6-FSA Financial Hints to Picking Stocks

8/8/2019 6-FSA Financial Hints to Picking Stocks

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Financial Statement Analysis

By G. Kevin Spellman, CFA, Do Not Utilize or Reproduce without Permission and Proper Sourcing

Helpful Financial Hints for Picking StocksOverview

Charges

Balance Sheet

Income Statement

Summary


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In this section, each of the major components of the income statement

and balance sheet are reviewed to determine the relationship between

changes in these items and future stock returns

Balance Sheet (fill in as class progresses)

Assets Direction +for Stock

Liabilities / Equity Direction +for Stock

Current Assets Current Liabilities

Long-Term Assets Long-Term Liabilities

PP&E Retained Earnings

Goodwill Common Stock

Overview

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Overview

Income Statement (fill in as class progresses)

ItemDirection +

for Stock

Sales

COGS

Gross Margin

R&D

SG&A

Depreciation

EBIT

InterestEBT

Taxes

E

Charges3


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Charges

Charges growing (exhibits 2 and 3)

0.4% of equity book

value (1970s and

1980s), 2.6% 1990s (upuntil 1997)

9% of operating income

recently

Charges growing to accumulate

reserves to manage EPS, andbecause investors tend not to

penalize companies for these

expenses (in the short-term)

Are Charges and Indicator ofStock Performance? Bernstein

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Large companies outperform the year of the charge and next three years (exhibit 4)

Small companies tend to underperform the year of the charge and the next year, but

then performance rebounds in the second and third year (exhibit 4)

Why the discrepancy? Charges are a sign of a real problem for small companies, but even

these companies revert to the mean later

"Are Charges and Indicator ofStock Performance? Bernstein

Charges

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Charges

The larger the

charge, the more

of a penalty in the

year of the chargeand the next one

(exhibit 5)

"Are Charges and Indicator ofStock Performance? Bernstein

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Charges

Companies that were losing money at the time of the charge perform

worse than those making money (exhibit 6)


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Charges

Growth companies outperformed in the year of the charge, but performance was worse

later on and vice versa for other companies (exhibit 7)

Growth companies have high P/Es and expectations built in, and the charge signals the

need to revise numbers down, while charges for value stocks may indicate change

(restructurings) and better things to come


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Balance Sheet

Capital Use: R&D, Patents, and Acquisitions, table 5, Bernstein

The data is for large-capitalization stocks

Outperformance can result from buying/shorting high/low R&D

spenders (see income statement discussion), low/high capital

spenders, low/high share issuers, and low/high acquisition spenders

Overall

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Balance Sheet

Capital Spending as a Long-Leading Indicator of Stock Performance:

Refinements to our Approach and How to Look for Extremes in Capital

Spending, Bernstein

When returns high, cash flow abundant (exhibits 5 and 6)

Capital spending

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Balance Sheet

Cash flow is used to purchase equipment (i.e. capital expenditures), and

the level of capital expenditures is a robust predictor of investment

performance (1955-2000)

High capital expenditure to depreciation foretells poor future

performance (exhibit 2) for every five years except the new era periodfrom 1996-2000 (this is least robust for technology - exhibit 11)

Capital spending

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Balance Sheet

Capital spending

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Balance Sheet

Low spending + low spending growth rates outperforms the high spending

+ high spending growth rate companies by a substantial margin in future

years (they underperform in the current year) (exhibits 9 and 10 of the

first article)

Capital spending

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Balance Sheet

Capital spending

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Balance Sheet

Low P/E + low capital spending model improves the returns from the low

P/E model (exhibit 12)

Capital spending

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Balance Sheet

Why do these relationships hold?

High capital spending leads to lower returns on investment in future

years (the high spenders outperform in the current year) and lower

cash flow (e.g. cyclical companies) Other?

Capital spending

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Balance Sheet

Share Buybacks, Goldman Sachs and Results of a Study that Looks at

Companies that Reduce their Shares Outstanding, Prudential Securities

Share buybacks grew to 30-40% of distributions to shareholders as a

percent of buybacks and dividends, up from 10% in the 1980s Share buybacks are completed to

Demonstrate that the shares are cheap

Distribute excess cash to shareholders

Offset employee stock options

Increase EPS

Make liquidity in stock

To take the firm private

Share buybacks

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Balance Sheet

On the balance sheet, share buybacks show up as a reduction in equity

known as treasury stock

Performance

Lakonishok, et al, showed that firms in the cheapest P/B quintile hadfour-year abnormal performances of about 45% after announcements

of share repurchase plans, versus low single-digit returns for the two

most expensive quintiles

Companies that reduced shares by > 5% and 1-5% outperformed

others (in all size and style groups)(1978-1996)(table 1) Only in technology and consumer services, was the frequency of the

down group beating the up group < 50% of the time (1978-

1996)(second table 1)

Why does the relationship hold?

Share buybacks

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Balance Sheet

Share buybacks

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Balance Sheet

Share buybacks

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Balance Sheet

Mergers and Acquisitions and Their Consequences, Bernstein

Acquisitions have NOT been rewarded in the stock market

Relative performance one year prior to the acquisition is up 24.5%, but the

cumulative returns three years after the deal is down 22.2% (table 11)

Mergersandacquisitions

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Balance Sheet

The larger the deal (as a % of the acquirers

capitalization) the worse the relative

performance in subsequent years (table 16)

Average size small, with target less than

one-tenth the size of the acquirer

In 27% of cases (for large-capitalization

stocks) where size was > 20% of acquirer,

performance was two times as bad (-

13.8% relative performance over two

years) as the small deals (-7.0%)

Relative performance is not necessarily

consistent across all sizes


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Balance Sheet

Acquirers that pay for deals with cash still underperform, but to a lesser

degree than the firms that pay with stock (table 17)


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Balance Sheet

Poor performance is almost

uniform across sectors, with the

exceptions being

telecommunications and utilities

(table 19)

Why do the above relationships

hold?

What is managements motivation

to acquire other companies?


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Balance Sheet

Capturing the Information in Current Asset and Liability Accounting,

Bernstein

Study (years beginning as early as 1952 through June 2001) analyzes changes

in net accruals and changes in net accruals normalize by total assets, book

value and sales; the study also reviews accounts receivable, inventories, and

accounts payable alone

Companies with rapid growth in net accruals, accounts receivable,

inventories, and accounts payable tend to underperform in the first year

(exhibit 2) and over multiple years (exhibit 3) and vice versa

Netaccruals

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Balance Sheet

Netaccruals

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Balance Sheet

Netaccruals

The exists for all sectors except

utilities (exhibit 6)

Why do the above

relationships hold?

High growth in net accruals

is a sign of over-optimism

and of poor events to

come

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Balance Sheet

Among Difference Cash-Based

Metrics, Cash/Market

Capitalization and Cash/Capital

Have the Greatest Predictive

Efficacy, Bernstein

The study ( 1965-August 2002)

looks at levels of cash

Companies with highest cash &

equivalents / market

capitalization have bestperformance (exhibit 6)

Cash

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Balance Sheet

Results consistent, for the most part,

across sectors (exhibit 8)

Results less robust during the 1998-

August 2002 period; however, this may

be due to the fact that the information

technology sector, which has fallen,

raised substantial cash during the

bubble were still benefiting from high

cash levels at the end of the period

Why do the above relationships hold? High cash levels are a sign of

conservatism and conservative

companies tend to be more

rationale with their spending plans

Cash

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Balance Sheet

More on the Use of the Balance

Sheet as a Predictor of Stock

Returns, Bernstein)

Study (1959 through July 2001)looks at changes in long-term debt

/ total assets

Companies with rapid growth in

long-term debt / total assets tend

to underperform (exhibit 2)

Why do the above relationships

hold?

Long-termdebt

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Balance Sheet

More on the Use of the Balance Sheet

as a Predictor of Stock Returns,

Bernstein

Study (1967 through July 2001) looks atchanges in intangibles/total assets

Intangibles = goodwill, copyrights,

trademarks, licenses, client lists, etc.

Rapid growth in intangibles / total

assets tend to lead to

underperformance (exhibit 3)

Why do the above relationships hold?

Intangibles

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Balance Sheet

Fixed Assets and Costs as Predictors of Stock Returns, Bernstein

Fixed intensity = fixed assets to employment and fixed assets to sales

High levels of fixed assets associated with underperformance (exhibit 5)

Fixedassets

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Balance Sheet

Companies with lowest fixed asset intensity performed well during the

recession of the early 1990s (exhibits 8 and 9)

Fixedassets

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Balance Sheet

Within sectors,

the highest return

to lowest capital

intensity is in

technology and

health care

(exhibit 10)

Why do the

above

relationshipshold?

Fixedassets

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Income Statement

Much of the focus of financial analysis is on the income statement, while

the balance sheet actually has more predictive power

General

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Income Statement

Fixed Assets and Costs as Predictors of Stock Returns, Bernstein

Fixed intensity was measured as fixed costs to sales

Fixed costs = depreciation, amortization, interest and SG&A costs

High levels of fixed costs associated with outperformance (exhibit 11) The highest fixed cost intensity companies outperform the low

fixed cost intensity companies during all periods examined and

over 1, 2, and 3 year periods

Fixed costs

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Income Statement

Fixed costs

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Income Statement

Companies with the highest fixed cost intensity performed very well

during the recovery of the early 1990s (exhibit 12 and 13)

Fixed costs

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Income Statement

Within sectors, highest return

to high fixed cost intensity is

commodities and other cyclical

groups (technology only area

where this strategy fails)

(exhibit 14)

Why do the above

relationships hold?

High overhead businesses

are easier to manage?

High overhead business

have the most leverage to

the upside?

Fixed costs

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Income Statement

Growth Stocks: Does

the Level of SG&A

Spending Tell Us

Anything? Bernstein

Logic - higher SG&A

as a percent of sales

= less efficient

operations

This is not so for

growth stocks(exhibit 2) (also not

true for large

stockssee exhibit

7)

SG&A

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Income Statement

SG&A

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Income Statement

SG&A good at picking winners (in the growth area) and exceptional at

picking losers (exhibits 4 and 5)

Why do the above relationships hold?

For growth stocks, companies need a higher level of SG&A to

support faster growth (e.g. health care)

SG&A

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Income Statement

R&D Spending as a

Selection Tool,

Bernstein

Performance(1970-April 2000)

(exhibits 2-5, 8)

High / low R&D

produces better

/ worse returns

for largecapitalization

stocks (exhibit

2)

Research&Development

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Income Statement

Relationship

more

pronounced

for growth

stocks (exhibit3) (technology

and health

care is most

important)

(see sectorbreakdown

exhibit 8)

R&D

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Income Statement

R&D

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Income Statement

Relationship even more important in the late 1990s (exhibits 4 & 5)

11

R&D

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Income Statement

R&D expense as a share of capital spending has been rising (exhibit 6)

R&D

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Income Statement

Low traditional

capital

expenditures

(primarily use for

building/plant

expansions, etc.) to

depreciation

combined with

high current R&D

as a percent ofsales produces a

powerful model

(exhibit 11)

Why?

R&D

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Income Statement

Low price to sales combined with high R&D to sales produces a

powerful model (Looking for Low-Priced R&D, table 1, Bernstein)

Why do the relationships hold?

R&D

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Summary

Contrary topopular perception, shrinking a company or growingatmodestrates is better than growing a company quickly

Why?

- What is managements motivations to grow?

Job preservation, pride, overconfidence, and monetary rewards

Management of high growth companies are pressured to manipulatethe books when growth slows

Shrinking or growing slowly is a sign of conservatism

High growth cannot last forever (see Analyzing the Future, Sector

Analysis, Life Cycles)

Investor expectations are lower for those companies with modest growth

rates

Lower expectations leads to positive surprises

Valuation reflects expectations (at least to an extent), so low

expectations equates to low valuation and multiples expand with each

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6-FSA Financial Hints to Picking Stocks