Summing Our Financial Strength

Cover Story, by Mark Robertson, Managing Partner January 1st, 2007

A company can't be best-of-breed without a high relative financial strength.

Financial Strength. The financial strength rating is an important component of a MANIFEST quality rating. Effective January 2007, we will publish a unique rating that is a combination of sources, including but not limited to: Morningstar, Standard & Poor’s and Value Line.

Financial Strength is an important component of a MANIFEST quality rating. Effective January 2007, our Financial Strength rating will be calculated based on multiple sources – in effect, becoming a consensus ranking (or index) of Financial Strength. The new rating will be substantially similar to the existing rating but will now be more granular, dynamic and will represent more than just one opinion. There is merit in increasing our independence from a single source. The result creates yet another distinctive feature of Manifest Investing and strengthens our resources and method.

“A position of true leadership in a particular business is very valuable because success tends to breed even more success.” – Brad Perry, Winning the Investment Marathon

Best of Breed

For all of his rants and raves, CNBC’s Jim Cramer leans pretty hard on the financial strength characteristic when he assumes an ownership stake in an enterprise. Ignore the projectiles and flying furniture and listen closely when he calms down. During the “Lightning Round”, watch the companies displayed as subtitles. “Company X is a holding of the Cramer partnership trust.” With few exceptions, these companies ooze financial strength. And for all the noise and commotion, a truism floats above the chaos: “A company can’t be best-of-breed without a high relative financial strength.”

The Strength of Consensus-Building

Are more heads better than one? Since the inception of Manifest Investing, we have leaned pretty heavily on the Value Line Investment Survey for their opinion of financial strength. We have had – and will continue to have – great respect for the validity and utility of Value Line’s financial strength rating.

According to Value Line, “Financial Strength is a measure of the company’s financial condition, and is reported on a scale of A++ (highest) to C (lowest).” What goes into the financial strength rating? “[VL’s] Financial Strength rating takes into account a lot of the same information used by the major credit agencies. Our analysis focuses on net income, cash flow, amount of debt outstanding and the outlook for profits.” Other factors (e.g. loss of patent protection) also are considered.

All of that makes a lot of sense to us. So does Morningstar’s Financial Health. “Our financial-health grade consists of two components … We look at financial leverage (assets/equity) from the most recent quarterly balance sheet, cash position, cash flows and free cash flow trends to arrive at a grade.” Morningstar punishes companies with deteriorating financial health [trends]. The Morningstar ratings also make a lot of sense to us – and they range from “F” (lowest) to “A+” (highest).

The Quality Rank published by Standard & Poor’s makes a lot of sense to us too. S&P’s version accounts for the growth and stability of earnings and dividends and is designed to capsulize the nature of “considerable analysis” in a single symbol ranging from “D” (lowest, in reorganization) to “A+” (highest).

Despite an overwhelming consensus of agreement in relative ratings, they don’t always agree. The new Financial Strength Index at Manifest Investing compiles and blends a score from (but is not limited to) these types of sources/opinions that we respect greatly.

An Antidote for Sluggishness or Teacher’s Pets?

The new financial strength index represents a consensus of opinion. A change will be triggered any time one of the sources changes its outlook. There have been several times in the past where our community of investors waited for a change in financial strength rating – to reflect current pressures and/or reduced expectations – only to see an unwavering grade bestowed by a single research service. In other cases, we’ve witnessed what seem to be teacher’s pets while some companies seem to be perpetually penalized in the rankings.

There will also be increased granularity. Prior to the change, 45 companies received 100% (A++) ratings. Following the change, only 11 companies display a 100% financial strength index. For what it’s worth, only two companies exhibit a unanimous top rating from all three major research services. Can you name them? (Answer at bottom of page) The void between 90% and 100% will now be filled with approximately 250 companies. That’s what we mean by better granularity.

Take a look at the accompanying chart. For most of the companies, the financial strength index is relatively the same as the prior rating. But there are clearly fewer 100% scores and differences of opinion with companies like AFLAC, Cisco Systems, Biomet and Fastenal.

When Financial Strength Matters Most

Are more heads better than one? We think so. We believe that the collective experience of investment clubs suggests that pooling is a pretty good idea. As we explored the various research services and their definitions of financial strength, etc. we came across a number of compelling references. Although most of the Googlish results on the Internet link financial strength to the probability that an insurer will be able to deliver a check to its insureds, it is clear that the concept of financial strength for non-financial companies is pretty important too.

In an equity research report by S&P chief investment strategist Sam Stovall, he explained, “Nothing makes the stock market sweat like uncertainty, and nothing, it would seem, fogs future visibility more than geopolitical disturbance.” He examined the impact and response to six shocks: Pearl Harbor, the Cuban missile crisis, the Kennedy assassination, Iraq’s invasion of Kuwait, September 11, and the 2004 Madrid bombings. On average, the S&P 500 fell 2.9% on the trading day after these events, from a low of 1.1% (the Kuwait invasion) to 4.4% (Dec. 7, 1941). Markets are amazingly resilient in the face of unanticipated shocks. Excluding Pearl Harbor, Stovall found, the S&P 500 was trading at new highs a mere 15 days after the event (55 days including Pearl Harbor).

As it turns out, markets are less forgiving to things that negatively impact our daily lives – higher food costs, a bigger heating bill, or anything “Maslow.” Inflation or slowing profitability trends are more harmful to markets. With MIPAR (see page 6) near historic lows, we urge investors to focus on companies of the highest-quality and the highest financial strength characteristics.

In The Intelligent Investor, Benjamin Graham recommended that the average investor buy reasonably valued stocks of companies with long records of stability and growth in earnings and dividends. These stronger companies have weathered the storms of stock market corrections over the decades. Companies with relatively high financial strength (in aggregate) seem to decline less when chaos arrives and recover faster relative to the weaker companies in the aftermath of a stock market disruption. Inasmuch as S&P focuses on these attributes in the development of S&P’s Quality Rank, this becomes a welcome component of our financial strength index.

We still believe that this may be a good time to consider adding some stocks with high financial strength characteristics and high quality ratings to your portfolio.

Financial Strength matters. We believe that you will find the consensus ranking of opinions on financial strength to be a valued contributor to your long-term investing efforts.

Morningstar, Standard & Poor’s (McGraw-Hill) and ValueLine are all registered trademarks. All three provide subscriptionresearch services. For more information, visit: www.morningstar.com, www.standardandpoors.com, and www.valueline.com.

Answer: Johnson & Johnson and Pepsi.

Mark Robertson

Mark Robertson is founder and managing partner of Manifest Investing, a source for research and portfolio management focusing on strategic long term investors.