USA Today Article Follow-up: "Score Big With 9 Stocks in 2015"

I wanted to follow up on USA Today's 2015 kickoff article in the money section, the 9 Best Stocks for 2015. It's written by my friend Matt Kranz, and Matt and I have talked a lot about research and earnings and cash flow and valuation. And one of the reasons I believe he likes to rely on our research, or at least utilize our research in what he does, is because he knows we're doing all that homework that investors believe should be done, or investors believe analysts and Wall Street people are doing, and, and what I believe really ought to be done before you make any kind of recommendations. And specifically, I'm talking about going through the entire annual report or the full set of financial data that companies make available. The problem with that is that these annual reports are on average 200 pages long, or more than your average novel, and they're a little more complicated. Than the average novel, let's put it— to put it mildly. And we see some of these filings as much as 1,900, 2,000 pages long. It's a ton of work. And I'll be honest with you, being an ex-Wall Street veteran, most, if not almost all analysts on Wall Street, they don't have time to read annual reports. And try it sometime. You might find just to read 5 annual reports and build a model with the data from those annual reports for all 5 years, it would probably be all you did for 3 or 4 months. Okay. For 8 hours a day, at least 5 days a week or more. So it's an enormous task, and that's what we do. And so Matt and I have talked a lot about this. And so he used our rating system, our research, to help determine or winnow down that list. Now, Matt has talked to me about ratings before, and you'll see in the article that only 3 of the 9 stocks get our attractive rating. The other 6 get neutral. And what Matt and I have talked about stocks and ratings. He's asked me, you know, okay, what can I use in an article to make a recommendation? And I said, look, I'd really like you to focus on the very attractive and the attractive. If you use a neutral, I'm not going to go crazy, but definitely don't use any dangerous or very dangerous rated stocks. So the 3 stocks that got the— the only 3 stocks that got the attractive rating were LyondellBasell, Gilead Sciences, and Michael Kors. And they got attractive ratings because they had high and rising returns on invested capital, right? And if there's one metric that's the most important metric for understanding profitability, it's return on invested capital. That's the universal metric for profitability because it measures how much cash flow the business generates relative to how much capital has gone into it. If you were investing in a business or providing money with a manager, that's how you measure performance. It doesn't matter how much gross money they send— they give to you or how much revenue they give back to you or even how much profit they give back to you. You care about how much profit relative to how much capital you gave them. They give you $100 and you gave them $1 million, not very good. They give you back $100 and you only give them $10, that is good. So you need to know both cash flow and the capital. And that's what we measure in terms of return on invested capital. And for LyondellBasell, Gilead Sciences, and Michael Kors, great returns on invested capital, rising returns on invested capital. Now another key component of the attractive rating is going to be a cheap valuation. Now cheap valuation for me means specifically that the market price implies conservative expectations for future cash flow growth. Specifically for LyondellBasell, they have a 1.2 price-to-economic book value ratio. That simply means that the current price and stock price in the market means that the company's profits are gonna grow, or implies the market believes the company's profits are gonna grow no more than 20% over and above what they are today over the remainder of its life. No more than a 20% improvement over existing cash flows for the remainder of its life. I believe that to be a conservative expectation, especially for a company who has got high and rising returns on capital. High and rising returns on capital is a huge green flag for cash flow and profit generation. And that's why those 3 stocks get an attractive rating. Now in order to get to return on invested capital, again you have to measure NOPAT divided by invested capital. Simple formula. We like to keep things simple. The key though to this process is that you gotta have the right ingredients and the right data to calculate NOPAT on invested capital. Anyone can calculate it. I gave you the formula. And you go to our blog or website, you're gonna see we provide these formulas everywhere. The key is getting those data right. And, you know, with any model, there's no such thing as a magic formula model. Anyone who's trying to sell you one, you should think twice about doing any business with. The key to any model is the quality of the inputs. Ever heard the old saying, garbage in, garbage out? It's a good one, especially when it comes to financial modeling. We have the best models in the world because we have the best data in the world. Because we go through more annual reports with more granularity than any other firm or agency or regulatory deal in the world. And we know this from experience because I've been doing this for 20 years and I've talked with everyone across government, across hedge funds, across data providers, and we've simply done the best in the world for it. And that's, that's the service we provide for our clients. It's an expertise we focus on. It's our focus. I'm not saying it's because we have whiz-bang, you know, artificial intelligence. We don't. We have a lot of focus, a lot of effort, a lot of expertise. It makes our return on invested capital the best in the world. Now, these other stocks that get a neutral rating, the one that I like the most out of all 6 is probably Freeport-McMoRan, ticker FCX. I like it because it's got decently low expectations for future cash flow growth, and I think that they could be pretty well positioned, assuming a pretty decent global rebound, inactivity. I think the U.S. economy is going to be decent, but as long as we have decent global growth, Freeport-McMoRan should do well. And it's got the lowest expectations. And importantly, the growth appreciation period for Freeport-McMoRan implied by the current market price is zero, all right, which means there's almost no growth baked into the current stock price when you look at exist— or historical growth rates as a backdrop in our decent discounted cash flow model. If you want to see— learn more about growth appreciation period, visit the blog. The stock I probably like least out of all the 9 that get a neutral rating is Tyson Foods. That's because it's got a negative 38% free cash flow yield. Now the interesting thing about Tyson in our model is that the return on invested capital for Tyson, though it's only 10%, did rise a little bit in this past year. And it brings into— brings up a very important adjustment we make. Because it's hard to see on the surface how a company could have a rising return on capital and a very negative free cash flow. The reason for that is because they did an acquisition. The acquisition happened late in the year. So when you actually look at the cash flow generated in the year, net of what they spent for the year, free cash flow is really negative. But our return on invested capital time-weighted averages the invested capital relative to how long it was in the business. So we don't charge Tyson Foods— when measuring return on invested capital, we don't charge their invested capital calculation and assume that that capital was in the business the whole year because you know what? It wasn't. And our NOPAT calculation, which comes a lot from the income statement, doesn't have a full year's worth of that acquisition's income in it, right? It has only a portion of the year, so we only time-weight the portion of the capital in the invested capital calculation as well, so that we're consistent with our numerator and denominator. And when you look at it from that perspective, the deal looks pretty good. However, free cash flow is really bad, and the current stock price implies, or has a price-to-economic book value ratio of 1.6, which is pretty high. You know, it's higher definitely than Gilead Sciences at 1.2. It's not great. That's a neutral rating in our system. Now, none of these stocks are stocks that are, hey, they get a neutral rating, They made the list for Matt for good reason. They got some good ratings from some other providers. Our rating system tends to be a little more strict, but again, neutral rating. Just talking about my best and worst of those 6. Still gets a neutral rating. I'm not saying it's the end of the world, just my least favorite of those 6. One of the stocks that I think is also pretty interesting on this list, one that we've liked a lot in the past, a business model that I really love actually, is Google. It gets a neutral rating. The issue with Google is that it's kind of gotten a little expensive recently. Price-to-economic book value of 1.5. But it's had super high returns on capital in the past. And it's a company where, for me, like a drop in return on invested capital, it's not the end of the world. Because when you're coming from 70% or so, you know, that's when you're still at 29, that's pretty good. So I like Google. And even though it's a neutral rating, because the valuation is not so great. Again, in order to get an attractive or better rating, you gotta have good cash flows, rising returns on invested capital, and a cheap valuation, because that's the risk-reward that matters most, or is the best. And in a world where you can't predict the future, managing risk-reward is the best thing investors can do. If you can't predict the future, and I'm not claiming I can, and if anyone who's giving you advice claims they can, you should maybe think twice about working with them. If you can't predict the future, the best thing you can do is manage risk-reward. And the best way to manage risk-reward is to focus on what the market believes to be the best signal. The best signal is understanding true cash flows and relative valuation. And the best risk-reward, or the attractive and very attractive stocks, have strong cash flows and cheap valuations. And the worst risk-reward are the dangerous and very dangerous stocks, and they have— they tend to have bad cash flows often misleading cash flows, and very expensive valuations. So many thanks to my friend Matt Kranz for using us in his article to kick off 2019, the money section of 2019 for USA Today. If you want access to these articles or reports on all of the companies I mentioned today, please feel free to click the button at the end of this video. And if you want access to any of the definitions of the items I mentioned, please visit our blog. Thank you.