What is the best measure of quality?


In an earlier post, I examined the performance of different value metrics. My conclusion was simple: cheap stocks beat expensive stocks.

Most value investors don’t simply look for cheap alone. They try to find companies that are both cheap and good. Good is typically defined as companies that can earn high returns on their capital.

Finding these companies is a worthwhile pursuit but it is difficult to pull off systematically because companies earning high returns on capital are going to attract significant competition. I think it is far more difficult to do this than most value investors appreciate. Mean reversion, fueled by competition, inevitably pulls these returns down. Finding the rare birds that don’t succumb to this is hard.  These companies usually have a “moat“, which is hard to identify. Needless to say, this kind of investing requires a touch of genius that I don’t have. When investing, I operate under the assumption that every company succumbs to mean reversion.

With that said, finding these rare opportunities certainly pays off over the long run. You can park money in a company like Coca-Cola or Nike and earn high returns over long stretches of time, while reducing taxes and transaction costs.

The Magic Formula 

Joel Greenblatt sought out a systematic quantitative method to find companies that are simultaneously cheap and earn high returns on capital. The result was The Little Book that Beats the Market. In the book, Greenblatt demonstrated that simultaneously buying cheap companies that earn high returns on invested capital will outperform. He calls this the magic formula and generously maintains a free screener here.

Tobias Carlisle took this a step further in Deep Value and discovered that the quality metric of high returns on invested capital actually reduces returns from the magic formula. He explains in Deep Value how mean reversion tends to bring these returns down. Cheap alone is better than cheap plus good. In other words, it takes qualitative insight to determine which companies have a moat that will allow them to sustain high returns on capital. Tobias maintains a free large cap screen for this here.

I would recommend reading both The Little Book That Beats the Market and Deep Value.

Backtesting Quality Metrics

I decided to test the returns for myself and try to see which “quality” metric works best when combined with a value factor. The test I ran is limited to Russell 3000 components. My definitions of cheapness were:

  • EBITDA/Enterprise Value is higher than 20%
  • Price to free cash flow is less than 15
  • Price to sales is less than 1
  • Earnings Yield is over 10% (i.e., P/E is less than 10)
  • Price to book less than 1
  • Price to tangible book less than 1

In addition to examining metrics that define high returns on capital, I also included metrics for financial quality, such as the debt to equity ratio and the Piotroski F-Score. Below is a summary of all of the quality metrics that I tested.

Return on Equity – This is the oldest and most simple method of corporate quality. It is simply the company’s net income divided by equity (assets – liabilities). For the purposes of the test, I define high ROE as over 20%.

Return on Invested Capital – Joel Greenblatt’s preferred measure of quality. This is earnings before interest and taxes divided by invested capital. Invested capital is defined as working capital plus net fixed assets. For the purposes of the test, I define high ROIC as over 15%.

Gross Profits/Assets – Robert Novy-Marx created a very simplistic measure of quality, gross profits/assets. He found that this  method works extremely well, because it uses profits further up of the income statement where it is more difficult for a firm to manipulate the numbers. You can read his paper on the subject here. For the purposes of the test, I define good gross profitability as over 30%.

Debt/Equity – This is another simplistic measure of financial quality. It is simply total debt divided by equity (assets-liabilities). For the purposes of the test, I define a good debt/equity ratio as under 50%.

F-Score – This is a more complex measure of financial quality designed by Joseph Piotroski, who is currently a professor at Stanford. Piotroski designed a 9 point scale of financial quality in a paper written back in 2000. Piotroski backtested combining this measure of financial quality with price to book and found that the results greatly exceeded the market. Each component adds to the score. A perfect F-Score would be a 9. It’s too bad F-Scores don’t go up to eleven. The components of the F-Score are defined below.

  • A net decline in long-term debt for the current year.
  • A net increase in the current ratio in the current year. The current ratio is current assets/current liabilities. It measures the liquidity of the company’s balance sheet to meet short-term obligations.
  • A positive increase in gross margins in the current year.
  • Faster asset turnover in the current year.
  • The total number of shares outstanding is flat or decreasing. In other words, the company isn’t issuing new equity and diluting the current pool of shares.
  • Return on assets is positive.
  • Operating cash flow is positive.
  • Return on assets for the current year is higher than the previous year.
  • Operating Cash Flow/Total Assets is higher than return on assets.

The results of the backtest are below. The results are in the Russell 3000 universe with annual rebalancing beginning in 1999.


The High Return Metrics – ROE, ROIC, GP/Assets

Measures for returns on capital – ROE, ROIC and GP/Assets – actually detract from the performance of EBITDA/Enterprise Value. They add performance to the other valuation metrics slightly, with Gross Profits/Assets being the best.

The middling performance of high return quality metrics is due to mean reversion, or the propensity for high return businesses to eventually succumb to the pressures of competition.

With that said, if you are trying to identify high return businesses, the best metric to use appears to be Gross Profits/Assets.

Financial Quality (The Debt/Equity Ratio and the F-Score)

In contrast, measures of financial quality, such as the debt/equity ratio and the F-Score, supercharge all of the valuation metrics that are examined here. Why is this?

Cheap stocks are only cheap because they are in some kind of trouble. There is an “ick” factor. Any time you run a value screen, you will scratch your head and think “Do I really want to invest in this garbage?”

This is why financial quality metrics are more useful than business quality metrics. If a company has a good balance sheet and is financially healthy then it has time to resolve its problems. Managers have time to implement a new strategy that can turn things around. Even without a new strategy, time will help the financially healthy company. For instance, if the company is in a crowded, competitive industry, the financially healthy company can weather the storm while the highly leveraged firms will go out of business first. Less firms means less competition. Less competition means that future returns in the industry will improve.

This is the essence of the simple Graham method that I follow with my own portfolio. I am looking for cheap companies that have the financial ability to weather the storm that they’re in.

This is also why the high return metrics add a little to the other valuation metrics but detract from the EBITDA yield. Unlike the other valuation metrics tested here, the EBITDA yield is the only one here that uses Enterprise Value in the calculation. Enterprise Value brings balance sheet health into the valuation ratio. For EBITDA/Enterprise Value to result in a high yield, the company must have little debt and a lot of cash on hand. In other words, valuation metrics that use Enterprise Value will identify companies that are both cheap and have safe balance sheets.

RadioShack vs. Best Buy

This reminds me of an article I read over at the Motley Fool. The author explains why Radio Shack fell apart and Best Buy was able to turn around.

Radio Shack had numerous problems, including asking for your phone number when you buy batteries.

Best Buy’s problem is that it basically became a showroom for Amazon. The referenced article explain how Best Buy successfully turned things around by cutting costs, emulating the Apple Store, expanding the Geek Squad and improving their website.

I have a more simplistic explanation for why Best Buy was able to recover and Radio Shack fell apart. Radio Shack had a lot of debt and Best Buy didn’t. Radio Shack’s debt to equity ratio was over 670%. Best Buy’s debt to equity ratio was 41% a few years ago and is 29% today.

Best Buy’s balance sheet gave them an edge: time. They had time to work through their problems and try to find a solution. If Best Buy had Radio Shack’s debt levels, the CEO would have never been able to pursue the turnaround strategy. All troubled companies are trying to turn things around, but only those with financial strength will have the time to do so.

Screening for High F-Scores and EBITDA Yield

One of the most robust combinations tested was the F Score and the EBITDA Yield, with a 17.69% rate of return since 1999. I ran a screen for companies with an EBITDA yield over 20% and an F-Score of 8 or higher. This combination of criteria is very stringent. It only returned 5 results out of the entire Russell 3000. Best Buy actually comes up in this screen, implying that it is still a financially healthy bargain. Output from the screen is below.


I am not going to buy positions in these companies, but wanted to share the results of what I found. Hopefully this will give you some useful leads that are worthy of further research.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“Shoe Dog” by Phil Knight


I recently finished Shoe Dog by Phil Knight. I love memoirs and biographies. When they are combined with business insights, I am particularly interested.

Shoe Dog focuses on the early years of Nike and focuses almost exclusively on the experience of Nike in the 1960s and 1970s before the company went public. The structure of the book is a part of its appeal. Most memoirs take you on long boring slogs through the author’s childhood, teen years and later life. This book focuses almost exclusively on the most exciting time in Phil Knight’s life: when Nike struggled in the 1960s and 1970s to make its mark. He is also remarkably honest about the experience. He discusses all of the problems he faced and the doubts and stress that went along with it.  With most business memoirs, you get the sense that the writer had it all figured out from day #1. Phil’s story is different. He is also an amazing writer.

I was born in 1982, so throughout my life Nike has always been one of those brands that was as iconically American as a can of Coca-Cola or a Big Mac from McDonalds. Whether it was Marty McFly’s power laces, or Forrest Gump’s trek across America in the Nike Cortez, Nike has been sewn into the fabric of our culture. I never realized how new Nike was until I read the book. Nike had only gone public two years before I was born and the company wasn’t even called Nike until the 1970s.

The Story

Phil Knight’s story begins in college where he ran track for the legendary Bill Bowerman, who would later become the co-founder of Nike. Phil went on to graduate school at Stanford, where he wrote a paper about how Japanese sneakers could take down German brands, just as the Japanese did the same thing to German camera manufacturers.

Phil took the idea with him as he toured the world after college. During his travel throughout the world, he went to Japan. He met with the executives of a shoe company called Onitsuka. He told them that he represented the Blue Ribbon company and wanted to sell their sneakers (called Tigers) in the United States. He bought $50 worth of sneakers and began selling them out of the back of his Plymouth Valiant.

He continued to sell sneakers but needed a full time job, so he earned his CPA and began working for Price Waterhouse. He also spends some time as a professor of accounting after leaving Price Waterhouse. As the ’60s wore on and the shoe business expanded, he ultimately quits and runs the company full time.

The book takes you through the ups and downs (mostly downs) of running the company. The downs are gut wrenching. The book is as much an inspiration for would be entrepreneurs as it is a cautionary tale about the perils that await those who want to go into business for themselves. Nike had multiple near death experiences, including:

  • An early brush with death when Onitsuka threatens to end the relationship with Phil Knight when it was just beginning.
  • Conflicts with an east coast seller of Tigers, a former Marlboro Man living in New York.
  • Constant conflicts with Onitsuka, including a threatened hostile takeover and threats to use other sellers. Phil fought against this (which was the impetus for creating the Nike line and finding alternative suppliers), but this resulted in a court showdown that could have also potentially destroyed Nike.
  • Dancing the razor’s edge of leverage throughout the 1970s. Unwilling to take the company public and use equity financing (he was afraid that it would ruin the company culture), Nike’s early growth was fueled almost entirely with debt, leading to terrible cash flow problems. At one point, payroll checks bounce and Nike’s bank threatens to call the FBI because they suspect fraud.
  • A showdown with US customs. Influenced by lobbying efforts by Nike’s competitors, customs fines Nike $25 million (its annual sales at the time) over customs technicalities. Nike would then have to wage a lobbying war of their own to defeat the injustice.

Through the struggles, Nike and Phil grow. The story of Nike’s growth and the problems it encounters make the book exciting. The story ends with Nike’s public offering in 1980. The following decades are covered at the end, but the focus of the story is almost entirely on Nike’s early development.

Life Lessons

If there is anything to be learned from Phil’s story it is: don’t give into negativity. Things may look dark at times, but it will get you nowhere if you give into negativity and stop trying. There were many times when Phil could have thrown in the towel, but he never gives up no matter how bad his problems are. I suspect a lot of this comes from Phil being a runner. When you are running, you constantly want to stop. Running is about resisting that. Mind over body. Phil takes the same attitude towards business.

Another great lesson of this book: cultivate relationships. You never know where a relationship might lead in the future. One of the most important relationships that Phil developed was with Bill Bowerman. Who could have imagined that his college track coach would help him found one of the greatest American companies of all time? Relationships must be cultivated, because you never know what dividends they might pay in the future.

The Stock

Nike is one of the best performing stocks of all time. Nike is one of those franchise stocks that are extremely hard to identify early on. It’s a Buffett/Munger kind of stock. (Although, Buffett owns Brooks, a Nike competitor, so he would probably disagree with the characterization!)

Nike is one of those firms with an amazing enduring brand and a high return on equity that won’t quit and is seemingly immune to the kind of mean reversion that brings down most high flying businesses (Nike’s return on equity was 27.58% in Q4 2016).

$1,000 invested in Nike stock back in 1981 at the IPO price would be worth $336,046.15 today.  Shockingly, that’s even better than Apple. A $1,000 investment in Apple at the IPO price would be worth $274,490 today.

Indeed, there is something magical about that swoosh.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Is the Bubble About to Burst?


Q4 2016 Data

In an earlier post I referenced an excellent market valuation model that I found at the Philosophical Economics blog. To sum it up: the model projects the next 10 years of market returns by using the average investor allocation to equities. The theory is that most bull markets are fueled by rising valuations as investors move money from other asset classes into stocks. The model tells you how much “fuel” is out there to push equities higher.

The Q4 2016 number recently became available over at Fred. The current average equity allocation at the end of the year was 41.279%. Let’s plug this into the equation I referenced in my earlier blog post on this topic:

Expected 10 year rate of return = (-.8 * Average Equity Allocation)+37.5

(-.8 * 41.279) + 37.5 = 4.48%

We can therefore expect the market to deliver a 4.48% rate of return over the next ten years. Not particularly exciting, but not the end of the world either.

Market Timing

Most hedge fund letters this year emphasized how market valuations are at historic highs and take a cautionary approach to stocks. I agree with their spirit because I think everyone should always approach the market with caution. If someone cannot handle losing half of their money, then they have no business in the stock market. A drop of that magnitude can happen at any time no matter where valuations stand. That short-term risk is the very reason that stocks outperform other asset classes over the long-term.

If I were an alarmist, I would agree with some of the hedge fund letters and say: “The market hasn’t traded at these valuations since 2007! Get to the chopper!” This implies that we are on the brink of another historic meltdown in stocks. This is the prognostication that is often heard about stocks today. I think it is misleading.

Valuation simply predicts the magnitude of future returns over the long run. Higher valuations mean lower returns and lower valuations mean higher returns. That’s it. It does not predict what the market will do over the next 12 months. It does not mean that if you wait long enough, you’ll have an opportunity to buy when valuations are at more attractive levels. Anything can happen in the next year. There could be an oil embargo. A war could break out. Terrorists could strike. Our politicians could cause another crazy showdown that imperils the economy. Trump-o-nomics might actually work. Maybe it won’t. No one really knows and anyone who proclaims otherwise is lying.

It is tempting to look at market valuations as a tool to time the market. Wouldn’t it be great to sell in 2007 and buy in 2009? Get in when the market is depressed and get out when valuations rise and the market looks like it is due for a correction? My view is that market valuations should not be used as a market timing tool. When it comes to timing the market, I think Peter Lynch put it best when he said:

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

This is great advice. Today’s market valuations may be at 2007 levels — but they were also around these levels in 2004 (S&P 500 up 8.99%), 1968 (up 7.32%), 1997 (up 25.72%) or 1963 (up 17.51%). It makes little sense to try to time the market based on valuation or refuse to participate simply because the market isn’t offering the kind of compelling bargains that it presented in 2009. The question is: is this 2007 or 1997?

Stopped clocks are always right twice a day. This is how I feel about the permanent bears. They certainly called it in 2008, but did they call the turnaround? How many of them have been predicting disaster for the last decade and have been proven wrong year after year? There is bound to be another meltdown at some point in the future, but there is no way to predict when that will happen. The wait can be long. While you wait, more money can be lost through unrealized gains than is lost in the actual correction. 2017 may be the year for a major market meltdown of and the end of the bull market. Perhaps. Taking the advice of the permanent bears will help you avoid it, but how much more money was lost listening to their advice since 2009? It doesn’t make sense to refuse to participate in the market simply because the market isn’t offering compelling valuations.

Valuation in a Vacuum

Stock market valuation doesn’t occur in a vacuum. One should always compare the expected returns in stocks against the expected returns in other asset classes. My view is that the best asset to compare stocks to is AAA corporate bonds. The way to think about stocks is as corporate bonds with variable yields. The question isn’t “is the market overvalued?” The question is “Do current earnings yields justify the risk of owning stocks when compared to the returns on safer asset classes?”

This is why interest rates drive the stock market.

“Interest rates act on asset values like gravity acts on physical matter.” – Warren Buffett

Below is a historical perspective of market valuation compared to the interest rates on corporate bonds. The expected 10 year S&P 500 return is derived from the equation described earlier in this post.

Year Expected 10 Year S&P 500 Return AAA Corporate Bond Yield Equity Risk Premium
2017 4.48% 3.05% 1.43%
2012 9.38% 3.85% 5.53%
2007 5.06% 5.33% -0.27%
2002 4.33% 6.55% -2.22%
1997 7.86% 7.42% 0.44%
1992 14.43% 8.20% 6.23%
1987 14.37% 8.36% 6.01%
1982 19.24% 14.23% 5.01%
1977 15.03% 7.96% 7.07%
1972 5.22% 7.19% -1.97%
1967 4.41% 5.20% -0.79%
1962 5.66% 4.42% 1.24%
1957 9.81% 3.77% 6.04%


As you can see, there are times when the market adequately compensates investors for the risk of owning stocks and there are times when it does not. It is also evident that there is a strong correlation between interest rates and future market returns. Higher interest rates mean that stocks need to deliver higher earnings yields, something that is usually achieved by a market correction that depresses P/E ratios and boosts earnings yields.

From this perspective, the market isn’t wildly overvalued. The current market valuation is largely in line with historical norms based on where interest rates are today.

That is the right way to think about stocks. It is folly to think “valuations are too high, therefore I will not participate because a correction is imminent.” That is short-term prognostication and it is typically wrong. No one knows what will happen over the next year and market valuations won’t provide the answer.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“American Desperado” by Jon Roberts & Evan Wright


Cocaine Cowboy

Years ago, I saw the documentary Cocaine Cowboys. The documentary was about the transformation of Miami from a sleepy vacation and retirement destination in the 1960s to a hub of drug trafficking and murder in the late 1970s and 1980s. The story was enthralling. It transcended a normal documentary and unfolded like an action movie. The characters include drug traffickers, hitmen, murderers, shady attorneys, the cops on the front lines and the reporters of the era who documented the carnage. The documentary is on Netflix if you want to check it out.

In the documentary, the two most fascinating characters to me were the drug smugglers, Jon Roberts and Mickey Munday. In the documentary, both were portrayed as largely non violent, which made them more appealing. In the documentary, it was the hitmen that were the savage and violent characters. Munday and Roberts were largely non-violent, which made them stand out. They appeared to be far more intelligent than the characters they were forced to associate with. While they were criminals, they weren’t psychopaths like many of the hitmen and drug kingpins that they were dealing with. When I heard that Jon Roberts wrote a book called American Desperado about his experiences, I was excited to read it.

I feel that this blog entry is incomplete without Jan Hammer

The Dark Side

The book revealed a much darker side to Jon Roberts’ persona than what was in the documentary. Jon admits that he is an evil person. His motto for his life was “evil is strong”. While in elementary school, he witnessed his father murder another man and suffer no consequences for it. The young Jon was amazed that in real life (unlike the movies), bad people frequently got away bad things. This was a truly terrible lesson to absorb at a young age. As Jon learned far too late in life, bad things do catch up with bad people. Karma is real.

The early childhood trauma and lack of a positive father figure propelled Jon on a criminal path. In his youth, he was a juvenile delinquent. He spent his time robbing people and reacting violently to anyone who crossed him. He abused drugs and alcohol. After being arrested, Jon was offered the opportunity to avoid lengthy prison time by enlisting in the military during the Vietnam War. In Vietnam, where he behaved like a murderous psychopath. For instance, there is a section of the book where he describes how to skin a person alive. The description is terrifying. His criminal career evolved from early experiences setting up drug deals with the intention of robbing people, drug dealing, to becoming embedded in the New York mafia and managing night clubs.

Jon had some clashes with made men and was tied to a murder. This led to a falling out with the mafia. Jon had to flee New York City to get away from the police and the mafia. Jon was able to leave the geography of New York and reinvent himself in a new location. He decided on Miami because he had family there. He begins in Miami by trying to live a straight life with a dog training business but quickly strays back into his criminal ways.

Drug Kingpin

Slowly in Miami, Jon evolves in the preeminent drug smuggler in the area. He estimates that his fortune at one point exceeded $100 million. He still engages in violent behavior. He alludes to murders during this time period, but it is not nearly as violent as his time in New York. Still, Jon is relatively tame compared to his counterparts at the time. His lifestyle is unbelievably decadent and he describes this in depth as well.

In one amazing incident, Jon organizes a trafficking operation on behalf of the CIA. He then contends that Barry Seal did this as well, which appears to be supported by evidence. Barry Seal later became an informant. The Colombian drug cartels also ask Jon to kill him. Later, they did this themselves without Jon’s help.

Eventually, Jon is arrested after the government obtains information acquired through an informant and close business associate of Jon’s, Max Mermelstein. He spends years living as a fugitive in both Colombia and Mexico. While in Mexico, he is arrested as a result of their version of America’s Most Wanted. He ultimately escapes from the Mexican prison and hides in the United States in Delaware, until he is ultimately arrested in the early 1990s.

Jon also has a son, whom he genuinely loves. Despite his seemingly tranquil family life in the 2000s, Jon knows deep inside that his demise is coming. He actually says that he spent his life in service of the devil and expects God to punish him with a painful death. Ultimately, Jon died of cancer in 2011.

Mickey Munday

The book left me with a still largely positive image of Mickey Munday. Unlike Jon, Mickey was truly non violent and an incredibly smart guy. He didn’t engage in any materialistic flashiness. He was involved in drug smuggling solely for the challenge and fun of it. He is incredibly innovative. In one amazing section of the book, it is described how Mickey developed a stealth boat after reading about the stealth bomber in a magazine. He equipped the boat with a silent drive and navigated at night without lights while he wore night vision goggles and the boat was invisible to radar. As a nice touch, he would ride the stealth boat while listening to Phil Collins’ In the Air Tonight on his headphones. Mickey didn’t do drugs and his main vice was milk and cookies. He was the most fascinating and likable character to me. I wish Mickey would write a book, as I would love to read more about him.


I liked the book, but I can’t recommend it to anyone who wants to read a book with a likeable protagonist. Jon is a scoundrel. With that said, he at least admits it and doesn’t try to sugar coat it. He is completely honest about the evil in his life. He was a murderer and likely a psychopath. I imagine watching his father commit murder seeped into him and left an impression which impacted his mentality throughout his life. At one point, he talks about the best way to kick someone’s face with a steel toed boot and you can detect that he actually enjoys it, as evidenced by the level of detail in his description. Amazingly, despite a lifetime spent in crime, the most horrific activities that Jon engages in are in Vietnam.

Despite Jon’s admitted evil, he is actually quite charming and at times very funny. A particularly humorous incident involves Jon and OJ Simpson, who apparently had an insatiable appetite for Jon’s drugs. After a drug binge, Jon must take Simpson to an airport on the morning of a game and leads Simpson through the airport in a wheelchair because he is unconscious and will not wake up.

Jon’s story is a fascinating one, but I was also left wondering how much of it was actually true because the stories are so extreme that some of them sound fabricated. To his credit, the co-author Evan Wright attempts to document as much as possible and offers his own commentary on the validity of Jon’s claims. Evan also conducted interview of Jon’s associates and those perspectives are also included in the book.

I can’t recommend this book to everyone, but if you can stomach reading the life of a truly evil man with extraordinary life experiences, then you should check it out.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.