While RDY and RSPR (described in the previous two chapters) are great for identifying potential value stocks, the purchase decision must not be made until a company's fundamental factors have been looked at. After all, if the fundamentals are poor, a company could continue to appear cheap on a dividend or sales basis for many years to come.
Tengler discusses twelve fundamental factors she looks at for stocks that pass the RDY and RSPR screens. If a stock passes 2 of the 3 qualitative factors, and 5 of the 9 quantitative factors, it passes the test:
1) Are the company's products/services becoming obsolete? As an example, Tengler identifies JC Penny in 1998 as a company occupying a position in the retail market that no longer served a purpose.
2) Does the company have a franchise value? Nike and Gillette are cited as examples of companies with brands that help the company succeed. Other questions investors should ask to help answer this question include whether the company is growing market share profitably, and whether it can leverage its franchise to enter new markets successfully.
3) How good are management and the directors? Management should be accountable, should have low turnover, and should have their compensation tied to shareholder interests. Most directors should be independent.
4) Does the company consistently grow its sales? Sales growth serves as economic proof of the acceptance of the company's products.
5) What are the company's margins? Tengler advises looking at trends in operating margins over time and versus competitors.
6) What are the P/E ratios? Tengler looks at forward, trailing, normalized, peak and trough P/E ratios against those of competitors.
7) What is the company's free cash flow? Cash flow trends should be compared to those of earnings to establish the relationship there. Also, working capital turnover (using cash flow) should be examined relative to competitors.
8) What is the dividend situation? The payout ratio should be sustainable and in-line with the industry.
9) What is the asset turnover? Trends in this number should be examined to see if the company is paying too much for incremental sales growth.
10) What is the company's ROIC? Investors must determine if management is making good investments. Comparing the company's ROIC to its cost of capital should help in this regard.
11) Is the company over-leveraged? A company may be growing earnings only because it is utilizing leverage to grow its assets.
12) What is the company's financial risk? Off-balance sheet debt should be brought into the equation, and coverage ratios should be examined (e.g. EBIT/Interest).