Stock Metrics Can Lead You Astray: This Is What Fund Managers Say About It.
Many Americans have taken up stock metrics as a new hobby as markets have continued to rise following the Covid-19 epidemic. In January of this year, Google searches for “stocks to invest” were three times more than they were a year before.
The sheer amount of financial data, however, can be overwhelming for inexperienced investors. It’s easy to go into difficulty if you don’t completely comprehend what those signs represent and why they might be deceitful at times.
Barron’s asked two mutual-fund managers––both with years of expertise and strong track records––how they utilize metrics in their decision-making and what are some of the typical misconceptions when buying stocks––to assist stock pickers to navigate the market more efficiently.
Our purpose isn’t to argue that portfolio managers always know best––performance pressure might compel them to invest with a short-term mindset––but rather to highlight a few aspects that most experts pay attention to.
In other not to be led astray in stock metrics, learn the below:
Cash vs. Earnings
To determine if stock metrics are overpriced, many investors compare their price/earnings ratio to that of their peers. However, fund managers don’t necessarily choose P/E as a valuation tool.
To begin with, many young businesses do not have a consistent revenue source. Even if they do, many of them fail to report results in accordance with widely accepted accounting rules. Non-GAAP data are easily modified to make them appear better, making apples-to-apples comparisons between corporations problematic.
Nicole Kornitzer, manager of the $662 million Buffalo International Fund (ticker: BUFIX), prefers to look at a company’s free cash flow compared to its share price since it is more difficult to manipulate. “More free cash means more opportunities for acquisitions or to return value to shareholders through buybacks or dividends,” she explained. “Those ideals aren’t necessarily reflected in the money.”
The Buffalo International Fund invests in developed-market large-cap growth firms. According to Morningstar, it has outperformed 80% of its rivals over the last decade.
Sales vs. Profit Margin
Another teaching about stock metrics: Many investors look at sales revenue to assess if a firm is growing at a healthy rate. However, because revenues aren’t adjusted for inflation, seemingly high figures could simply be the result of higher prices rather than more products sold. Instead, investors should look at sales unit growth and see if the company’s profit margin has dropped, according to Kornitzer.
In today’s inflationary economy, this is especially vital. A bigger margin reflects a firm’s capacity to pass on rising expenses to customers, whereas a tight margin suggests the company must absorb such costs.
For example, consumer-staples businesses in the S&P 500 reported significant year-over-year sales growth of 7.5 percent in the third quarter, but only 3.9 percent in profitability. In fact, profit margins narrowed for two-thirds of the companies during the quarter, the highest ratio of any industry. This indicates a lack of pricing power in the face of growing inflation.
Ratio of Dividends to Payouts
Consistent dividend increase in the past frequently indicates a company’s long-term success and a better possibility of future dividend growth for income investors. But, according to Michael Shelton, manager of the $486 million Nicholas Equity Income Fund, it’s also vital to look at the payout ratio or the number of a company’s revenues delivered to shareholders via dividends (NSEIX).
Payout ratios should neither be too high nor very low. According to Shelton, more research revealed that the optimal number is approximately 40%. “If it rises beyond 55 percent, you’re effectively choking off financing from the firm, making future expansion impossible,” he added.
Some of the so-called “dividend kings” have been increasing dividends for so long that they can’t afford to lose their title, even if they don’t have enough earnings to keep growing them. As a result, the payout ratio rises. “It’s almost like a badge of honor,” Shelton added. “They’re simply trying to maintain their track record, and investors should be wary of these firms.”
The Nicholas Equity Income Fund invests mostly in U.S. large-cap value companies. Over the last 15 years, it has outperformed 97 percent of its rivals.
Cyclicality vs. Debt
Finally, organizations with higher debt levels than their ability to create revenues are more likely to struggle to satisfy their financial obligations during recessions or other difficult periods. A debt-to-earnings ratio of more than three times is usually regarded as concerning, however, this varies by industry.
ALSO READ: 5 Reasons for Cryptocurrency’s Success
Because they must make substantial capital expenditures to create new projects, utility firms, for example, generally have a lot of debt on their balance sheets compared to other industries. During cyclical downturns, however, their earnings and cash flows are frequently less impacted than those of other businesses.
“It’s prudent––and often even necessary––for a utility firm to have both high debt levels and a high payout ratio,” Shelton explained, “since their business won’t be squished even during recessions.” He believes the debt-to-earnings ratio in the utility industry may reach five times before it becomes alarming.