The financial meltdown has shown yet again why solid balance sheets are so important. This screen can find firms that have them.
As we've all noticed, financial markets are subject to shocks--shocks of such magnitude that common financial models suggest they are virtually impossible. For the equity investor, these shocks reinforce the importance of focusing on companies with solid balance sheets. Companies that rely little on short- or long-term debt are those most likely to survive the kind of severe recession and credit crunch we're currently living through.
Why is leverage so deadly? For a company with $10 billion in assets supported by only $500 million in equity--a leverage ratio of 20 to 1--it only takes a 5% decline in the value of assets to wipe out its entire equity base, leaving it insolvent. Plus, when credit markets freeze up because investors are wary of supplying capital, refinancing debt can become problematic. By taking on debt, a company forfeits some control over its own destiny.
The focus of this screen is to find companies with the balance-sheet strength to make it through this mess. To help us do this, we turn to the Morningstar Financial Health Grade, which we recently retooled. The new algorithm is a huge improvement over the older version, both in terms of methodology (better) and the number of companies graded (more). Most important, if you and your clients are looking for bargains in this bear market, the financial health grade is a good quality screen to use along with your valuation criteria.
The idea behind the new financial health grade is to show at a glance how much cushion a company has before it starts running into financial difficulties. The grade compares a company's enterprise value--the sum of its equity and debt capital--with its total liabilities. By examining the historical volatility of enterprise value, we can estimate the likelihood that enterprise value falls below the company's liabilities at some point in the future. If this were to happen, default is expected to occur, the equity is worthless, and the firm is turned over to its creditors. That's bad. The financial health grade uses option-pricing algorithms and probability distributions to estimate the likelihood of such an event. The greater the likelihood, the worse the grade.
The financial health grade is automated-- there's no analyst input. While this means the grade will miss some company-specific idiosyncrasies, it also means we can grade most every company in Morningstar's database. Currently more than 8,000 stocks receive a financial health grade. And so far the results are encouraging. Of the stocks that dropped more than 80% during the June-October time frame, two thirds of them earned financial health grades of D or F.
To begin the screen, we'll require a financial health grade of A. Roughly 10% of Morningstar's universe receives an A grade.
Financial Health Grade >= A-
Let's narrow our list by focusing on companies with decent growth and profitability. We can use Morningstar's growth and profitability grades, which we also retooled within the past year to make them more robust. The growth grade measures how rapidly a company has been able to increase its revenues over the past five years. For the purposes of this screen, we're not so much looking for blow-out growth numbers as looking to eliminate firms that may be in secular decline or stagnation. The profitability grade measures how high and steady a company's return on equity has been over the past five years.
And Growth Grade >= B
And Profitability Grade >= B
Next, we require that a company earn a wide economic moat rating. This is a measure of the strength of a company's competitive position, as judged by our staff of 110 equity analysts. Because they dominate their markets, wide-moat companies are those in the best position to weather tough economic times.
And Economic Moat = Wide
Finally, we'll focus on just those stocks that trade at a steep discount to fair value. For this we use the Morningstar Rating for Stocks, which is based on the fair value estimate our analysts derive using a detailed discounted cash-flow analysis. Only stocks that have fair value estimates well above the current market price earn a 5-star rating. For investors, this gives an added margin of safety in case growth, profitability, or financial health deteriorate.
And Morningstar Rating = 5 stars
Five companies passed the screen on Nov. 21, 2008. They're a good list to start with if you're looking to take advantage of market volatility to pick up some solid companies on the cheap.
Applied has a wide moat for several reasons. Its installed base has expanded to more than 22,000 tools, and the firm has engineers in nearly every chip-manufacturing facility in the world. Applied's scale and trusted name have allowed it to develop close relationships with customers, giving the firm insight into current and future customer technology needs. Further, Applied's substantial resources allow it to compete successfully in various market segments, in aspects ranging from pricing and marketing to research and development. Few firms can rival Applied's roughly $1 billion annual R&D budget. A strong balance sheet gives the company flexibility in a deeply cyclical industry and allows it to enter new markets with relative ease, either through internal development or acquisitions.
We believe Cisco Systems continues to be well-positioned to gain momentum in emerging, high-growth products and services as the next wave of Internet connectivity takes form. Cisco's proven reliability, scale, and large installed base of enterprise and carrier customers are the source of its competitive advantage. As data have become a critical component of business, customers prefer established, trusted vendors and are loath to switch to unproven suppliers. The company's growing cash hoard is a key competitive advantage to sustain technological dominance via continued strategic acquisitions that expand Cisco's addressable market.
Expeditors Intl of WA
Expeditors International of Washington is the performance leader among non-asset-based freight-forwarding and third-party logistics providers. Investors seeking exposure to the growing international shipping market will be hard-pressed to find a more profitable firm. Expeditors' record of steady growth, high margins, and high returns on invested capital supports a wide economic moat that will deliver the goods for years to come.
While Fastenal's growth is likely to slow because of the developing manufacturing recession, it has defied the weak economy through the third quarter, with sales and earnings both up 17% from the year-ago third quarter. Morningstar analysts attribute Fastenal's relative strength versus its peers and the broader economy to a strategy aimed at harvesting share gains at existing stores via additional salespeople. Gross margins expanded nicely as the company continues to add new (more profitable) small and medium-size clients, pushes harder on less profitable sales or accounts, and reaps the benefits of commodity inflation fl owing through the business model.
While its high-growth days are long gone, Microsoft can still post solid growth as the worldwide installed base of PCs and servers expands. Entry into new markets like video games, business software, and mobile devices will also help move Microsoft's top line upward. Microsoft is extremely profitable. Operating margins hover in the high-30% range, and the firm generates more than $1 billion in cash per month. Even after buying back $40 billion of stock over the past two years, Microsoft's fortresslike balance sheet still boasts $30 billion of cash and long-term investments against only $36 billion in total liabilities.
Haywood Kelly, CFA, is vice president of equity research at Morningstar.