In his new book, Charles Rotblut distills the strategies of value investing legends. Here, he walks through his time-tested process for finding plays with lower risk and higher reward.
Charles, I understand you’ve written a book, Better Good than Lucky. Tell me about it.
Sure. It’s actually based on a lot of the famous investing concepts out there.
I’m a Warren Buffett-type of investor, so there’s a lot of Phil Fisher, and there’s a lot of Benjamin Graham in there, but I also have some John Bogle of Vanguard in there.
Basically, the idea behind the book is if you’re looking at stocks, you want to find stocks with more potential upside reward and less potential downside risk. So, you’re trying to find that balance between risk and reward and actually have that ratio work in your favor.
How do you screen for stocks like that?
Well, I look for a few main things. I look at the business model. I look at cash flow. I look at financials. I also look at the valuation. Finally, I look for earnings and sales growth.
Let’s talk about the business model.
Sure. The business model is really, what does the company do to make money. Specifically, one of things I look for: does the company make products that fulfill a need, versus products that just merely fulfill a want?
A good example is Lululemon (LULU). A lot of people like the stock because it has performed well. I’ve done yoga for almost a decade, and Lululemon makes high-end yoga clothing. I can assure you that you don’t need a $100 pair of yoga pants to do a downward dog.
If you look at some other companies like a Parker Hannifin (PH), which I own, which makes industrial parts, their products are very important to the industry, and manufacturers want those types of products not to fail. Therefore, you actually have a business that fulfills a need.
Since there’s a lot of maintenance required, they actually have a built-in market for aftermarket sales as well. So, that’s the difference between looking at a business model that fulfills a want versus one that fulfills a need.
How about the strong balance sheet?
Sure. When you’re a shareholder, you want to make sure the company is adequately financed. You want to make sure it has enough cash on hand, and you also want to make sure it’s not too much in debt.
It’s the same as being a consumer. If you actually have a lot of cash in your savings account, you’re more flexible to buy things, you have more flexibility to actually finance investments and create wealth in the future, versus if you actually have a lot of debt and you don’t have a lot of cash, chances are you’re going to stay in debt. It’s much harder for you to do things that could actually build your wealth in the future.
So, just like, as consumers we want our balance sheets to be strong and in good shape, as investors we want our companies to also have strong balance sheets.
Which, I guess, leads us into the positive of free cash flow.
Absolutely. When you’re investing in a company, you want to generate cash flow. A lot of people look at earnings. Earnings are important, but it’s important to realize earnings are merely an accounting figure.
Cash is what you can spend. Cash is what you can invest. The cash flow from operations or cash flow from operating activities, which is found on a cash flow statement, tells whether or not a company is actually generating cash or if it’s using more cash than it’s bringing in.
Earnings though. Everybody—especially as we’re into the earnings reporting season—people are focused on that. Are you saying we shouldn’t, or just not give it as much weight?
I think you should focus on earnings because they are a scorecard of how a company is doing. But I think when you’re comparing earnings to cash flow, I would put more weight on cash flow.
You want your company to be profitable, because obviously, positive earnings helps drive cash flow over the long term. But I think people make the mistake of solely looking at the income statement, when really they should look at the cash flow statement first and then go back to the income statement.
Any other things that investors, the individual investor, should be aware of?
Yeah, I think it’s very important to focus on valuation. It basically comes out to a simple rule: The higher the valuation, the higher the expectations. The higher the expectations, the greater chance there is that the company could disappoint.
So if you’re buying stocks with low valuations, not only are you getting them at bargain prices, but you also don’t have the additional risk of expectations being high. Therefore, you actually get a dual advantage to buying stocks with low price-to-book, low P/E multiples, versus paying up for a stock.
This being said, you want bargain stocks. So, sometimes you’re better off paying a little bit more in terms of valuation to get a quality company than solely focusing at a low price-to-book or a low P/E multiple.
Hence, Better Good than Lucky.
Absolutely.
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