This week I want to use my space here to discuss “micro” economics instead of “macro” economics. What more can I add to the macro conversation at this point anyway?  

Macroeconomic analysis is also an extremely complicated affair. Just to make a prediction about the direction of the U.S. economy alone requires answering questions about the direction of U.S. interest rates, capital spending, Chinese buying, oil & commodity prices, the Middle East, the Japanese Yen, and of course the direction of the Euro (and I’m just scratching the surface here).  

Just imagine how many variables you have to get right to predict the direction of the economy or interest rates. That’s why, if you get nothing else out of this, I hope you know how silly it is to make/listen to/believe/plan for any economic prognostications that go out longer than 4 – 6 weeks (that is your hint to turn off CNBC). 

Now back to microeconomics. I’ve always liked individual company analysis because the variables are far, far fewer to analyze and understand. Instead of trying to understand whether or not the Saudis are re-funneling their gas money to the U.S. to buy bonds, you can study a company’s debt-to-equity ratio; instead of watching to see if Japan is going to raise rates ¼ point or ½ point, you can see what the company generates each month in cash flow. 

You may be thinking to yourself that I’m oversimplifying how hard it is to pick stocks. I’m not. I just think that trying to predict the economy is much, much harder. Simply by having fewer variables to analyze, your risk (of being wrong) is lowered.  

Thus, today I’ve re-edited an article I wrote long ago, in an effort to help explain the potential of this month’s Fallen Angel Stocks recommendation. This is not because I’m feeling particularly lazy today – far from it.  

It’s just a great time to explain some of the key factors you should look at when buying shares in a company.

What Neighborhood Do You Live In? 

It’s no secret that homes in different neighborhoods cost different amounts; a 3-bedroom house in Beverly Hills, California costs much more than the same house in Flint, Michigan. So what can comparing the price of homes across the country teach us about investing in the stock market?  

More than you may think.  

Picking the Right Neighborhood 

In my role as CIO of Fallen Angel Stocks, I tend to look at the S&P 500 as a collection of different “neighborhoods.”  

But instead of the neighborhoods being determined by different industry groups, our neighborhoods are determined solely by Return on Invested Capital (ROIC).  

Why ROIC? Because more than any other microeconomic measurement, it tells you how much money a company earns each year in relation to the amount it spends to earn that money.  

Let’s start with a simplified but revealing example:  

Let’s say you start a business called XYZ Shoes. You end up spending $100,000 on retail space, inventory, and a fax machine. The $100,000 you’ve invested into the business is referred to as your invested capital.  

Now, let’s assume that you make $20,000 each year, after expenses, from your business without investing another dollar. That would be your return. Expressed as a percentage, your return-on-invested-capital would be 20% ($20,000/$100,000).     

For the past one hundred years, the average company in America has averaged a 12 percent ROIC each year. Using the example from above, that amount would be $12,000. A truly exceptional company can have a ROIC of 40 percent ($40,000) and a poor performer would average in the single digits or worse.  

In our S&P 500 neighborhood, a company with an ROIC of 40 percent would live in Beverly Hills, while a company with an ROIC of 12 percent would live in a middle class neighborhood similar to where I grew up in Queens, New York.  

Why “Maximizing Shareholder Value” is Wrong 

Most managers today are worried about “maximizing shareholder value” through increased earnings. That thinking is dead wrong. Anybody can make a stupid acquisition and increase earnings which, by default, would increase the stock price.  

Or anybody can lower prices so dramatically that revenue explodes.  However, as the internet companies found out, revenue without profit is called charity.  

The greatest leap made in the field of security analysis during the past quarter century (thanks again, Buffett) was in studying the relationship between return-on-invested-capital and stock prices.  

This point is so critical to your investment success that I want to take an additional moment to explain this. 

What Buffett realized was that companies that earn a high return-on-invested capita, increase shareholder value at a far faster rate than companies that don’t.  

For example, every time a company with a 40% return-on-invested capital brings in $1 per share in earnings, it can gain $7 in stock market value. In contrast, companies with a 12% return on capital may only add $1 in shareholder value for every $1 in earnings.  

(The reasons for this delve much deeper into the very nature of microeconomics. For those of you who are interested in learning more, I’d be more than willing to share them with you if you write in and ask). 

Picking the Right Block 

But just moving into the “Beverly Hills” section of the S & P 500 alone is not enough.  Now we have to find the “block” we want to live on. Here’s how you do it:    

1. Find companies with a debt to equity ratio below 25%. Having a low debt to equity ratio has implications far across the company. The most important is that the company has an underlying business that is fundamentally strong enough not to have to borrow money. Secondly, when a company that has a lot of debt is faced with earnings problems (remember, it happens to every company at one point or another) the stock gets hammered a lot more than a company without debt. Although this is not a hard and fast rule (different types of companies can support different capital structures) it is a good one.   
2. Invest in companies where capital expenses represent no more than 15 percent of a company’s cash flow.  I hate to pick on Intel Corp., the chip manufacturer, but for every $1 in cash that the company generates, 25 cents has to be reinvested into new plants to create more chips.  Conversely, for every $1 in cash Coca-Cola generates, only .10 goes into new plants.  The reason? Intel operates in an industry where, to remain competitive, it has to introduce newer, faster chips every few years. Newer, faster chips mean newer, more expensive plants. New plants mean lots of capital spending. Lots of big spending creates lots of big risks. Especially when we know that at some point or another, an incompetent CEO will be in charge of the spending.   
   
3. Invest in companies with consistent, predictable earnings. Let’s use the following earnings comparison to illustrate the point:

Year                Company A            Company B  

1999                .18                       .18  
2000                .24                       .12  
2001                .38                       (.29)  
2002                .47                       .58  
2003                .58                       .23                     

As you can see, Company A’s earnings are more predictable than those of Company B. What does this imply? First and foremost, it suggests that it is easier to predict, and therefore to value, Company A.  

In addition, it suggests that management from Company B doesn’t understand the business it’s operating in.  

Finding the Right Home … At the Right Price 

Ok, so we know what neighborhood we want to live in, and we found a block that gives us a warm and fuzzy feeling. But the most important aspect is yet to be accomplished – finding the right “home” at the right price. 

Let me start with an analogy that takes us back into the “real world.” If you were shopping for a home and you found a 3-bedroom house that you liked, you would first have to find out what the house was selling for. If you determined that the house was worth 1 million dollars, but the seller was asking $2 million, you would pass.  

Conversely, if the seller was distressed and was asking $500,000 you would jump at the opportunity. The exact same rule applies when investing in a stock – the primary objective is to buy a great asset at a cheap price. 

Let’s take Company A from the example above to illustrate our point. Assume that Company A sells low-carb health food. The Company has a 20 percent ROIC, a low debt/equity ratio, low capital expenses and predictable earnings.  

After doing some research, you determine that Company A, fairly valued, should trade with a P/E of 20 (which approximates its 20 percent ROIC). Since the Company earned 58 cents in 2003, that would place a fair value of $11.60 on the stock. If the stock were selling for $25 per share it would clearly be overpriced; at $5 you would consider it under priced.  

In this example there’s a point that must be emphasized clearly: It is critical that you separate the performance of a company from the performance of its stock price

For example, Company A could be the best health food company on the planet. The question is – what is it worth? As good of a company as it is, is it worth $25 per share?  No.  

Therefore, as investors it’s important to note that the difference between price and value within the S&P 500 is based on the same principles that would apply if you were buying a home. A gorgeous 3-bedroom house may be on the best block in Beverly Hills.    

But would you pay twice its value? I hope not.  

If you consider yourself a student of investing, re-read this page several times. Learn it, memorize it. I am being serious … it will give you x-ray investing vision.