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Your Portfolio: "... at least, do no harm."

|Includes:AAPL, DHI, DIA, Alphabet Inc. (GOOG), SPY, THC

 “… to help, or at least do no harm.”

                          Hippocrates

Investors, without recognizing the implications of their decisions, often sway from the fundamental concept of doing their portfolio no harm.

And during bull market runs this credo further fades beyond the horizon as the money grab for yield and capital gains is the investor’s new best friend with risk becoming another 4 letter word.

This won’t happen again, right? We’re smarter now.

As any Las Vegas (or local) bookmaker knows, risk is often not what it appears. It is sub-surface. A great athlete may be facing marital or court issues, a nagging injury, didn’t sleep well, stomach cramps, girlfriend problems, or contract issues. Even the great Lebron James played awful during last season’s NBA basketball playoffs as his thoughts turned to playing for another team.

This analogy is clear-cut when it comes to investing. Certain risks are obvious, others not so. Some are clearly spelled out, such as patent protection and existing lawsuits in a company’s Form 10-K. Other risks are not so obvious, such as a reporting firm’s use of the standard, but incorrect definition of free cash flow of operating cash flow minus capital expenditures. I guess the management at such companies believes moral and legal obligations such as preferred dividends, purchase agreements and other liabilities that need to be settled with cash, such as derivative contracts, workers compensation claims or lawsuit judgments, don’t matter. 

The great macro risks-those that impact all securities and firms practically worldwide-often appear to come out of the blue, but history suggests this is not the case.
 

Federal Reserve Inflation Crackdown 1980
S&L Junk Bond Crises 1990
US Subprime Mortgage Crisis 2007
Mexican Debt Crisis 1982
Asia (Thailand) Debt Crisis 1997
Russia Default 1998
Argentina Economic Crisis 1999
Mortgage/Debt Crisis 2007-2009
Greek/Eurozone Crisis 2009
Click to enlarge

 

On the individual security level, the uncovering of risk goes beyond that found in the revenue line, where most security analysts spend their time. Sure, I look at revenue growth and stability of revenues as a metric in our cost of capital model. However, over time, you will find it is management’s ability to most efficiently utilize the firm’s resources that creates value.

The value-altering risks which impact individual firm’s worth are practically always apparent, and it is here where security analysts and investors should spend the bulk of their time. This is the area where the big winners and losers emanate. Both Apple (AAPL) and Google (GOOG) flashed greatness years ago with their strong and consistent free cash flows alongside low cost of capital, especially relative to peers. On the other hand, firms with high cost of capital, revealing unacceptable risk, was particularly noticeably for many firms whose stocks have fallen over the past years, such as Tenet Healthcare (THC) or DR Horton (DHI), which has been financing its operations primarily via asset sales and income tax refunds.

If a firm cannot increase its free cash flows, it does not create value for shareholders, given a fixed level of invested capital. It is for this reason, free cash flow based ROIC is a metric that CT Capital focuses on. Any risk must be explored regardless of the cause, and a sensitivity analysis prepared showing a range of potential outcomes. Investors need to work off a checklist, as we do at CT Capital—see Security Valuation and Risk Analysis for such a checklist-and evaluate any potential source or risk to the uncertainly of cash flows and financial structure.

While events overseas have always effected the financial market here in the U.S., I cannot recall a time period when there are so many hotspots of concern as there exists today—the Greek financial crises simmers down and the Irish crisis begins; now there are additional concerns in Portugal, Spain, and even Russia where sovereign debt has a higher yield than its best corporate obligations.

While all investors can do is hope today’s international issues are resolved, as they inevitably become, a more hands-on approach is required when it comes to the analysis and ownership of individual stocks. By carefully evaluating any and all risks to the firm’s cash flow, invested capital and cost of capital, the investor is not only helping himself, but at the same time, doing no harm. Given the recent stock rally, I would say such stepped-up analysis is quite important.

For additional information, including a complete discussion related to the analysis of credit quality and risk see Security Valuation and Risk Analysis, McGraw-Hill, 2010.

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Disclosure: No positions

Kenneth S. Hackel, CFA
President
CT Capital LLC

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If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” (McGraw-Hill, 2010).



Disclosure: No positions.
Stocks: GOOG, AAPL, THC, DHI, DIA, SPY