Love hurts: Pandemic teaches new ways to evaluate stocks
By Kyle McIntosh
Over the last several years, I fell in love. This is not a love story about my family or our not-so-smart golden doodle. Instead, this is a story about how I fell in love with a stock, and the turmoil I’ve experienced with it during the COVID-19 pandemic. While my relationship with that stock will never be the same, investment analysis in crisis mode has taught me valuable lessons about how to better screen stocks.
The way things used to be
My historic approach for investing was to start with fundamental financial analysis to determine if a deeper dive was justified. The traditional measures I used were: price-to-earnings (or “P/E”) ratio; sales and earnings growth; dividend yield; and debt-to-equity ratio.
If a stock looked promising based on these measures, my next step was to review financial statements, read analyst reports and create a valuation model.
In 2014, I came across a hotel investment firm with a seasoned management team that was taking a unique approach to building its portfolio. I saw the stock as attractive based on the measures above: Its P/E ratio was reasonable; sales and earnings were solid with potential to grow; its dividend yield was over 5 percent; and it had a manageable level of debt. This looked like a winner!
I made an investment, and the company delivered on its sales and earnings projections. As a result, its stock price increased, and it was able to raise its dividend multiple times. This stock outperformed the market, and it became the largest stock in my portfolio.
A new investment lens
My positive outlook has changed over the last several months. With the COVID pandemic, the company’s business of serving travelers has dried up, and its stock has taken a substantial hit. With sales down, earnings negative and a canceled dividend, my traditional stock analysis measures were no longer valid. In order to consider whether to sell or hold my investment, I had to come up with new ways to analyze the company and its prospects.
As any trained CPA would do, I went to my comfort zone and reviewed the company’s financial statements. Through crisis came clarity: In addition to gaining insights into this stock’s ability to weather the pandemic, I developed four measures to add to my future investment toolkit.
• Cash: Cash, including short-term investments, may be overlooked by investors who see it as a given for a public company. Cash can be compared to current liabilities and operating cash expenses to give an initial indication regarding liquidity. If current assets are concentrated in inventory or accounts receivable, the company can face a liquidity crunch as it takes time to convert such assets to cash.
• Cash operating expenses: With the pandemic, many companies went from having positive net cash inflow to having sizable net outflow. Given the uncertainty about revenue, I compared cash to current liabilities and cash operating expenses. While current liabilities are on the balance sheet, this latter measure can be estimated by subtracting “depreciation” on the cash flow statement from total operating expenses. Comparing cash to short-term liabilities plus cash operating expenses gives a worst-case estimate of how long a company’s cash balance can sustain operations.
• Debt and commitments: Beyond current liabilities, it’s important to review debt and other commitments to understand the nature and timing of obligations. For long-term debt, a company will disclose the repayment schedule in its footnotes. Companies also disclose commitments and contingencies in the footnotes to show fixed future outflows, such as rent.
• Lines of credit: Financial statements give the terms of lines of credit to include unused borrowing capacity, length and covenants. Significant unused borrowing capacity, or lack thereof, can signal a company’s ability to weather short-term crises.
After considering these measures, I decided to hold my investment. I believe the company’s cash and borrowing capacity are adequate to get through the next 36 months. By that time, the worst of the pandemic should be behind us, and people should be traveling again. Further, the management team remains in place and could be well-placed to add to its portfolio should acquisition targets favorably re-price.
• Kyle McIntosh is a CPA and an accounting lecturer in California Lutheran University’s School of Management.