Doc's note: "Every business has a key metric that investors must understand. Without knowing a business' key metric, you might as well take your money to Vegas and gamble it away."
That's according to my colleague and Extreme Value editor Dan Ferris. Today, I'm sharing an essay from Dan where he explains how this understanding one metric will give your portfolio a dramatic upgrade... and help you sleep better at night.
"I wouldn't buy it, because I'm focused on volumes..."
That's what a former beer-company executive turned hedge-fund manager told me and a couple other investors as we sipped cocktails at the end of a three-day investor meeting I attend each year in the mountains of Colorado.
Another investor in the conversation was thinking about buying shares of Molson Coors Brewing (TAP). The former exec said he couldn't buy it, because a brewer with declining volumes is a nonstarter for a guy with his knowledge and experience.
In other words, you can't invest in a brewing company without knowing the amount of beer it sells.
You can find this kind of key metric in every industry – if you know where to look. Let me show you what I mean...
Earlier that evening, a veteran real estate investor discussed the merits of preferred stocks of various mall real estate investment trusts ("REITs"). The preferreds are higher in the capital structure, so they'll keep paying dividends... even if the company cuts its common stock dividend.
As he started his talk, he said, "The most important metric in malls is sales per square foot." High and/or increasing sales per square foot is good. Low or declining is lousy. Invest accordingly.
I'm not saying you only need to know a single number to invest in beer companies, malls, or any other business...
But I've learned something important over the past two decades: Every business has a key metric that investors must understand. Without knowing a business' key metric, you might as well take your money to Vegas and gamble it away.
Talk to a publisher or software maker who sells subscriptions. They're obsessed with marketing, advertising, and other costs associated with gaining subscribers.
Talk to a banker. He's obsessed with net interest margin, the spread between the interest costs the bank pays and the interest it earns from loans and securities.
Talk to a gold miner. He's obsessed with the all-in capital costs and operating expense of mining an ounce of gold.
By now, you're probably nodding your head and thinking of the most important metric in your own line of business... That's what I hope you're doing, anyway.
Now, take that hard-won wisdom and apply it to the stocks you buy. If you do that, your portfolio will likely get a dramatic upgrade... And you'll spend a lot less time worrying about it.
Understanding key metrics reduces risk... and with it, some of the excess worry too many investors seem to indulge about their equity portfolios.
Most key metrics are either costs or profits. But sometimes, they're neither. Social media platform Twitter (TWTR) has been consistently unprofitable. Yet the company and its shareholders remain focused on the number of monthly active users ("MAU"), with more than twice as many mentions of MAU in its annual and quarterly U.S. Security and Exchange Commission filings than daily active users ("DAU").
Twitter's highly profitable peer Facebook (FB) obsesses about the same number. (At more than 2 billion MAU, Facebook is more popular than communism, Islam, and Catholicism.)
You'll find this "key metric" phenomenon all over the business and financial worlds...
For example, anybody who listens to quarterly conference calls knows that most Wall Street analysts focus more on gross margin than most other financial metrics.
Gross margin is the percentage of gross profits left over after you pay the cost of the goods or services you've sold. After gross margin, deducting other layers of expense leaves you with operating, pretax, and net-profit margins.
Relatively small changes to gross margin can lead to big changes in other margins, including the cash-profit margin left over for cash dividends and share repurchases (cash in investors' pockets). In other words, for many analysts on Wall Street, gross margin is a key metric, if not the key metric.
Sometimes, knowing the key metric can help you strategize about larger developments in the overall economy...
For example, longtime subscribers to my Extreme Value newsletter are familiar with Automatic Data Processing (ADP), the largest payroll processor in the U.S., responsible for delivering roughly one-sixth of the country's paychecks.
I recommended the stock in October 2008, in the depths of the financial crisis, because I knew it was a wonderful long-term investment trading at a dirt-cheap price. I continue to recommend holding the stock, which has returned more than 400% (including dividends and spinoffs) since then.
ADP hangs on to your pay for a night or two, earning interest on the funds before delivering them to your bank account. Last year, ADP held overnight $1.8 trillion (with a "t") in employee payroll funds for its employer clients. That $1.8 trillion is "float," just like an insurance company. Float is money you receive from customers that you'll pay back to them some time in the future. For ADP, it's just a day or two. Float is the key metric for ADP (referred to as "funds held for clients" in company filings).
I continue to recommend my readers hold on to their ADP shares because small rises in interest rates can generate tens of millions of dollars, or perhaps $100 million or more of additional cash profit from the interest on float... without a single additional penny of expense or investment. It's like an insurance company, without the risk of underwriting losses. Who's afraid of rising interest rates? Not ADP shareholders who read Extreme Value!
In Extreme Value, we've used our understanding of key metrics to find incredible deals with huge upside and limited downside.
And earlier this year, I found the single greatest equity opportunity I've ever found in my 20 years playing this game...
I noticed that the most important number in that industry had risen dramatically – even through a brutal four-year industry-wide downturn.
That's a rare and highly robust business... one that gushes free cash flow, pays a 4% dividend yield, and has no debt.
All in all, I'm comfortable saying that this stock has limited downside risk and upside potential of as much as 20 times your money over the next 10 years or so.
In Extreme Value (and other Stansberry Research publications), we do the work other investors can't or won't do for themselves...
Ask yourself how many of the key metrics I've mentioned were squarely on your radar... something you look at before you look at anything else about a business.
Most folks answering honestly will realize they don't know the key metrics for the stocks they own. These people have a huge hole in their investing skill set... one we're laser-focused on plugging for you.
Learning to track key metrics isn't easy, either. You'd better know someone who's already pretty good at it. In fact, you may have noticed something else about these important numbers: Except for gross margin and net-interest margin, none of the key metrics I've discussed appear in a pristine, easy to use form on a company's quarterly financial statements. An accountant would probably say something like, "Most of these key metrics Dan is talking about aren't compliant with GAAP accounting rules."
He's right. They're not. But generally accepted accounting principles ("GAAP") aren't enough if you don't want to lose the money you invest (and make a whole lot). You must know key metrics, too. So, either the company must report them separately from its GAAP financials, or investors must learn to calculate them using the financials and other data the company reports.
It's like I tell my readers now and then: Analysis begins with the published financials – it doesn't end there.
If you want to make more money and take less risk in the stock market, you'd better be more informed than the average investor. I promise you, the average Joe doesn't have a clue what the key metrics are of the businesses he's invested in. That's just crazy.
If you buy a stock but don't know its key metric and other important data – some of which don't appear in quarterly reports at all – you're gambling with your portfolio.
I've been at Stansberry Research longer than anyone besides Porter. I've been working with just one analyst – the intrepid Mike Barrett – for most of the last decade. Between the two of us, we have around 50 years' experience (and lots of gray hair). Learning key business metrics is an important lesson that has been ingrained into our psyches over multiple decades. Passing it on to you is one of the most important roles we play in the lives of our subscribers.
If the topic of key metrics is boring to you, it's a sign we're right on track...
Investing is best when it's as boring as watching paint dry.
And for those who won't take the time to learn the key metrics of the businesses in their equity portfolios, we're grateful. The more ignorant they remain about key metrics, the more of an advantage we'll have in the stock market – and the better our readers will fare when they take our advice.
In Extreme Value, understanding these key numbers is one of the main tools that helps us find crazy good deals in the public equity markets.
Learn key metrics, before your investments give you a painful lesson in them. Or not. Your call.
Editor's note: In a recent issue of Extreme Value, Dan discussed what the "smart money" is doing, one trade you should avoid like the plague, and where he's seeing risk right now. If you want to be ready for whatever happens next in the market, click here to get started with Extreme Value today.