Each month, I intend to highlight a stock on our Approved List.  The purpose isn’t to promote a stock, since not all clients will own every stock for a variety of reasons, the idea to help describe the kinds of characteristics that we evaluate at when we make a stock investment.

In theory, our strategy is pretty simple: buy high quality companies at cheap prices.  It’s definitely not a new concept – Warren Buffet is the third wealthiest man alive because he has successfully applied the same concept long before we were in business.  Still, not everyone does it: there are plenty of momentum strategies, growth managers and technical analysts out there.  After all, somebody owns Netflix…

This month, I decided to look into another company with a powerful consumer brand, Procter & Gamble (PG).  Well, I should say brands, since they have over 23 brands that generate more than $1 billion in sales and another 20 that generate $500 million in sales.  Some of the brands include: Tide, Charmin, Pantene, Cover Girl and Gillette, just to name a few.

Brand is one of the key competitive advantages identified by Harvard Professor Michael Porter and we believe that having a strong competitive advantage is one of the most important components of being ‘high quality.’  To be truly high quality, a company with a competitive advantage has to make productive use of the advantage, which can often be identified by looking at the financial results. 

Financial results are backward looking, of course, but they do offer insight into how management is using (or not using) the competitive advantage that the company possesses.  With any company, we look at three financial factors: growth, profitability and financial strength.

Over the past ten years, PG has doubled their revenue, which works out to an annualized growth rate of 7.24 percent.  This is pretty remarkable ‘top line’ growth given that the company is very mature (it’s the seventh largest company in the S&P 500 with a market capitalization of $181 billion) and consumers have had a tough time in the two recessions that occurred during these ten years.

Just as importantly, PG has been consistently profitable.  There are a number of ways to measure this, but the simplest is to simply look at the earnings growth over the past 10 years.  In 2001, net income was 7.4 percent of revenues and in 2010, earnings (another name for net income) were 13.9 percent of net income.  While the company was growing, management was squeezing out higher profits.

The combination of these two factors has allowed PG to build a fortress-like balance sheet, the key sign of financial strength.  A quick way to check the balance sheet is to look at the credit rating, which is AA by Moody’s and S&P, although after the crisis, the ratings agencies credibility is a little lacking. 

A fundamental analysis by Morningstar suggests that PG should generate approximately $71 billion in free cash flow over the next five years, which when added to their current cash balance of $2.8 billion and the $9 billion available to them through various lending facilities, it won’t be hard to pay off the $20 billion in debt related interest payments and maturities.

Once we have identified that a company is high quality, through a business evaluation of their competitive advantage and a fundamental review of their financial statements to identify that management is generating growth, profitability and is financially sound, then comes the hard part: valuation.

Unfortunately, valuation is much more of an art than a science.  Two investors can look at the same business and financial statements and come up with completely different values for the stock.  In fact, that’s what happens every day in the market, but with millions of investors.

Broadly speaking, we use a technique known as relative value, which essentially determines the value of a company on the basis of how the market is pricing other, similar securities.  To a much lesser extent, we use discounted cash flow (DCF) models that attempt to determine the value by estimating the present value of future cash flows.  That’s a big topic that we will get to another time.

With relative value, we might look at a metric like the price-to-earnings (PE) ratio, which simply compares the price of a stock to the earnings of a stock.  Next year, the PG is expected to earn a profit of $3.96 per share and the stock price is $64.64 as if Feb. 8, 2010.  That means that the forward looking PE ratio is 16.32 (64.64 / 3.96).

When we do a relative analysis, we first look at the PE relative to other companies.  Some similar consumer products companies like L’Oreal (OR FR) are much more expensive with a forward PE of 21 and others are cheaper, like Kimberly-Clark (KMB) are cheaper with a forward PE of 12.5 (another fine company on our Approved List).

Second, we look at the PE compared to its own history.  On a historic (or time-series) basis, PE is cheap.  Most of the last decade, PG traded at a PE in the 20’s, which is substantially higher than it is today.  Only at one point, at the peak of the financial crisis, did PG trade at a lower PE. 

Although KMB is slightly cheaper today, PG is an attractive addition to many portfolios because of the combination of their iconic brands, financial position and relative inexpensiveness.  As I mentioned at the outset, the purpose of the Spotlight Stock isn’t to ‘sell’ anyone on a particular stock, but to help outline our thinking and analysis as we attempt to find high quality companies at inexpensive prices.