“An expert is someone who has succeeded in making decisions and judgements simpler through knowing what to pay attention to and what to ignore.”
– Edward de Bono
Stock Investing: The 4 Key Metrics I Look at for Future Gains
35 years ago, I was a partner in a profitable business. Every year, my boss/partner and I would sit down and decide how many of those profit dollars we would put in our pockets and how many we would leave in the company for future growth.
Before then, I didn’t even know this was something company owners did. I always assumed that shareholders pocketed 100% of the profits each year. In fact, that’s not possible. Businesses need cash flow to operate current activities, and savings (capital) to invest in new projects and products. If you take out all the profits, it’s nearly impossible to grow.
There is no hard and fast rule for what percentage of profits should be retained and what should be distributed to shareholders. The ratio depends on lots of things: the economics of the business itself (i.e., whether it’s labor or capital intensive, whether it generates or consumes cash, whether the ROIs come quickly or slowly, etc.) plus the growth ambitions and greediness of its owners.
In that long-ago business, there were only two partners: my boss/partner and me. It was, as I said, very profitable. It gushed cash and had no debt. So, in theory, we could take a good percentage of the profits each year. And we did. We typically banked 70% to 80%. This made us personally very wealthy, but it was a bit of a strain on the business – and probably hindered its growth. We peaked at revenues of $135 million.
15 years later, when I took a minor ownership interest in another, similar business, I was shocked to discover that the protocol was to distribute only 10% of the yearly profits to shareholders. This, at first, appalled me. For every thousand dollars of profit we made, our cut was only $100 – of which my partner would get $88 and I’d get $12!
It took a long time to get used to. But, in retrospect, was mostly a smart move. Retaining 90% of the profits allowed us to grow the business without ever borrowing money. And it meant we always had plenty of cash to pay for our mistakes.
That second business grew quite large – to more than 10 times the first one. But eventually we realized that leaving so much cash in the business had an unintended negative consequence: It encouraged a culture with too much financial space for sloppiness and wastefulness. A higher percentage of distribution would have been better.
A third business, which was born out of the second, was developed by a protégé of mine. He distributed a good deal more than 10% of the profits to us, to himself, and to other key players to whom he gave equity. This business had better overall results, both in terms of growth and its eventual value.
So, what does this have to do with investing in public companies? It taught me a lesson about one of the key metrics I use to assess them.
Metric #1: Dividends History
Every business, as I suggested above, has its own internal dynamics. So there’s no such thing as a percentage of retained profits that is right for all industries, let alone all businesses. But I can say this: When I’m looking at companies to invest in – private or public – I like those that are committed to retaining the cash they need to solve unexpected problems and invest in growth, while at the same time distributing profits to shareholders as often and as generously as they can.
It says something important about the company’s management: that it is cautious, not greedy, and yet understands the importance of rewarding stakeholders along the way.
So that is the first of the four metrics I look at when investing in stocks: a history of paying dividends to shareholders. I want to know how often the company pays out dividends… and how much.
Metric #2: Earnings History
With a few exceptions, I want to see a steady growth in revenues. A volatile sales history makes me nervous – especially when I can’t figure out why it’s so erratic. A steady increase in revenues is at least an indication that the people running the business understand how to make it grow. You’d be surprised at how often this is not the case.
The rate of growth is important, too. For small companies, I like to see faster growth. After the first several years, I want to see significant growth – 30% to 50% a year. Then, when the business gets to the $100 million level, I’m happy with 20% to 30%. And when it breaks through the $500 million barrier, I’m comfortable with 10% to 20%.
Occasionally, I make exceptions to these expectations. But only when I can clearly understand why growth was less and how it might recover. If I’m too far away from the business to understand the why and how, I stay away from them.
Metric #3: Recent Sales
The history of earnings is very important, but I also like to see how sales have been doing in the past 6 to 12 months. This is important for the most obvious reason: I want to make sure that something really bad hasn’t happened since the company’s last annual report.
Metric #4: Current Industry Status
In Delivering Happiness, Tony Hsieh compared investing in businesses to playing poker, the only casino game where the odds are not stacked against the player. The most important rule of poker, he said, is what table you are playing at.
If you choose a table that has too many players, it is difficult to win even if most of them are amateurs. If you choose a table with only a few players all of whom are experts, it is difficult, too. The right table is one where your odds of winning are the best, and that is a table where the expert competition is limited.
The same is true with investing. As a general rule, you will do better investing in a solid but unexciting company in a fast-growing industry than you would putting your money into a business with an exciting story in an industry that is going nowhere or is on the decline.
In short, I look for quality in making my stock investments. I look for the quality of the financials, of the management, of the products, and of customer relations. I want to invest in companies that have a proven growth strategy, a sufficient flow of cash, a commitment to employees, customers, and shareholders. And a company that plays a prominent role in an industry that is growing.
But quality is a subjective value. You can’t measure it. But you can measure the history of a company’s dividends, earnings, sales, and its status in its industry. These four metrics won’t insure success in stock investing, but for the typical pedestrian investor like me, they are a very good start.
