Recently I was asked by a client if I had to choose one stock out of the 17,000 stocks that our Friedrich Global Research analyzes (from 36 countries) which one would it be? The answer without a doubt is MasterCard (MA) and the following should explain why.
As a long term investor, the first thing you want to concentrate on is in finding companies that have little in the way of competition or what Warren Buffett calls a "moat" or "toll bridge". The industry that MasterCard operates in has very few players in it (as shown in the illustration below).
In 2016 MasterCard and Visa (V) handled 80% of all purchase transactions using global cards and MasterCard's volume grew 12.7% from the year prior. Visa is another stock that I also own in our client portfolios and even though it handled twice the transaction volume of MasterCard, its numbers (from a free cash flow point of view) are not as attractive as MasterCard's are.
Free cash flow analysis is the most powerful tool that any investor can use in order to get down to the real story behind what is really happening on Main Street. As a free cash flow analyst, 99% of my work is done on Main Street as Main Street is where MasterCard invests in its own operations. How well Ajaypal S. Banga (CEO of MasterCard) and management do in running those operations determines how profitable the company will be. Wall Street then reacts based on the success or failure of management to meet its goals. Main Street and Wall Street are thus interlinked, but because anyone with a computer, an internet connection and a brokerage account can buy or sell any stock at any time, expertise is not a requirement in order to invest on Wall Street. This results in Wall Street being a very dangerous place to operate in as many investors tend to operate through emotion or tend to follow the herd in and out of stocks. During bull markets, investors feel like they can do no wrong as "the rising tide lifts all boats." But when a bear market suddenly shows up, these same investors tend to panic and like lemmings stampede over the cliff. Thus we have the classic case of "greed vs. panic."
Having noticed this problem some 30 years ago, I spent the last three decades building an algorithm called Friedrich. Our algorithm was designed to assist all investors (both pro and novice alike) and give them the ability to quickly compare a company's Main Street operations, to its Wall Street valuation (overbought or oversold condition). Friedrich can do this on an individual company basis or assist users in analyzing an entire index like the S&P 500 (NYSEARCA:SPY), an ETF, mutual fund or individual portfolio.
Many years ago, while reading Berkshire Hathaway's (NYSE:BRK.B) (NYSE:BRK.A) 1986 letter to shareholders, I discovered a ratio, which Mr. Buffett called "owner earnings," or what we may consider to be Mr. Buffett's version of "free cash flow." To my amazement, in that little footnote, Mr. Buffett explains how to use it and basically states that it is one of the key ratios that he and Charlie Munger used in analyzing stocks. In that article, he defined the term "owner earnings" as the cash that is generated by the company's business operations.
[Owner earnings] represent (A) reported earnings plus (B) depreciation, depletion, amortization, and certain other non-cash charges…less (C) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume."
I have used this free cash flow ratio for decades, using data from the Value Line Investment Survey, whose founder was Arnold Bernhard. Mr. Bernhard was a big fan of free cash flow and probably introduced it sooner than Mr. Buffett did. I know this as I was able to calculate the FCF ratio using old Value Line's sheets for my 60-year backtest of the DJIA from 1950-2009.
Having had great success in using Owner earnings, I then created the following ratio in order to make Owner earnings more powerful. FROIC turned out to be the most important ratio I use (out of 66) when analyzing a company on Main Street and this is how it is calculated.
Here is MasterCard's real time FROIC calculated for you.
FROIC means "Free Cash Flow Return on Invested Capital"
Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) + (Capital Spending)]
FROIC = (Forward Free Cash Flow)/ (Long-Term Debt + Shareholders' Equity)
Net Income per diluted share = $4,181,000,000/1,082,400,000 = $3.86
Depreciation per diluted share = $1,292,000,000/1,082,400,000 = $1.19
Capital Spending per diluted share = $-242,000,000/1,082,400,000 = $-0.22
Revenue Growth Rate TTM = 3%
[(($3.86 + $1.19) (1.03%)) + ($-0.22)] =$4.98
Long-Term Debt = $5,216,000,000
Shareholders Equity = $5,611,000,000
Diluted Shares Outstanding = 1,082,400,000
FROIC = (Forward Free Cash Flow)/ (Long-Term Debt + Shareholders' Equity)
$4.98/$10.00 = 49.8%
FROIC = 49.8%
What the FROIC ratio does is tell us how much forward free cash flow the company is generating on Main Street relative to how much total capital it has employed. So, if a company invests $100 in total capital on Main Street and generates $20 in forward free cash flow, it therefore has a FROIC of 20%, which we consider excellent.
Having said that, how did MasterCard do on the FROIC front?
As you can see MasterCard's FROIC is incredible, while here is Visa's:
As you can clearly see, from a FROIC point of view, there is no comparison and MasterCard has been the clear winner over the last decade. Now the sharp drop in FROIC in 2016-2017 for Visa has to do with its recent merger with Visa Europe and since Friedrich only uses GAAP data when doing its analysis, those numbers can dramatically change to the upside going forward. Having said that, I don't intend to ever sell Visa as, along with MasterCard, it is a duopoly in one of the fastest growing industries around.
Here is our most current Datafile and Friedrich Chart on MasterCard, which will show how well the company is run by its elite management.
The slots that are green are considered ideal according to our system (legend) and those in red are not, so Friedrich is telling us that we are looking at fields of green when investing in MasterCard.
Though MasterCard is no longer a bargain (very few stocks are these days) it is still selling below its Main Street price (the price per share that a businessperson would value any business on Main Street at) and is still far away from its overbought price.
That is all well and good but, going forward, what does the future look like for both companies? Well, here is an illustration that should impress - and it basically makes both companies permanent foundational holdings for my client portfolios.
Going forward, as a long term buy and hold investor, it is my opinion that one cannot do much better that having MasterCard in one's portfolio. The future is so bright in the Asian-Pacific region that it is outright shocking as to how good things look. So even if the current bull market ends soon, as a conservative investor I will continue to sleep well at night knowing that I have a foundation holding like MasterCard in my client portfolios.
In conclusion, it is my belief that free cash flow analysis is the ultimate tool when analyzing companies, and my hope is that you may add our FROIC ratio to your own investor tool box in order to help you in your own due diligence. If you have any questions, please feel free to ask them in the comment section below and don't forget to hit the "Follow" button after our Friedrich Research username on top as we plan to do many more studies like this one in the near future.
Disclosure: I am/we are long MA, V.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.