We spotted a “Multi-beggar” stock 3 years back – You can, too!

Yes, you read it right. There is no typographical error in the title. A minor swap of ‘a’ and ‘e’ does make a huge difference. A “multi-beggar stock” is a casual reference to the very opposite of a multibagger stock! R Srivatsan explains how his method to spot bad businesses came good and how you can do it too!

In April 2017, R. Srivatsan (who would like to be referred to as a freefincal reader) explained how you can identify the next “Satyam”. That is, how to differentiate a good business from a bad one, using a stock valuation technique known as Earnings Power Box, introduced by Hewitt Heiserman, Jr, in his book,  “It’s Earnings That Count: Finding Stocks with Earnings Power for Long-Term Profits” (available on Amazon).

Srivatsan then sent me an Earnings power module which is now part of the freefincal automated stock analyzer. Another reader, Lokesh Verma then used this to list 50 stocks with solid earnings power: Ability to self-fund and create value. Later, the analysis spreadsheet was extended to include US stocks which Hewitt Heiserman, Jr was appreciative of (private correspondence).

What is Hewitt Heiserman Jr.’s Earnings Power Box?

This is a plot of two the Defensive EPS (earnings per share) vs Enterprising EPS. The idea is to spot where a company falls in. This is based on the Earnings Power Valuation Model (doc file).

Srivatsan has defined enterprising and defensive EPS as follows: Enterprising EPS = (Enterprising Income)/(Shares Outstanding) and Defensive EPS =  (Defensive Income)/(Shares Outstanding). Therefore:

Enterprising Income = Net Income – (15% x total capital). Here 15% is the weighted average cost of capital (WACC) and is an expected return. Also, 15% x total capital = enterprising interest.

Defensive Income = Free Cash Flow – change in working capital since last FY. Now over to Srivatsan.

Two interesting things happened this week:

1. Almost 3 years back, I wrote the first draft of Heiserman’s earnings power box article (linked above)
2. My friend Punith (shout out) sent me the news that Talwalkar’s fitness had gone bankrupt (this is about three months old, but did not see it earlier).

So, what’s the big deal here?
I request the readers to please take a closer look at slides 3, 17 and 18 (reproduced below) from my presentation: It’s Earnings That Count: Can you identify the next Satyam?

It was Talwalkars’ wonderful EPS graph that actually started the whole ball (avalanche?) rolling. Talwalkars was the mysterious real company X that resembled an energizer bunny on a treadmill (Kudos to the Holmes/Poirots who figured this red herring clue 🙂 )

Please remember during 2016-2017, to paraphrase Buffett bhakts – this was a dream business with a good moat, good business model (with customers paying upfront as a subscription) and the target segments becoming more and more fitness-obsessed and willing to pay more and more.

Within 2 years of Earnings power box revealing that everything is not hunky-dory; contrary to the financial results and prevailing market sentiment at that time – the company has crashed and burned.

So, this is what I request the readers to think and do:

1. If your screener throws up a miraculously undervalued, hitting the 52wk lows, a too good to be true stock especially in the current scenario– run it through the earnings power box. If it falls in quadrant 3 – ruthlessly eliminate and move on.
2. Use this method to review your current direct stock holdings annually (preferably after the annual report comes out) – If any of your stocks have gone into the quadrant 3 – alarm bells should be ringing.
3. Eliminating a “multi-beggar” is far easier, quicker and takes very little effort and has a greater impact on our portfolio; compared to the time and effort involved in chasing that elusive “multi-bagger”.

“All I want to know is where I’m going to die, so I’ll never go there.” — Charlie Munger