Reading Between the Lines

It's that time of the year again, when investors start receiving colorful annual reports from companies in which they own stock. As I start opening these envelopes, I notice subtle little changes. They are smaller and thinner. Maybe this is to cut down on costs, or perhaps the management has very little cheer to share with us this year.

I like to read the annual reports, because they give me a picture of the health of the company, and they help me determine whether a company is a good fit for the investment philosophy I pursue on behalf of my clients.

I turn first to the statement of financial position to look at the changes in the cash on hand, and at the debt structure to see if there are any big changes in the levels year over year. Next I look at the statement of earnings to see changes in sales/revenue and costs -- which eventually gets us to the net earnings. Because of course, in the end, profitability is the key indicator of health of a company.

As I have discussed in previous newsletters, I want to buy good quality companies. There have been "broad" definitions of quality when describing a company, but I believe a quality company is one that has a high return on capital.

Buying a share of a good business obviously is better than buying a share of a bad business. One way to do this is to buy shares of a business that can invest its own money at high rates of return rather than a business that can only invest at lower ones. I have found that Value Line gives me a clean snapshot of companies for the past 15 years. Within the snapshot, I can zero in on the return on capital line and see the trends for the companies (good or bad).

For instance, the January 23, 2009 publication of Value Line gives a 15-year "snapshot" of the General Electric Company. It shows that in 2000, the year that the stock multiple peaked at 40.1 times earnings, the company had a return on capital of 9.6% and long-term debt of $82.132 billion. At the end of 2008, the multiple had been reduced to 14.7 times earnings -- possibly because they had more than $345 billion in debt with a return of capital of only 4%. In other words, they leveraged their finance unit up during the good times, but with our "new new economy" they are literally choking on all their debt.

The Financial Times reported on March 30 that GE has started to see the first "glimmers of hope" in the world economy. GE points to positive data, including the recent rise in the Baltic dry shipping index, which acts as a proxy for global trade, and increasing housing sales in the United States in February. We will have to wait and see if these "glimmers" become beacons of hope.

On the other hand, look at the financials of the McDonald's Corporation. Over the past decade they have increased their dividend eight-fold (I want my cheese!) and repurchased more than 25% of their stock. Since 2002, they have almost doubled their return on capital. (That's a lot of Big Macs!)

I also stay with companies that are generating free cash flow. This allows them all sorts of flexibility -- such as dividend increases, buying back stock, debt payment -- and it also allows them to make "strategic" acquisitions. Exxon Mobil is a classic example of a company with tremendous financial flexibility. Back in 1999, Exxon issued more than 2 billion shares to purchase Mobil Oil, the No.2 U.S. oil company. Since that time, Exxon has retired all 2 billion shares and more while increasing the annual dividends to stockholders because of the company's strong free cash flow.

So when someone tells you to invest your money in quality companies, ask about the financial returns of these companies and whether they pay a dividend -- especially important because a third of total equity-market returns since the late 1920s has come from dividends rather than share-price gains.

There are many good "quality" companies that don't need to finance and leverage their balance sheets to produce healthy profits for their stockholders. A little research and reading between the lines will help identify those companies.

Garry K. Schaefer
Atlanta, Georgia
April 7, 2009

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