Scoring and Weighting my CCP - Part 2
New learnings incorporated
Readers might recall my writing about scoring and weighting my coffee can portfolio (it was a rather popular post, being the 3rd most read post since this newsletter was started in the first place, with my piece on Bunzl being the most popular so far.)
While I was filling my dataset with free cash flows (FCF) and book values recently I started thinking about how to incorporate this new found information into my own Business Value Score (BVS)1 system that I had built earlier. Additionally I had found that the previous scoring system weighed very heavily towards companies with PBT2 growth while ignoring most of the other parameters, so a review of the weights was in any case due. Today, I would like to unveil v2 of the Scoring and Weighting System.
Business Value Score
The v2 Scoring System contains the following additional information:
Consistency of Positive Cash Flow generation - in what proportion of the last 15 years does the company generate positive free cash flow
Consistency of Cash Flow growth - in what proportion of the last 15 years does the company grow it’s Free cash flow
FCF Growth on a CAGR basis - this measures the magnitude of the growth of FCF over the past 15 years. (This differs from the above, which measures how consistent does the company grow its FCF)
FCF/share growth on a CAGR basis - this measures the same as the above, but on a per-share basis. This is to identify and reward companies that decrease their share count while growing FCF, or conversely, penalise companies that grow their share count over time.
I am fully aware that the 4 above metrics are essentially mild variations of the core metric - cash flow generation, but the variations matter. Companies tend to score in one and not the other, so having all 4 is useful.
Along with the previously incorporated metrics, my current model uses the following metrics (along with the weights provided) is calculating the Business Value Score:
Basic growth
2% Years of increasing dividend (max 15) 2% Years of increasing revenue (max 15) 2% Years of increasing diluted EPS (max 15)
Balance Sheet Strength
8% Current Ratio (last balance sheet) 8% Total Ratio (last balance sheet) 4% Longevity of data (how far back is the data we are considering. Capped at 15 years)
Consistency of profit and cashflow generation
4% %age of Years of PBT growth > -10% (mild drops are okay) 4% %age of years of PBT drop is not worse than 50% (big drops are especially bad) 8% %age of years of +ve Cashflow 4% %age of years of cashflow growth
Base growth of the business profitability
4% Terminal PBT over original PBT (over the length of time measured)
Growth of key business metrics
6% Revenue CAGR 8% OPAT CAGR 8% Diluted EPS CAGR 8% Dividend Growth CAGR 4% Share Price Growth CAGR 8% FCF Growth CAGR 8% FCF per share growth CAGR
Valuation
While the above changes, both adding of new fields as well as weights, provided a much better understanding of the business, I wanted to review Valuation too. In v1, valuation was purely based on P/E, i.e. how cheap or costly the business is relative to its earnings.
With new metrics available, specifically Free Cash Flow, I wanted to see if there is a way to incorporate that too. At the outset I found that FCF can be a bit noisy and jump from one year to another. While I wanted to value the most recent FCF of a company, I value the ability of the company to generate FCF over medium term (i.e. 3 years) a lot more.
Similarly, Book Value is not a useful metric on its own. However, I wanted to find a way to reward the valuation of companies with very low book value (relative to share price) and punish very high book value companies, but do so in a tempered fashion3. I found a formula that just about does the trick in generating something useful.
So, the new measure of valuation is as follows:
60% Price / Earnings 30% Price / 3-year-FCF-per-share 10% Price / latest-FCF-per-share + / - Tempered Price-to-Book bonus / penalty
Relative Value
Relative Value of a company (i.e. attractiveness of the company) continues to be
Companies with positive Relative Value (RV) are worth buying, but the higher the relative value score, the better, for obvious reasons.
Findings
Before I jumped headlong into using these metrics, I wanted to compare it with previous metrics. For instance, of the 48 companies in the portfolio, 45 have continued to stay positive or negative respectively, in terms of relative score, between v1 and v2. Only 3, coincidentally, all Swiss companies, Nestle, Novartis and Roche, have switched from positive to negative and vice versa, but all three companies were anyway on the borderline, so the jumps in either direction with new formulae are not that surprising.
Best Companies
The best 5 companies in the new scoring are:
Anhui Conch Cement / HKG:0914 (previously #3)
Sinopharm / HKG:1099 (previously #2)
Legal & General / LON:LGEN (previously #9)
Stella Jones / TSE:SJ (previously #5)
Tencent / HKG:0700 (previously #4)
Legal and General’s (LON:LGEN) upward move can be easily explained by the superior cashflow characteristics, with it’s per share free cash flow growing 21.34% in the past 15 years.
Most Gainers
PetMed Express / NASDAQ:PETS (from #37 to #9)
Challenger Financial / ASX:CGF (from #36 to #16)
PetMed Express (PETS) benefitted from higher weightage to growing dividends, where it boasts 12.25% per year CAGR. Challenger Financial (ASX:CGF, last post), unsurprisingly benefitting from good cashflow growth rates clocked in at 18.14% growth in FCF/share over the past 15 years.
Bottom of the Pile
Among the worst ranked in v2 scoring system are (starting from #48):
Amazon / NASDAQ:AMZN
Disney / NYSE:DIS
Mondelez / NASDAQ:MDLZ
McCormick / NYSE:MKC
PepsiCo / NASDAQ:PEP
All 5 of the above companies have reasonably good Business Value Scores, but their valuations are very rich and in the current scoring framework, lose out heavily due to that factor. Take PepsiCo for example, whose P/E is only 28.61, but it only produces about $4+ in FCF per share. It trades today at about $183, which puts it blended valuation at 35.87x, resulting in a negative relative score.
All round understanding
Despite everything I have in this post it is imperative for me to note that I strongly believe that no formula and no algorithm can perfectly capture the opportunity each business makes available for future returns. There is always some subjectivity involved. This subjectivity will likely not be a finger in the air, but rather depends on reading the annual results, and understanding the story of the company at some level of depth. There are 2 such stories in play at the moment where the metrics don’t capture the full risk/reward trade-off, on which I have written detailed notes in the recent past - Fresenius Corporation & Challenger Financial.
Taking this further, would I totally shy away from adding to my Amazon position altogether due to where the relative score of the company lies? Possibly not, but I wouldn’t do so as enthusiastically as adding to my Stella Jones (TSE:SJ) position. Similarly, however good the relative score for the Chinese companies are, I will still proceed with caution in terms of increasing my China exposure beyond a point, largely to avoid geographical concentration risk, specially in a market fraught with geopolitical risk.
Rounding up these metrics with a deeper understanding of the opportunity & risks is always necessary.
Overall, I am confident that v2 of the business scoring system is a better indicator of all round capabilities of a business and I shall be using it going forward.
Changes to my Coffee Can Portfolio sheet
My Coffee Can Portfolio sheet is herewith being upgraded to support all the v2 findings. I have provided both the Business Value Score, the normalised Valuation Score and the Relative Value score. Status is now updated to directly come from Relative Value score.
I am also providing my holdings in exact percentage, so that you can review my holdings. I will be updating them rather infrequently, but I will strive to keep them up to date at least once every 3 months.
In terms of Labels in the Status section, I have internally assigned companies with Relative Value of more than 5 as “Accumulate”, those between 0 and 5 as “Maintain” and those less than 0 as “Dilute”. Thankfully, some 85% of my investments happen to be in companies marked as either Accumulate or Maintain.
I have already added the following tabs:
Changelog - to keep track of changes to individual line items over time (tab)
I hope everything mentioned in this post can be put to use by readers in a profitable manner. Happy Investing!!
Disclaimer: I may hold positions in the tickers mentioned in this post. I am not your financial advisor and bear no fiduciary responsibility. This post is only for educational and entertainment purposes. Do your own due diligence before investing in any securities.
Business Value Score is intended to be a score that determines how good is a company at producing growing profits in a reliable manner.
Profit Before Tax
Calculating it as (SQRT (Shareprice / Bookvalue-per-share) - 1) is a reasonable estimate. For companies with low bookvalue-per-share, it will be negative and adding it to the valuation will make the normalised multiples look better, and vice versa. The Square-root function allows for tempering of the metric.