Justin's note: Today, we're wrapping up Palm Beach Daily editor Nick Rokke's three-part series on picking elite companies. Mastering this system will give you a leg up on most investors. If you missed the first two steps, you can catch up here and here.
Below, you'll learn the third and final step...
You see the red line in the chart below?
It shows the cream of the crop. The best investments money can buy…
If you want to ride that red line all the way to the top, read on…
Review: Three Criteria for an Elite Business
Over the weekend, I told you about my three-step method for picking elite companies.
The first step is to find companies with a high return on invested capital (ROIC). Just doing that would put you on the blue line in the chart above.
The second step is to find companies with a high ROIC and high growth. Just doing that would put you on the green line in the chart above.
Today, we’ll conclude our series on the three steps to picking elite companies with the third and final step in our method: cheap valuations.
It’s this final step that will book your ticket on the red line…
A Three-Layered Filter
There are 4,200 publicly listed U.S. companies with market caps over $200 million.
On Saturday, we narrowed that down to 281 by looking for companies with an average ROIC of over 20% per year for the last five years.
We put the 10 companies with the highest ROICs on a list.
Then on Sunday, we winnowed that list down by choosing companies showing long-term growth in three categories: revenue, free cash flow, and profit margins.
Of the 10 companies we selected, four met that criteria.
From that handful, we were able to select a potential superstar performer using our third criteria…
How to Find an Elite Company on the Cheap
We look at three ratios to determine if an elite company candidate is cheap:
Price to free cash flow
Enterprise value divided by EBITDA
Price-to-earnings ratio divided by the growth rate (PEG ratio)
We applied those three metrics to our sample shortlist from last week. Only one company passed the final test: Natural Health Trends (highlighted in green below).
|Fifth Street Asset Mgmt.||FSAM||993%|
|Moelis & Company||MC||216%|
|Natural Health Trends||NHTC||182%|
Natural Health Trends is the only company on our list of the 10 companies with the highest ROICs to pass our three-step test.
Based on this test, we believe it will be a good investment going forward.
For our backtest, we bought the 25 cheapest elite companies every month starting in 1997 to see how they would perform using our strategy.
When a company became too expensive, we sold it and bought a replacement.
Every $1,000 invested in this strategy since 1997 would have turned into more than $50,000. If you had $100,000 to invest in this, it would have turned into $5 million. That’s a 5,000% gain (see chart below).
Now, most people won’t be able to duplicate the returns in the chart above on their own…
You’re just not going to get the same entry and exit points.
But you can use our system to create a shortlist. From there, you can spend time researching each company and make your own decision.
If you apply our three-step test, we believe you’ll have a leg up on most investors.
Nick Rokke, CFA
Analyst, The Palm Beach Daily