Many times in the history of the markets we have seen street darlings fall from grace – with the bubble being burst explained by fraud, speculation, mass hysteria or all three. We all know emotionally, it’s easy to get caught in a company’s “story”. When everyone seems to be making money and a stock is only going one direction it’s tough for many to sit on the sidelines. And because most managers out there have a relative focus we often hear "well, it’s a big part of the index, so I have to own it." As active managers who focus on absolute returns and downside risk, avoiding these speculative traps is one way we at Cambridge, look to deliver value for clients.
I was recently asked a great question, “How does your team figure out if a company is just too good to be true?” In reality there are quantitative as well as qualitative tools we use to avoid these traps. Common sense is a great starting point for any analysis: stepping back and asking yourself if it makes logical sense? These companies often claim to be able to do something that has never before been achieved. Often, management has taken part in speculations in the past and in some cases, company projections are simply impossible to achieve. Sometimes a company won’t have the production capacity to deliver the sales it projects and may even forecast becoming greater than the entire industry it operates in! A key part of the analysis of a growth company is understanding the source of growth to figure out how sustainable that growth is.
Beyond this, there are two things that help avoid these problem areas: first, with our experience meeting many management teams and analyzing many business models over the years we have all developed the ability to sense whether or not someone is being sincere. This is a very helpful tool to determine if a management team is more focused on running its business or selling you its stock! Again, finding management teams that think like owners is a key part of our research process.
The second and more direct way to sniff out potential problems is by comparing reported EPS to adjusted EPS and investigating how these numbers flow through to cash flow. Over the years, the market focus has veered further and further away from Generally Acceptable Accounting Principles (GAAP) earnings – instead focusing on “adjusted” or “cash” earnings. While analysis of fundamentals, excluding “one time” noise can be helpful in determining underlying business drivers and true intrinsic value, if these “one time” items happen every year they aren’t exactly “one time” and need to be included in the analysis. And of course, it’s important to look across the income statement, cash flow statement and balance sheets to look for inconsistencies and gauge earnings quality. After all you can’t fake (unadjusted) cash flow!
Let’s look at an example: Valeant
Early on, this company was able to create value by finding cheap cash flow streams to purchase and reducing expenditures in an industry that had historically overspent. However, as time went on the drug companies got smarter on their own businesses, cutting costs and lowering tax rates. Additionally, a number of copy cats entered the market and began competing on deals (e.g. ENDP, MNK and KRIMM – which never happened, was a spectacular example). Valeant also had to acquire larger and larger companies to move the needle, given their size. These factors made it exceedingly difficult to operate the same value creation engine as they did in earlier years.
Let’s look at the business model with some common sense. Valeant's modus operandi consisted of buying companies, cutting R+D, increasing drug prices and structuring it in a way they could avoid paying income tax. Essentially, they reduced innovation, fired people, increased health care costs and avoided paying taxes (to the U.S. government, their largest customer) – not a sustainable business model in the long run in my view.
Now to the quantitative – when we look at the progression of GAAP vs. adjusted earnings for Valeant over the years we can see a pattern:
From 2010 (when the stock really took off) through 2015, Valeant reported $34.23/share in total adjusted earnings while under GAAP they lost $1.83/share.
Adjustments to earnings include consultants used to analyze acquisitions, integration and restructuring costs, tax consultant costs and non-cash amortization of intangibles. These are all costs related to their core business and probably should not be excluded from the analysis.
It is worth noting a large part of the amortization related to acquisitions is non-cash and could be adjusted in analyzing the business. As M+A is a core part of their business model, I would include it in my analysis, but let’s look at operating cash flow per share compared to the reported EPS for argument’s sake:
The company’s ability to convert net income into cash flow was hampered over this time period as well. (As a side note, Valeant is one of the few companies I have seen that actually reported adjusted cash flow from operations).
Operating cash flow per share grew a lot over this time, but what was the source of this growth? Take a look at net debt per share:
Valeant added $80/share of debt to generate an incremental $4/share of operating cash flow from 2010 through 2015 and we all know debt as a source of growth is not sustainable over the long run.
As we navigate the opportunities out there we will continue to use our common sense, our own numbers (and our own analysis of the numbers) to truly understand the source of value creation a company is delivering before getting investing our in a business. While it’s easy to get caught in stock price moves, diligent analysis will help distinguish perception from reality.