There are several ways which we help our clients sift through large pools of companies to filter out potential torpedo stocks and identify stocks likely to outperform. One of the metrics we utilize to filter out companies likely to underperform is our Management Quality grade. This metric attaches a letter grade of A or F to every company in our database based on a company’s management strategy and management’s ability to create wealth for its shareholders.
Using AFG’s Management Quality grade in the process of screening through large lists of stocks can help investors to identify and eliminate companies which continue to grow their businesses when they are not profitable. Growing a losing business is a strategy that often tends to destroy shareholder wealth. When business units are unproductive and destroying wealth, management teams should not be looking to grow that business unit but instead concentrate on the parts of their company that have been creating wealth.
The way we determine whether a company is profitable or not is whether the firm is able to earn above its true economic cost of capital (positive Economic Margin). Our system punishes companies that attempt to grow their assets if they are unable to earn back its cost of capital (negative Economic Margin) and for good reason as this strategy has proven likely to lead to poor returns.
The Economic Margin metric takes into account three important factors; 1) the amount of Cash Flow a firm is generating, 2) the capital base from which the cash flow is derived, and 3) the opportunity cost of employing that capital. Firms with a negative Economic Margin are not generating Operating Cash Flow beyond the cost of the capital employed, thus destroying investor wealth. When a company is destroying wealth for its shareholders the last thing you want management to do is continue to try to grow a losing business.
We recommend avoiding companies that earn a Management Quality Grade of “F” as these firms have proven in backtests to underperform sector and benchmark peers who earn an “A” grade. By excluding “F” graded firms investors can eliminate many potential torpedoes from constituent lists and spend more time and effort researching the companies with a greater likelihood of outperforming. Regardless of time horizons, market cap, sector or growth/value orientation this metric has proven successful at identifying firms likely to underperform that should be avoided.
The charts below highlight the performance achieved when utilizing AFG’s Management Quality variable to filter out the bottom half wealth destroying firms. Both from a long term perspective (1998-present) and over the past 1 year, investors would have benefitted from eliminating “wealth destroying” firms from their focus lists.
The table below contains 10 companies from within the Russell 1000 index that currently earn a grade of “F” for Management Quality. These companies are currently following what we consider a strategy that is likely to destroy shareholder wealth as they are not profitable from an economic standpoint, yet continue to grow their assets. These companies have characteristics inherent in companies likely to underperform and should be viewed with a cautious eye.