Financial Statement Analysis Blog #11 – investment decision making
“Trust your instincts, and make judgements on what your heart tells you.”
After all of those analyses, it is time for decision making. If you have $1 million to invest, will you put it on our example company Caterpillar (CAT)?
Well, there is no right or wrong really. Investment decision is a person-by-person (or firm-by-firm) decision. Different investors have different investment criteria, different prioritization of those criteria, combined which lead different investors to different investments. As going with a particular investment may mean foregoing another investment (opportunity cost), it is important to fully understand the trade-offs when making an investment – mainly around the investment returns and the required investment holding periods. The financial analysis techniques that we covered in this series of financial statement analysis are just the beginning. It must be combined with operational due diligence when proper. In the end, a gut check is also needed in making the decision.
As it is, I will not be investing my $1M in CAT. My reasons are as follow:
· The construction machinery manufacturing industry that CAT is in has not performed well in the past five years. In addition to the many challenging characteristics of the industry (dependence on the up-and-down construction industry, production inefficiencies, large R&D capital investment need, increasing competition level, and exposure to steel prices), the S&P 500 Index has outperformed the S&P500 Machinery Index -- an indicator that there are better industries and companies to invest in.
· Aside from the industry analysis, when I looked at CAT’s qualitative measures, there are some troublesome signals: the low stock ownership level of the CEO (indicating his own lack of confidence on the company), the auditor (PwC) 38% dependence on non-audit fee, the lack of a chief ethics officer, and the many small and large environmental and ethical lawsuits.
· On quantitative measures, CAT has shown:
1. A declining ROE that is caused by declining operating margin and declining total operating efficiency (total assets turnover).
2. An increasing level of leverage that is not being effectively used (borrowing cost exceeds its marginal rate).
3. A lack of ability to take advantage of the improving general economy and growing demand for housing and constructions in these past couple of years. In laymen terms, CAT did not “make hay while the sun is shining.”
4. A tendency of over-reliance on homegrown organic growth. Management themselves admitted in their 2015 10-K that, in certain geographies, CAT faced local competitors who have more regional advantages. This admission should have indicated to management that they should consider more geographical acquisitions of competitors or other partners that can be vertically integrated to their operations. As CAT’s long-term capital strategy of moving to less financially risky capital base demonstrated, current management might be too risk-averse to embrace new unfamiliar growth opportunities.
5. A deterioration of abilities in maintaining liquidity, collecting cash from customers, managing inventories, managing working capital, and decreasing debt-fueled assets.
6. A failure to recognize the most profitable market segments within the company and correspondingly to allocate assets and capital expenditures to those segments.
7. Overall, a weakening profit generation ability.
I will reconsider my investment decision if the following happens:
There are signs of improvements on the financial metrics: ROE, leverage ratio, sales and profit, acquisitions, liquidity ratios, cash conversion cycle, and debt-fueled assets.
There is a pivot of capital allocation towards Asia Pacific and Europe.
There is an increase in the stock ownership of the CEO.
There is a decrease in the amount of environmental and ethical lawsuits.
There is a change in leadership of the company.
Please note that the analyses done in the 11 financial statement analyses blog posts were done in the Fall of 2016. Caterpillar may have changed since then for the better.