March Midness 2015 Round II: Financial Health

Which company is financially healthier?

We are now in the second round of our what may be the world’s first single-elimination tournament for mid cap stocks. In Round I, we assessed the earnings growth of our 32 competing stocks by applying ranked screening weights. The results of those matches are below (note that the numbers shown below represent the companies’ tournament seeding):

Now, with our Sweet Sixteen, we turn our attention to financial health. Specifically we want to see that companies are not diluting their shares, are able to meet their short- and long-term financial obligations, have a safe level of debt, and have increasing cash flow and free cash flow.

Scoring

In order to compare the financial health of the competing equities in each match, I’ve created a scoring system where stocks are assigned a 1, 0, or -1 in the following fields:

• Morningstar Financial Health Grade: The grade Morningstar has assigned to the company based on financial leverage and trend, according to the company’s most recent quarterly balance sheet. Because this particular group of stocks does very well in this category, I graded on a curve. Rubric: 1 for A, 0 for B, -1 for C
• Share Count Over Time: The number of shares over the past 10 years. An increasing number indicatesshare dilution, which, while not a bad thing in all cases, is certainly not something we’re looking for. Meanwhile, a decreasing share count indicates that the company is buying back its own shares, therefore increasing the value of outstanding shares. Rubric: 1 for decreasing share count, 0 for the share count staying roughly the same, -1 for an increasing share count
• Debt/Equity: A straightforward measure of financial leverage, comparing total debt to total equity.Rubric: 1 for below 0.4, 0 for between 0.4 and 0.7, -1 for above 0.7
• Debt/Equity Over Time: We want to see the company’s debt load decreasing relative to its equity.Rubric: 1 for decreasing under 0.7 or steady under 0.4, 0 for under 0.7 and increasing or over 0.7 and decreasing, -1 for increasing at or over 0.7
• Current Ratio: A measures of the company’s ability to pay short-term obligations, calculated as current assets divided by current liabilities. Rubric: 1 for 2 and over, 0 for between 1.5 and 2, -1 for below 1.5
• Quick Ratio: Also called acid-test or liquid ratio, this measures a company’s ability to meet its short-term obligations with its most liquid assets. It is calculated as current assets minus Inventory divided by current liabilities. Rubric: 1 for 1.0 and over, 0 for 0.8 and 0.9, -1 for below 0.8
• Cash Flow Over Time: Cash flow is the measure of cash into or out of the company.Rubric: 1 for increasing, 0 for remaining roughly the same, -1 for decreasing
• Free Cash Flow Over Time: Free cash flow measures how much cash a company generates after capital expenditures. It is calculated by subtracting capital expenditure (cap ex) from cash flow. Rubric: 1 for increasing, 0 for remaining roughly the same, -1 for decreasing

The scores are totaled for all of the competing stocks and compared. In most cases, the scoring rubric worked beautifully. In a handful of cases, evaluating the trend was not cut-and-dried, so I used my best judgment. So whereas Round I was completely quantitatively determined, Round II is just the slightest bit squishier.

The process of evaluating the stocks in each of these areas was fairly quick. I created a view with all the relevant columns, then simply expanded each row to see how the company has changed in each metric over a 10 year period.

For example, here is my Round II table with Maximus (MMS, in blue) expanded:

Now here is the resulting score sheet for each of the matches:

All but one of the companies received a 1 for increasing cash flow over the years. Free cash flow trends also looked generally good in this group, with all but three companies receiving a 1. Other metrics helped put some daylight between the contenders, although most companies still ended up with a positive score.

MMS turned out to be the only company that received a perfect score (thereby crushing its opponent, Algonquin Power (AQN.TO), which had a score of 0). Other strong showings came from #1-seeded Taro Pharmaceuticals (TARO) and Gentex (GNTX), which both appear to stand on very solid financial ground, with low debt and high current and quick ratios. That is unfortunate for United Therapeutics (UTHR), which had an above-average score, but not enough to catch its opponent GNTX.

Lithia Motors (LAD) was the big loser. While the company has been growing earnings fast enough to make it this far in the tournament, its relatively poor financial standing was exposed in this round. With a high debt/equity that has increased over time, negative free cash flow, and poor current and quick ratios, this company needs to get its balance sheet in order before it has a shot at the championship.

LHO vs. OTC.TO

As you might have noticed in the scoresheet above, we have a tie on our hands! LaSalle Hotel Properties (LHO) and Open Text (OTC.TO) each have 2 points. So this match goes into overtime. Which is just as well—since LHO does not have a current or quick ratio available, this will give us more comparison opportunity.

Our tie-breaking factor will be equity growth. We’ll be calculating the compound annual growth rate (CAGR) for the 10-, 5-, and 1-year periods. Best out of three wins.

Here are how each company has grown its equity over the past 10 years:

LHO’s equity has traveled a farther distance, but as you’ll see below, its CAGR is lagging over all three periods.

So that settles it. OTC.TO wins this match and advances to Round III!

Moving Up

We now have our Elite Eight. Here is our bracket going into Round III:

So far, it seems that any of these companies could be a champion. Our lowest-seeded survivor at this point is Tyler Technologies (TYL), which was ranked 30 out of 32 by our original March Midness ranked screener (which, in case you didn’t already know, is available for download in our library, along with the watchlist of the original 32 competitors). TYL performed well in this round—I’ll be interested to see if it can upset #5-seeded Polaris Industries (PII) next week.

See you in Round III: Efficiency!

Correction: The score sheet should show AQN.TO with a -1 for both Debt/Equity columns.