Posts tagged ‘free cash flow’
A Sleepy Stock that Can Wake Up Your Portfolio
In over 35 years of investing, I have rarely encountered a company in such a unique – and frustrating – position as Harmony Biosciences (“Harmony” – HRMY). As a shareholder through my firm, Sidoxia Capital Management, I approach this analysis with a dual lens: as an investor seeing immense value, and as a fiduciary who expects corporate leadership to act in the best interest of its owners.
While Harmony’s executive team has executed brilliantly on its clinical mission, they are currently failing their fiduciary duty regarding capital allocation. Here is why Harmony is a “Diamond in the Rough” that needs a wake-up call.
Harmony Biosciences Overview – A Rare Disease Powerhouse
Harmony is a neuroscience-focused company targeting rare and underserved conditions such as narcolepsy, Prader-Willi Syndrome, and certain rare epilepsies—areas where treatment options are limited or nonexistent.
Today, the vast majority of revenue is driven by narcolepsy, a neurological disorder that disrupts sleep-wake cycles and leads to excessive daytime sleepiness and sudden sleep attacks. While approximately 135,000–200,000 Americans are diagnosed, the true number is likely higher due to underdiagnosis and misdiagnosis.
Harmony’s flagship drug, WAKIX (pitolisant), is on track to surpass $1 billion in annual revenue in 2026, achieving blockbuster status. Importantly, WAKIX is the only FDA-approved narcolepsy treatment that is not a controlled substance as defined by the U.S. Drug Enforcement Administration (DEA), providing a meaningful competitive advantage over alternative therapies.
Significant Growth Beyond WAKIX
Harmony’s long-term opportunity extends well beyond narcolepsy. The company is leveraging the pharmaceutical compound behind its franchise drug WAKIX (pitolisant) to expand and diversify its revenue base into additional CNS (Central Nervous System) indications, with five ongoing Phase 3 registrational programs (see below):
- Pitolisant HD (High Dose) – Idiopathic Hypersomnia (IH) – potential $1.5 billion – $2.0 billion market with possible FDA submission for approval in 2027.
- Pitolisant HD (High Dose) – Narcolepsy – potential to accelerate the growth of $1 billion WAKIX franchise (2026 estimate) by offering enhanced efficacy for fatigue. FDA submission for approval of Pitolisant HD could come in 2027.
- Pitolisant – Prader-Willi Syndrome (PWS) – There are an estimated 15,000–20,000 people in the U.S. with PWS. Over half of these targeted patients suffer from EDS, which is effectively treated with Pitolisant. PWS has a potential of reaching $300 million – $500 million in revenue and receiving FDA submission for approval during the 2nd half of 2026.
- EPX-100 (Clemizole HCl) – Dravet Syndrome (epilepsy with onset at infancy) – expands Harmony into a potential $800 million global market by 2030 with possible FDA submission for approval in the 1st half of 2027.
- EPX-100 (Clemizole HCl) – Lennox-Gastaut Syndrome (LGS) (epilepsy with multiple seizure types) – opens the company to a potential $1 billion market globally.
Collectively, this pipeline has the potential to generate billions in incremental revenue.
A Diamond in the Rough
There are many ways to value a stock, but one common approach is to compare a company’s price-to-earnings ratio (P/E) to that of the S&P 500. Generally, stocks trading below the market’s average P/E are considered cheap, while those above it are viewed as more expensive.
Harmony shares currently trade at approximately 8x trailing twelve-month earnings and 7x its 2026 earnings forecast. By comparison, this represents roughly a -70% discount to the average S&P 500 stock. Based on these metrics, Harmony appears dramatically undervalued—assuming the company’s fundamentals remain intact.
Of course, valuation must be considered alongside growth and execution. On that front, management continues to emphasize strong underlying performance.
And the results support that claim. In less than three years, CEO Dr. Jeffrey Dayno has grown revenue by approximately 74%, from roughly $500 million in April 2023 to over $860 million today, with expectations to exceed $1 billion in annual sales by the end of the year.
But wait, there’s more. The balance sheet tells a similarly compelling story. Over that same period, Harmony’s net cash position (gross cash minus debt) has increased from approximately $201 million to $719 million, even after completing two acquisitions totaling about $69 million (Zynerba and Epygenix). During this time, quarterly revenue growth has averaged roughly +23%, while cash has more than tripled, despite the acquisitions.
What’s more, Harmony’s cash profitability is equally impressive. In 2025, Harmony generated a 40% free cash flow margin, meaning $0.40 of every $1 of revenue converted into free cash flow. That level of efficiency would rank among the top two percent of companies in the S&P 500, placing Harmony alongside some of the most profitable behemoths in the market, including NVIDIA Corp.
Which brings us to the key question: If the stock is this inexpensive and the fundamentals are this strong, why isn’t the company aggressively repurchasing its own shares hand-over-fist? To date, management has not provided a clear or credible answer to this question.
What is the Downside to Harmony?
All this fundamental strength and financial momentum sounds like great news for shareholders—but where’s the risk and bad news? Regrettably, despite strong execution under CEO Dr. Jeffrey Dayno over the past three years, the stock is down approximately -14% (from ~$32 to ~$28 per share).
If everything is going so well, why have investors been so spooked recently? The primary concern centers on potential generic competition for WAKIX, the company’s key drug. To Harmony’s credit, it has already settled litigation with six of seven generic challengers, but one holdout—AET Pharma—has taken the case to trial. Some Wall Street analysts and investors believe the judge may rule in favor of AET, which contributed to a sharp decline in the stock last month.
If Harmony loses, WAKIX’s patent protection—currently expected to extend through 2030—could be materially weakened, potentially allowing generic competition to enter the market as early as late 2026 or early 2027, depending on the timing of the ruling and subsequent developments.
Fear not, says management. They remain confident in their defense strategy. As CEO Dr. Dayno stated, “Pitolisant GR will extend the WAKIX franchise and our leadership in narcolepsy as a line extension of WAKIX with its broad clinical utility. We are on track for NDA submission in Q2 this year with a target PDUFA date in Q1 2027.”
Management believes this next-generation formulation, Pitolisant GR, could significantly mitigate—or even eliminate—the impact of generic competition. Unlike WAKIX, which faces potential patent challenges, Pitolisant GR is expected to have patent protection through 2044.
If the timeline holds, the company expects a substantial portion of WAKIX patients to transition to GR, reducing the impact of any generic entrants. Additionally, even in a worst-case scenario where AET prevails, the financial risk associated with launching an “at-risk” generic—particularly if Harmony were to win on appeal—could be significant enough to deter entry and easily push AET towards a settlement with Harmony.
Am I Missing Something?
When a stock trades at such an egregiously low valuation, I inevitably ask myself, “Am I missing something?” If management is sitting on its hands doing nothing, perhaps Harmony’s fundamental outlook is worse than they are leading investors to believe. If management is unwilling to deploy even a portion of its inefficient, over-bloated cash hoard toward share repurchases – especially with the stock arguably at its cheapest level in history – why should investors commit their hard-earned capital to what could be a sinking ship?
Is it possible that management lacks confidence in the Pitolisant GR NDA data, or that the Q2 NDA timeline could slip? If so, and if AET prevails in court, Harmony’s entire $1 billion franchise revenue base could be at risk.
Management has dismissed these concerns and continues to insist that everything is on track. If that’s truly the case, then – with a clear line of sight into the company’s prospects – Harmony should be aggressively buying back its stock if the outlook is as strong and rosy as they claim.
Actions Speak Louder than Words
According to management, Harmony’s fundamentals remain robust. Not only does Harmony have five late-stage, phase three indications in the pipeline, it also claims to have a near bullet-proof generic competition protection strategy. Yet, with the stock down around -33% from its 52-week high, it is difficult to justify why management is not forcefully repurchasing shares at prices that are currently highly accretive to EPS.
I have raised this issue with senior management multiple times, but unfortunately my concerns have fallen on deaf ears. I’m hardly alone – other investors have voiced similar frustrations but inaction remains the default stance of management. The company’s response to this elephant in the room remains perplexing.
On the most recent fourth quarter conference call with investors, CFO Sandip Kapadia stated, “Business development is a high priority, and our intention is to deploy capital to expand our pipeline and commercial portfolio.” CEO Dr. Jeffrey Dayno echoed this sentiment, emphasizing a “commitment to generate even greater value through the pursuit of smart business development opportunities.”
It’s great that Harmony “intends” to deploy capital and “pursue” opportunities, but the fact remains, Harmony effectively has not devoted a penny over the last two years to capital deployment, and the company has spent next-to-nothing on capital deployment since the company’s IPO (Initial Public Offering) in August 2020.
Meanwhile, the company’s massive net cash balance – currently $719 million – is rapidly expanding by more than $100 million+ per quarter and is on track to swell to $1 billion this year. By the end of 2026, cash could represent as much as two-thirds of Harmony’s total market value, particularly if the share price remains depressed or declines further.
Walking and Chewing Gum
Can Harmony walk and chew gum at the same time? In other words, can the company allocate a portion of its gigantic cash balance toward a monumentally accretive share repurchase program while simultaneously pursuing business development (M&A – Mergers & Acquisitions) opportunities? The short answer is yes.
In fact, Harmony did exactly that in 2023 and 2024 – deploying nearly half of its cash toward share buybacks while ALSO completing two acquisitions that contributed to its expanding pipeline of promising new indications.
Management argues it’s currently evaluating a broad list of acquisition targets. However, one could reasonably contend that Harmony will be hard-pressed to find opportunities more attractive than its own stock. The bar is exceptionally high: identifying highly profitable companies with similarly robust pipelines, that are also trading at a steep discount and offering comparable growth characteristics.
By comparison, Harmony’s own shares appear to trade at roughly a -70% discount to the market, with approximately 50% of its market capitalization in cash, while delivering ~20% top-line growth, and securing a deep pipeline of five Phase 3 programs. Under these conditions, it seems like Harmony buying back their own stock is a no-brainer.
Where Is the Board and Why Are They Not Acting?
This is a question I’m asking, and I hope the board will answer the capital allocation question more thoughtfully. Ideally, the response will come in the form of a material share repurchase (i.e., action).
For those curious, I have identified the distinguished group of Harmony board members, and I intend to pursue an explanation relating to the board’s inaction. Here are Harmony’s current board members:
- Jeffrey S. Aronin (Executive Chairman) – Founder and CEO of Paragon Biosciences.
- Jeffrey M. Dayno, MD (President, CEO & Director) – Former CMO of Harmony; Board-certified neurologist.
- Peter Anastasiou (Independent Director) – CEO of Capsida Biotherapeutics; former Lundbeck executive.
- Antonio Gracias (Independent Director) – Founder/CEO of Valor Equity Partners and Director at Tesla.
- Mark Graf (Independent Director) – Former CFO of Discover Financial Services.
- Ron Philip (Independent Director) – CEO of Orbital Therapeutics and former CEO of Spark Therapeutics.
- Juan Sabater (Independent Director) – Partner at Valor Equity Partners and former Goldman Sachs MD.
- Gary Sender (Independent Director) – Former CFO of Nabriva Therapeutics and Shire PLC.
- Linda Szyper (Independent Director) – Former COO of McCann Health; pharmaceutical sales veteran.
- Andreas Wicki, PhD (Independent Director) – CEO of HBM Healthcare Investments.
I’m not sure whether the board is asleep at the switch, but it has a clear fiduciary duty to allocate capital efficiently and maximize shareholder value. Allowing the balance sheet to become excessively bloated while taking no meaningful action falls short of that responsibility. The company needs to act.
As Harmony’s share price remains stagnant and under pressure, management and the board continue to irresponsibly let cash accumulate. Net cash now represents approximately 45% of the company’s market capitalization. If Harmony were in the S&P 500, this would place it among the top 1% of companies by cash as a percentage of market value – all while trading at roughly a -70% discount to the broader market.
We remain long-term shareholders, but there are only two plausible explanations. Either management is correct, and this represents a generational buying opportunity—or the company knows something investors do not, which may explain the lack of action and the continued buildup of cash.
Bottom line: assuming a successful defense against generic competition and a conservative rollout of the pipeline—including Pitolisant GR and Pitolisant HD—$7 in EPS by 2030 at a 22x multiple implies a $154 price target, or roughly +450% upside from today’s ~$28 share price.
Harmony may be a sleepy stock today, but it has all the ingredients to wake up your portfolio. While management and the board have been slow to act and have yet to fully meet their fiduciary responsibility on capital allocation, I remain optimistic that they will ultimately do the right thing. By deploying capital more effectively – most notably through a meaningful share repurchase at today’s historically attractive valuation – Harmony has the opportunity to awaken significant shareholder value and live up to its full potential.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in HRMY, NVDA, TSLA, GS, and certain exchange traded funds (ETFs), but at the time of publishing had no direct position in DFS, HBMN, HLUYY, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Brain or Machine? Investing Holy Grail
Source: Photobucket
Paul Meehl was a versatile academic who held numerous faculty positions, covering the diverse disciplines of psychology, law, psychiatry, neurology, and yes, even philosophy. The crux of his research was focused on how well clinical analysis fared versus statistical analysis. Or in other words, he looked to answer the controversial question, “What is a better predictor of outcomes, a brain or an equation?” His conclusion was straightforward – mechanical methods using quantitative measures are much more efficient than the professional judgments of humans in coming to more accurate predictions.
Those who have read my book, How I Managed $20,000,000,000.00 by Age 32 know where I stand on this topic – I firmly believe successful investing requires a healthy balance between both art and science (i.e., “brain and equation”). A trader who only relies on intuition and his gut to make all of his/her decisions is likely to fall on their face. On the other hand, a quantitative engineer’s sole dependence on a robotic multi-factor model to make trades is likely to fail too. My skepticism is adequately outlined in my Butter in Bangladesh article, which describes how irrational statistical games can be misleading and overused.
As much as I would like to attribute all of my investment success to my brain, the emotion-controlling power of numbers has played an important role in my investment accomplishments as well. The power of numbers simply cannot be ignored. More than 50 years after Paul Meehl’s seminal research was published, about two hundred studies comparing brain power versus statistical power have shown that machines beat brains in predictive accuracy in the majority of cases. Even when expert judgments have won over formulas, human consistency and reliability have muddied the accuracy of predictions.
Daniel Kahneman, a Nobel Prize winner in Economics, highlights another important decision making researcher, Robyn Dawes. What Dawes discovers in her research is that the fancy and complex multiple regression methods used in conventional software adds little to no value in the predictive decision-making process. Kahneman describes Dawes’s findings more specifically here:
“A formula that combines these predictors with equal weights is likely to be just as accurate in predicting new cases as the multiple-regression formula…Formulas that assign equal weights to all the predictors are often superior, because they are not affected by accidents of sampling…It is possible to develop useful algorithms without any prior statistical research. Simple equally weighted formulas based on existing statistics or on common sense are often very good predictors of significant outcomes.”
The results of Dawes’s classic research have significant application to the field of stock picking. As a matter of fact, this type of research has had a significant impact on Sidoxia’s stock selection process.
How Sweet It Is!
In the emotional roller-coaster equity markets we’ve experienced over the last decade or two, overreliance on gut-driven sentiments in the investment process has left masses of casualties in the wake of losses. If you doubt the destructive after-effects on investors’ psyches, then I urge you to check out my Fund Flow Paradox article that shows the debilitating effects of volatility on investors’ behavior.
In order to more objectively exploit investment opportunities, the Sidoxia Capital Management investment team has successfully formed and utilized our own proprietary quantitative tool. The results were so sweet, we decided to call it SHGR (pronounced “S-U-G-A-R”), or Sidoxia Holy Grail Ranking.
My close to two decades of experience at William O’Neil & Co., Nicholas Applegate, American Century Investments, and now Sidoxia Capital Management has allowed me to build a firm foundation of growth investing competency – however understanding growth alone is not sufficient to succeed. In fact, growth investing can be hazardous to your investment health if not kept properly in check with other key factors.
Here are some of the key factors in our Sidoxia SHGR ranking system:
Valuation:
- Free cash flow yield
- Price/earnings ratio
- PEG ratio
- Dividend yield
Quality:
- Financials: Profit margin trends; balance sheet leverage
- Management Team: Track record; capital stewardship
- Market Share: Industry position; runway for growth
Contrarian Sentiment Indicators:
- Analyst ratings
- Short interest
Growth:
- Earnings growth
- Sales growth
Our proprietary SHGR ranking system not only allows us to prioritize our asset allocation on existing stock holdings, but it also serves as an efficient tool to screen new ideas for client portfolio additions. Most importantly, having a quantitative model like Sidoxia’s Holy Grail Ranking system allows investors to objectively implement a disciplined investment process, whether there is a presidential election, Fiscal Cliff, international fiscal crisis, slowing growth in China, and/or uncertain tax legislation. At Sidoxia we have managed to create a Holy Grail machine, but like other quantitative tools it cannot replace the artistic powers of the brain.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
The Buyback Bonanza Boost
With the S&P 500 off -1% from its all-time record high, many bears have continued to wait for and talk about a looming crash. For the naysayers, the main focus has been on the distorted monetary policies instituted by the Federal Reserve, but as I pointed out in Fed Fatigue is Setting In, QE and tapering talk are not the end-all, be-all of global financial markets. One need not look further than the dozen or so countries listed in the FT that have bond yields below the abnormally low yields we are experiencing in the U.S. (10-Year Treasury +2.75%).
Although there are many who believe a freefall is coming, much like a trampoline, a naturally occurring financial mechanism has provided a relentless bid to boost stock prices higher…a buyback bonanza! How significant have corporate stock repurchases been to spring prices higher? Jason Zweig, in his Intelligent Investor column, wrote the following:
In the Russell 3000, a broad U.S. stock index, repurchased $567.6 billion worth of their own shares—a 21% increase over 2012, calculates Rob Leiphart, an analyst at Birinyi Associates, a research firm in Westport, Conn. That brings total buybacks since the beginning of 2005 to $4.21 trillion—or nearly one-fifth of the total value of all U.S. stocks today.
To further put this gargantuan buyback bonanza into perspective, a recent Fox Business article described it this way:
Companies spent an estimated $477 billion on share buybacks last year. That’s enough to buy every NFL team 12 times over, run the federal government for 50 days or host the next nine Olympic Games with several billion left to spare. This year, companies are expected to ramp up buybacks by 35%, according to Goldman Sachs.
The bears continue to scream, while purple in the face, that the Fed’s QE and zero interest rate program (ZIRP) shenanigans are artificially propping up stock prices. The narrative then states the tapering and inevitable Fed Funds rate reversal will cause the market to come crashing down. While there is some truth behind this commentary, history reminds us that not all rate rising cycles end in bloodshed (see 1994 Bond Repeat or Stock Defeat?). Even if you believe in Armageddon, this rate reversal scenario is unlikely to happen until mid-2015 or beyond.
And for those worshipping the actions of Ms. Yellen at the Fed altar, believe it or not, there are other factors besides monetary policy that cause stock prices to go up or down. In addition to stock buybacks, there are dynamics such as record corporate profits, rising dividends, expanding earnings, reasonable valuations, improving international economies, and other factors that have contributed to this robust bull market.
At the end of the day, as I have continued to argue for some time, money goes where it is treated best – and generally that is not in savings accounts earning 0.003%. There is no reason to be a perma-bull, and I have freely acknowledged the expansion of froth in areas such as social media, biotech, Bitcoin and other areas. Regardless, there is, and will always be areas of speculation, in bull and bear markets (e.g., gold in the 2008-2009 period).
Magical Math
Investing involves a mixture of art and science, but with a few exceptions (i.e., fraud), numbers do not lie, and using math when investing is a good place to start. A simple but powerful mathematical formula instituted at Sidoxia Capital Management is the “Free Cash Flow Yield”, which is a metric we integrate into our proprietary SHGR (a.k.a.,“Sugar”) quantitative model (see Investing Holy Grail).
Quite simply, Free Cash Flow (FCF) is computed by taking the excess cash generated by a company after ALL expenses/expenditures (marketing, payroll, R&D, CAPEX, etc.) over a trailing twelve month period (TTM), then dividing that figure by the total equity value of a company (Market Capitalization). Mechanically, FCF is calculated by taking “Cash Flow from Operations” and subtracting “Capital Expenditures” – both figures can be found on the Cash Flow Statement. The Free Cash Flow ratio may sound complicated, but straightforwardly this is the leftover cash generated by a business that can be used for share buybacks, dividends, acquisitions, investments, debt pay-down, and/or placed in a banking account to pile up.
The great thing about FCF yields is that this ratio (%) can be compared across asset classes. For example, I can compare the FCF yield of Apple Inc – AAPL (+9.5%) versus a 10-Year Treasury (+2.75%), 1-year CD (+0.85%), Tesla Motors – TSLA (0.0%), Netflix, Inc – NFLX (-0.001%), or Twitter, Inc – TWTR (-0.003%). For growth and capital intensive companies, I can make adjustments to this calculation. However, what you quickly realize is that even if you assume massive growth in the coming years (i.e., $100s of millions in FCF), the prices for many of these momentum stocks are still astronomical.
An important insight about the current corporate buyback bonanza is that much of this price boost is being fueled by the colossal free cash flow generation of corporate America. Sure, some companies are borrowing through the debt markets to buy back stock, but if you were the Apple CFO sitting on $159,000,000,000 in cash earning 1%, it doesn’t make a lot of sense to sit on the cash earning nothing. It also doesn’t take a genius (or Carl Icahn) to figure out borrowing at record low rates (2.75% 10-year) while earning +10% on a stock buyback will increase shareholder value and earnings per share (EPS). More specifically, when Apple borrowed $17 billion at interest rates ranging from 0.5% – 3.9%, a shrewd, rational human being would borrow to the max all day long at those rates, if you could earn +10% on that investment. It is true that Apple’s profitability could drop and the numerator in our FCF ratio could decrease, but with $45 billion smackers coming in every year on top of $142 billion in net cash on the balance sheet, Apple has a healthy margin of safety to make the math work.
Where the math doesn’t compute is in insanely priced deals. For example, the recent merger in which Facebook Inc (FB) paid $19 billion (1,000 x’s the estimated 2013 annual revenues) for a 50-person, money-losing company (WhatsApp) that is offering a free service, makes zero financial sense to me. Suffice it to say, the FCF yield on WhatsApp could cause Warren Buffett to have a coronary event. Yes, diamond covered countertops would be nice to have in my kitchen, but I probably wouldn’t get much of a return on that investment.
Share buybacks are not a magical elixir to endless prosperity (see Share Buybacks & Bathroom Violators), but given the record profits and record low interest rates, basic math shows that even if stock prices correct (as should be expected), the trampolining effect of this buyback bonanza will provide support to the market.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds (ETFs), AAPL and a short position in NFLX, but at the time of publishing SCM had no direct position in TSLA, TWTR, FB, Bitcoin, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Investing Holy Grail: Brain or Machine?
Source: Photobucket
Paul Meehl was a versatile academic who held numerous faculty positions, covering the diverse disciplines of psychology, law, psychiatry, neurology, and yes, even philosophy. The crux of his research was focused on how well clinical analysis fared versus statistical analysis. Or in other words, he looked to answer the controversial question, “What is a better predictor of outcomes, a brain or an equation?” His conclusion was straightforward – mechanical methods using quantitative measures are much more efficient than the professional judgments of humans in coming to more accurate predictions.
Those who have read my book, How I Managed $20,000,000,000.00 by Age 32 know where I stand on this topic – I firmly believe successful investing requires a healthy balance between both art and science (i.e., “brain and equation”). A trader who only relies on intuition and his gut to make all of his/her decisions is likely to fall on their face. On the other hand, a quantitative engineer’s sole dependence on a robotic multi-factor model to make trades is likely to fail too. My skepticism is adequately outlined in my Butter in Bangladesh article, which describes how irrational statistical games can be misleading and overused.
As much as I would like to attribute all of my investment success to my brain, the emotion-controlling power of numbers has played an important role in my investment accomplishments as well. The power of numbers simply cannot be ignored. More than 50 years after Paul Meehl’s seminal research was published, about two hundred studies comparing brain power versus statistical power have shown that machines beat brains in predictive accuracy in the majority of cases. Even when expert judgments have won over formulas, human consistency and reliability have muddied the accuracy of predictions.
Daniel Kahneman, a Nobel Prize winner in Economics, highlights another important decision making researcher, Robyn Dawes. What Dawes discovers in her research is that the fancy and complex multiple regression methods used in conventional software adds little to no value in the predictive decision-making process. Kahneman describes Dawes’s findings more specifically here:
“A formula that combines these predictors with equal weights is likely to be just as accurate in predicting new cases as the multiple-regression formula…Formulas that assign equal weights to all the predictors are often superior, because they are not affected by accidents of sampling…It is possible to develop useful algorithms without any prior statistical research. Simple equally weighted formulas based on existing statistics or on common sense are often very good predictors of significant outcomes.”
The results of Dawes’s classic research have significant application to the field of stock picking. As a matter of fact, this type of research has had a significant impact on Sidoxia’s stock selection process.
How Sweet It Is!
In the emotional roller-coaster equity markets we’ve experienced over the last decade or two, overreliance on gut-driven sentiments in the investment process has left masses of casualties in the wake of losses. If you doubt the destructive after-effects on investors’ psyches, then I urge you to check out my Fund Flow Paradox article that shows the debilitating effects of volatility on investors’ behavior.
In order to more objectively exploit investment opportunities, the Sidoxia Capital Management investment team has successfully formed and utilized our own proprietary quantitative tool. The results were so sweet, we decided to call it SHGR (pronounced “S-U-G-A-R”), or Sidoxia Holy Grail Ranking.
My close to two decades of experience at William O’Neil & Co., Nicholas Applegate, American Century Investments, and now Sidoxia Capital Management has allowed me to build a firm foundation of growth investing competency – however understanding growth alone is not sufficient to succeed. In fact, growth investing can be hazardous to your investment health if not kept properly in check with other key factors.
Here are some of the key factors in our Sidoxia SHGR ranking system:
Valuation:
- Free cash flow yield
- Price/earnings ratio
- PEG ratio
- Dividend yield
Quality:
- Financials: Profit margin trends; balance sheet leverage
- Management Team: Track record; capital stewardship
- Market Share: Industry position; runway for growth
Contrarian Sentiment Indicators:
- Analyst ratings
- Short interest
Growth:
- Earnings growth
- Sales growth
Our proprietary SHGR ranking system not only allows us to prioritize our asset allocation on existing stock holdings, but it also serves as an efficient tool to screen new ideas for client portfolio additions. Most importantly, having a quantitative model like Sidoxia’s Holy Grail Ranking system allows investors to objectively implement a disciplined investment process, whether there is a presidential election, Fiscal Cliff, international fiscal crisis, slowing growth in China, and/or uncertain tax legislation. At Sidoxia we have managed to create a Holy Grail machine, but like other quantitative tools it cannot replace the artistic powers of the brain.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Operating Earnings: Half-Empty or Half-Full?
A continual debate goes on between bulls and bears about which earnings metric is more important: reported earnings based on GAAP (Generally Accepted Accounting Principles) or “operating earnings,” which exclude one-time charges and gains, along with non-cash charges, such as options expenses. Bulls generally prefer operating earnings (glass half-full) because they are typically higher than GAAP earnings (glass half-empty), and therefore operating earnings make valuation metrics more attractive. This disparity between earnings choice is even broader over the last few years due to the massive distortions created by the financial crisis – gigantic write-downs at the vast majority of financial institutions and enormous restructurings at non-financial companies.
Options Smoptions
The options expense issue can also become a religious argument, similar to the paradoxical question that asks if God can create a rock big enough that he himself cannot budge? Logic would dictate that operating earnings should adequately account for option issuance in the denominator of the earnings per share calculation (Net Income / Shares Outstanding). As far as I’m concerned, the GAAP method reducing the numerator of EPS (Earnings Per Share) with an expense, and increasing the denominator by increasing shares from option issuance is merely double counting the expense, thereby distorting reality. Reading through an annual report and/or proxy may not be a joyous experience, but the exercise will help you triangulate share issuance estimates to forecast the drag on future EPS.
On a trailing 12-month basis (Sep’09 – Sep’10), Standard & Poor’s calculated reported earnings with about a -9% differential from operating earnings, equating to approximately a 1.5 Price/Earnings multiple point differential (17.8x’s for reported earnings and 16.2 x’s for operating earnings). For the half-glass full bulls, the picture looks even prettier based on 2011 operating earnings forecasts – the S&P 500 index is priced at roughly 13.6x’s the 2011 index earnings value of $95.45.
Forward More Important Than Backwards
As I make the case in my P/E binoculars article, the market is like a game of chess – a good player doesn’t care nearly as much about an opponent’s last moves as he/she cares about the opponent’s future moves. Financial markets operate in the same fashion, future earnings are much more important than prior earnings. From a practical standpoint, GAAP earnings are relatively useless. Market purists can evangelize about the merits of GAAP earnings until they are blue in the face, but the fact of the matter is that investors are whipping prices all over the place based on Wall Street EPS forecasts – based on operating earnings (not GAAP). In many instances, especially throughout much of the financial crisis, operating earnings will more closely align with the cash flows of a company relative to GAAP earnings, but detailed fundamental analysis is needed.
As far as I’m concerned, much of this GAAP vs Non-GAAP earnings debate is moot because both reported earnings and operating earnings can both be manipulated and distorted. I prefer using cash flows (see Cash Flow Statement article) because cash register accounting – the analysis of money coming in and out of a company – limits the ability of bean counters to use smoke and mirror strategies traditionally saved for the income statement. In other words, you cannot compensate employees, do acquisitions, distribute dividends, or buyback stock with GAAP earnings…all these functions require cold, hard cash. The key metric, rather than EPS, should be free cash flow per share. Growth companies with high return prospects should be given some leeway, but if the projects don’t earn a return, eventually cash resources will dry up. When EPS is materially higher than free cash flow per share, yellow flags fly up and I do additional research to understand the dynamics causing the differential.
These earnings-based arguments will likely never get resolved, but if investors focus on bottom-up analysis on individual security cash flows, determining whether the glass is half-empty or half-full will become much easier.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any security referenced in this article. The trailing 12 month data was calculated by S&P as of 1/19/2011. Forward 2011 operating earnings were calculated as of 1/18/2011. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Cash Flow Statement: Game of Cat & Mouse
Much like a game of a cat chasing a mouse, analyzing financial statements can be an endless effort of hunting down a company’s true underlying fundamentals. Publicly traded companies have a built in incentive to outmaneuver its investors by maximizing profits (or minimizing expenses). With the help of flexible GAAP (Generally Accepted Accounting Principles) system and loose estimation capabilities, company executives have a fair amount of discretion in reporting financial results in a favorable light. Through the appropriate examination of the cash flow statement, the cat can slow down the clever mouse, or the investor can do a better job in pinning down corporate executives in securing the truth.
Going back to 15th century Italy, users of financial statements have relied upon the balance sheet and income statement*. Subsequently, the almighty cash flow statement was introduced to help investors cut through a lot of the statement shortcomings – especially the oft flimsy income statement.
Beware of the Income Statement Cheaters
Did you ever play the game of Monopoly with that sneaky friend who seemed to win every time he controlled the money as the game’s banker? Well effectively, that’s what companies can do – they can adjust the rules of the game as they play. A few simple examples of how companies can potentially overstate earnings include the following:
- Extend Depreciation: Depreciation is an expense that is influenced by management’s useful life estimates. If a Chief Financial Officer doubles the useful life of an asset, the associated annual expense is cut in half, thereby possibly inflating earnings.
- Capitalize Expenses: How convenient? Why not just make an expense disappear by shifting it to the balance sheet? Many companies employ that strategy by converting what many consider a normal expense into an asset, and then slowly recognizing a depreciation expense on the income statement.
- Stuffing the Channel: This is a technique that forces customers to accept unwanted orders, so the company selling the goods can recognize phantom sales and income. For example, I could theoretically sell a $1 million dollar rubber band to my brother and recognize $1 million in profits (less 1-2 cents for the cost of the rubber band), but no cash will ever be collected. Moreover, as the seller of the rubber band, I will eventually have to fess-up to a $1 million uncollectible expense (“write-off”) on my income statement.
There are plenty more examples of how financial managers implement liberal accounting practices, but there is an equalizer…the cash flow statement.
Cash Flow Statement to the Rescue
Most of the accounting shenanigans and gimmicks used on the income statement (including the ones mentioned above) often have no bearing on the stream of cash payments. In order to better comprehend the fundamental actions behind a business (excluding financial companies), I firmly believe the cash flow statement is the best place to go. One way to think about the cash flow statement is like a cash register (see related cash flow article). Any business evaluated will have cash collected into the register, and cash disbursed out of it. Specifically, the three main components of this statement are Cash Flow from Operations (CFO), Cash Flow from Investing (CFI), and Cash Flow from Financing (CFF). For instance, let us look at XYZ Corporation that sells widgets produced from its manufacturing plant. The cash collected from widget sales flows into CFO, the capital cost of building the plant into CFI, and the debt proceeds to build the plant into CFF. By scrutinizing these components of the cash flow statement, financial statement consumers will gain a much clearer perspective into the pressure points of a business and have an improved understanding of a company’s operations.
Financial Birth Certificate
As an analyst, hired to babysit a particular company, the importance of determining the maturity of the client company is critical. We may know the numerical age of a company in years, however establishing the maturity level is more important (i.e., start-up, emerging growth, established growth, mature phase, declining phase)*. Start-up companies generally have a voracious appetite for cash to kick-start operations, while at the other end of the spectrum, mature companies generally generate healthy amounts of free cash flow, available for disbursement to shareholders in the form of dividends and share buybacks. Of course, some industries reach a point of decline (automobiles come to mind) at which point losses pile up and capital preservation increases in priority as an objective. Clarifying the maturity level of a company can provide tremendous insight into the likely direction of price competition, capital allocation decisions, margin trends, acquisition strategies, and other important facets of a company (see Equity Life Cycle article).
The complex financial markets game can be a hairy game of cat and mouse. Through financial statement analysis – especially reviewing the cash flow statement – investors (like cats) can more slyly evaluate the financial path of target companies (mice). Rather than have a hissy fit, do yourself a favor and better acquaint yourself with the cash flow statement.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in any security mentioned in this article. References to content in Financial Statement Analysis (Martin Fridson and Fernando Alvarez) was used also. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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