I am looking to build a screener that looks at some universal truths of promising companies. Something that when higher/lower it is basically always good. In this post I will argue for the inclusion of some traits and the avoidance of some common ones. Please see below:
What makes a promising company?
Sales, Operating Cash Flow, Free Cash Flow Growth: if you ain’t growing your dieing.
High Gross Margins: indication of significant value add
Low Debt and Interest Coverage: this is where risk of a company is. The lower the better, particularly if they are doing well in all the other factors.
Low Shareholder Dilution: like debt, if they are doing the other things well but give the company away, that’s no good.
Characteristics I’d argue against:
Net Income margin, Operating Income Margin, ROE: as you get farther down the income statement, more and more can be played with by management. Take AMZN for example. Look at this chart. AMZN had torrid growth and never grew earnings. Why did the stock go up even though it was and still kinda is a non-profit? They were reinvesting aggressively to fuel that growth ultimately growing their future cash flows more than they otherwise would have been if they showed a profit. Also by not having profits, you minimize taxes. AMZN isn’t the only one to do this, Salesforce did the same thing.
It’s not that I think NI, OI and ROE are bad, I am looking for promising companies that are before their maturity.
With ROE, that tells you where a company is, not where it’s going. Take Colgate, they have an ROE of 500%! Do we think that each incremental investment they make will yield a 500% ROE? of course not. They have been able to replace equity with debt to make the “E” smaller jacking up the ROE.
NI Margin is getting more manipulated with GAAP changes. For example, pass through gain and losses on security investments flow through the income statement. Berkshire is a classic case here.
OI Margin: As mentioned above, companies can purposefully spend more to boost growth and if you have say 60, 70, 80% gross margins, that seems like a great idea. This will mean no profits today, faster growth today, and hopefully a greater ability to harvest profits later.
What do you think, are there any other universal truths of promising companies?
Thank you for your insights!
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