If you’ve ever played organized basketball, then you’ve probably heard of the “triple threat.” The idea is that when a strong player receives a pass, he (or she) should be in a ready (knees slightly bent) position, poised for multiple avenues of attack.
It’s called the “triple threat” because there are three different ways of moving toward the goal – shooting, passing or dribbling.
Well, my beat is obviously long-term investing (rather than basketball). So how does the idea apply in that regard? Basically, the “triple threat” concept represents a company’s ability to perform in at least one of three critical areas.
When excelling in these three areas, a company has increased likelihood of producing incredible returns for shareholders. Companies that can sustain “triple threat” performance over long periods of time are valuable and very hard to come by. How close does your company come to being a “triple threat”? Let me explain further.
First, we know that earnings per share (often abbreviated as EPS) is closely related to the intrinsic value of a company’s stock price. (To further clarify, I am talking about future earnings per share.) Despite the shortfalls, looking at EPS is one of the most common metrics used by professional investors. (As long as it’s not the only valuation metric being used, EPS can be quite helpful.)
But what drives earnings per share? To figure that out, we need to take a look at a company’s income statement. In fact, “triple threat” analysis is largely based off of information found on the income statement. (The value of the income statement can’t be overstated. As long-term investors, we have to understand how a company makes its money!)
Start From the Top
When I do a “triple threat” analysis, the first item I consider is top-line performance, also known as revenue performance (i.e. how much money is coming in). One of the things that makes “triple threat” companies so powerful – and so rare – is the presence of top-line revenues that are not just growing, but actually accelerating in their growth. Specifically, a company might grow sales by 5% in year one... 8% in year two... 10% in year three, and so on. That would be an example of accelerating top-line growth.
The income statement shown above is from a leading technology company. This company grew its top line (annual revenues) by estimated amounts of 24%, 2% and 1% in the years 2007-2010 (based on forward projections). While revenues grew through the cycle, they did not accelerate. The top line has continued to grow, but that growth is slowing down. So our example does not qualify as a true “triple threat” contender in the first category (but still has use as an example).
Margin Improvement: No Excuses
The second “triple threat” element relates to operating margin. Well-run companies should be able to improve their operating margin consistently over time. As Investopedia defines it, “Operating margin gives analysts an idea of how much a company makes (before interest and taxes) on each dollar of sales. For example, if a company has an operating margin of 12%, this means that it makes $0.12 (before interest and taxes) for every dollar of sales.”
The idea is, as sales grow – think of that accelerating top line we just talked about – a larger percentage of revenue flows through to net earnings (as opposed to being spent on wages, equipment, raw materials and other things).
Operating leverage is based on the idea of generating higher revenues (via increased sales, higher pricing, or both) without a comparable increase in the cost of doing business. Higher revenues without commensurately higher costs means greater profit. In a healthy economic environment where revenues are accelerating, “triple threat” companies can increase their operating leverage (and thus their operating margin overall) meaningfully over time through a number of tried-and-true strategies.
In fact, for the handful of economically sensitive industrial-type names in the Safe Haven Investor portfolio, I anticipate tremendous margin expansion once sales rebound more fully. This makes me long-term bullish on these stocks, because as revenues and margins expand, most Wall Street analysts will have to raise their estimates, driving the share price up.
As another example, in challenging times (like the major recession we just encountered), many companies take dramatic steps to minimize the impact of weaker sales. To my surprise, even with sales falling off a cliff, companies were able to improve operating margins through activities like cost-cutting, inventory reductions, layoffs and other general productivity improvements. This propelled earnings in the second half of 2009 and could have further impact on the first few quarters of 2010.
Shareholder-Friendly
So far, we have worked our way down from the “top line” (revenues) to the operating level and “bottom line,” where profits (i.e. earnings) are tallied. The distinction between earnings and earnings per share (EPS) is now worth highlighting, since the last component of the “triple threat” analysis is based on the number of shares outstanding. A smart and attractive company is one that buys back enough outstanding shares so that the share count is reduced. By doing that, EPS, which is calculated as earnings divided by the number of shares outstanding, increases.
While some companies periodically announce major share buyback programs to reduce their share count, other companies are always in the market buying up shares, just to avoid EPS dilution that comes from having too many shares outstanding.
Do you remember the heyday of the Internet bubble, when companies issued their employees thousands of stock options as a cheap form of compensation? Those (converted) options and employee-issued shares caused significant earnings dilution – the phenomenon of having to split up a finite pool of earnings over a bigger and bigger pool of shares. And while the Internet bubble long ago went bust, most companies still include stock options and share issuance as a core part of employee performance incentives. Point being, there is always natural earnings dilution that should be addressed by occasional share buybacks.
Better yet, a true “triple threat” company is actively and routinely buying up shares of its stock with the free cash flow (another very important metric) that it generates. A long-running, consistent share buyback program will increase the EPS growth rate, and thus make a stock more attractive to investors. If we look to the previously mentioned income statement one last time, we can see that this company has steadily bought back its shares. EPS for 2010, which is projected to come in at $1.47, would have only been $1.40 if the number of shares outstanding had remained at 2007 levels. Buybacks are something to keep a close eye on.
Few companies can sustain “triple threat” results for more than a short period of time, and young (or small) growth companies are more likely to be “triple threat” contenders than large and mature ones (though this is not always the case). Cyclical industrial type companies can also move in and out of “triple threat” status, depending on where they are in the overall cycle.
When analyzing a company for its long-term investment potential, it’s helpful to determine whether there is a potential “triple threat” scenario in the works. Understanding (and paying close attention to) core concepts like top-line acceleration, margin expansion, and consistent share-count reduction can make you a better stock picker and investor.
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Serving as the editor of Taipan’s Safe Haven Investor, and contributing editor to the free e-letter, Taipan Daily, Kent Lucas has over 20 years of financial and business experience centered around seven years as a research analyst and portfolio manager for a leading investment management firm. In that capacity, he actively managed $1 billion worth of equity assets, with particular attention to multi-industrial companies along with auto, construction and farm equipment-related companies.
In addition to his professional asset management experience, Kent also has worked in leading financial institutions’ divisions including Tax-exempt Derivatives, Corporate Trust and Equities Sales and Trading. With a BA in Economics from Harvard University and MBA from Stanford University, Kent brings a fundamentally driven, value-oriented approach going against the crowd to find solid companies at attractive prices.
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