Kyle will know if I missed anything there because he puts that report together, and he'll be able to answer any of your questions, anything I missed via email. Okay, it doesn't look like any of you have any additional questions here. Again, if you do, just raise your hand and stop me here, and I'll wait for another minute or 2. But with that, I think we're going to wrap it up. Again, like I said, next week, same time and on the same day, Thursday at 4 PM, we're going to be covering the valuation section of our ratings. So today we covered quality of earnings, and the next time we're gonna cover valuation, which takes into account some of the stuff over here that we talked about with quality of earnings. There's a little bit more to cover here, so we decided to break that up into a separate webinar. So we hope to see all of you next week. Again, we really appreciate all of you coming. We love engaging with you. We hope you email us at support@newconstructs.com. Please feel free to comment on our blog. Each of our posts here has a comment section. And you can feel free to comment, ask any questions about any of the research that we're doing, or feel free to tweet at us or things like that on social media. We always like hearing from you. Great. Thank you. And we will see you guys next week, hopefully. Thank you.