Buying stocks at depressed multiples is the foundation of value investing. But for us, it is only a first step. For Heartland to take a stake in a business, we must identify factors that will cause the shares to reach our estimate of their true worth. Absent a stimulus that changes perception in the marketplace, a company may languish at depressed valuations for extended periods of time, making it a poor investment.
While outside forces can serve to unlock value in a stock, we favor catalysts that are generated internally. Because of the hard–to–predict nature of macro events, we prefer to identify companies that can help themselves through cost cutting, sales force and product positioning initiatives, improved pricing strategies, mergers and acquisitions, and improved capital allocation, among other factors. Over the long–term, these types of businesses are likely to be rewarded over those that are captive to outside influences.
As investors, we examine whether a company is in a position to generate improved results and garner attention in the marketplace. The three areas we focus on are: balance sheet strength, earnings, and valuation.
Every Balance Sheet Tells a Story
When examining the balance sheet, we seek to determine whether a company has the flexibility necessary to undertake strategic initiatives. Often that means looking for large cash positions and low debt levels. However, simply looking at debt–to–capital or interest coverage ratios doesn’t provide the full story. Companies must be viewed through a lens that reflects the industry in which they operate and whether there are idiosyncratic factors influencing the balance sheet. Has a company recently completed a capital expenditure cycle that depleted cash reserves but has positioned it for growth going forward? If the answer is “Yes,” the stock may be an appropriate investment. How do the balance sheets of a company and peers fluctuate over a business cycle? How do cash flows change in response to business cycle expansions and contractions? Balance sheets should also be evaluated against historic norms at the company and industry level to provide an accurate picture of financial condition.
The Role of Valuations
Once a thorough vetting of the balance sheet has been completed, we turn our attention to earnings reports and valuation multiples. Here again, understanding context of the numbers is key. A company with low margins relative to peers may indicate a business ripe for profit expansion, or it may reflect a pricing strategy pursued to gain market share. Our role as investors is to evaluate the profit structure of the company today and anticipate what it may look like in the future. During the analysis, we need to identify the key components necessary to reach improved earnings potential.
Examining valuation multiples such as price–to–earnings (P/E) and price–to–book value (P/B) provides us the framework to evaluate whether the market is accurately pricing a stock given its potential for change or if the street is overlooking potential improvements. Instead of relying exclusively on external research, we identify drivers that could allow future results to perform better than existing sell–side analyst estimates. We use a combination of proprietary models, financial statements, our own discussions with management teams and broader peer/industry research. By creating our own projections, we are able to factor in the effect of catalysts individually, giving us a more detailed look at which factors provide the greatest potential for a stock.
Bringing it all Together
A look at one of our holdings provides a clearer picture of how the Principles™ of Catalyst for Recognition, Financial Soundness, and Positive Earnings Dynamics work together to inform our stock picking.
We initially purchased Quest Diagnostics Inc., (DGX), a diagnostic testing and services company a few years back when it was trading at less than 13x on a forward fiscal year P/E basis and approximately 2.4x P/B.
Looking solely at the quantitative aspects, Quest seemed unremarkable. It was trading at a discount, but results weren’t compelling. The company had fallen out of favor with investors on many fronts, had a weak management team, a poor sales structure and was spread thin from pursuing far flung product and technology initiatives. Additionally, Quest’s cost structure was bloated and the company was losing market share to hospitals that were taking testing services in house.
Yet, a deeper look, which included recognition of how catalysts could play out, made the story far more compelling. Quest’s depressed valuation suggested the market saw little reason to believe things would change for the foreseeable future. Our research, however, identified the following opportunities for improvement:
Potential to build and grow preferred provider relationships with hospitals and clinics
More profitable mix of services
Greater clarity on reimbursement rates
Improved results through cost cuts and aided by share buybacks
Upon additional examination, we also came to the conclusion that a recent undertaking to revamp its sales strategy to focus on medical specialists was likely to produce results.
In the period since we first purchased Quest, it has achieved or made significant strides in many of the initiatives we identified during our initial evaluation. As illustrated in the table, the stock has benefited from the catalysts playing out in the form of higher multiples and a significant upturn in share price.