Yesterday I explained our research process as it relates to the top-down/bottom-up work that we do. This is about Disciplined Investing, as is our motto. It would be pretty easy to read sell-side research reports and consider that enough "research" to do and then to go fishing but that is not how we do it.
So today I will delve down a bit deeper into our bottom-up/micro/fundamental research process. As I said yesterday, I run excel files on all of our portfolio investments. Each company has an excel file and it is an ongoing process. There are several tabs in each file, as described yesterday, but one of the most important is the Cash Flow tab where we track historical financials and model the future cash flows and capital structure (see here for capital structure explanation: http://highrockcapital.ca/pauls-blog/an-introduction-to-the-capital-structure-of-a-corporation and-how-to-be-tactical) of each company.
Here is an info-graphic that I have used the past couple of years when I have been invited to be a guest lecturer at Queen's University's Master of Finance Program:
We start with Revenues (often referred to Top Line...harder for a company to manipulate) and then work our way down. Ebitda (Earnings before interest expense, taxes and depreciation and amortization) is often referred to as Cash Flow but it really is only the starting point. We need to take Ebitda and deduct items the company REALLY need to pay for (called Fixed Charges) like Interest Expense (if they don't pay that, they are in Default), and then Cash Taxes (some companies don't pay cash taxes because they have Net Operating Losses but if they do need to pay cash taxes, they really do or...they will end up in jail!). Also, most companies have to spend a bare minimum on their business. This is called Maintenance Capital Expenditure (Capex) which is the money spent too keep the business rolling forward (like doing basic repairs around your home). (Growth capex does not Need to be spent so we don't necessarily include it).
Then we get to Free Operating Cash Flow (FOCF). It is from here that companies can distribute Dividends to their shareholders. This is a key determinate in assessing a company's ability to pay Dividends. As you can see, we calculate the Dividends Paid as a % of FOCF. This is KEY if you are a Dividend Investor.
Not on the graph above but then we calculate the Capitalization (Capital Structure) of each company noting what the Covenants (Limitations on what the company can and cannot do) in their Credit Facility (Bank Debt) are track them each quarter. We do the same if they have bonds outstanding (especially High Yield bonds). This requires a ton of Legal reading as all of this information is found in Legal Documents called Credit Facility Agreements and Bond Indentures. They can be 250 pages long and are definitely not night time reading. Perhaps boring, perhaps a lot of work but extremely important.
Then we track how the Cash Flow Model compares to the Capital Structure to derive and compare their "credit metrics" with their allowances under their Credit Facility and their Bond Indenture. This is called "Headroom". Should they get close on their Headroom their securities (stocks and bonds) will start getting nervous and selling off.
So that is the more in-depth work I do on each portfolio company (and many more at about 50 of them). This work is done initially and then quarterly as each company reports financials on a quarterly basis. This is the type of work our clients are paying for as we believe it helps us in our investment decision making process. It doesn't guarantee success in our investments but it sure does lend a solid level of confidence and takes advantage of where others may not be a Disciplined in their process.
Next week I will attempt to describe what we do with all of this fundamental research and how we actually execute in our portfolios. Part III coming up...