7 Portfolio Metrics I Use To Measure Portfolio Performance (With Zero Emphasis On Stock Price) As A Long-Term Investor
Price fluctuates wildly, stick with the fundamentals, and you'll avoid the majority of common mistakes
My goal is to make returns in excess of the index, therefore I'm trying to build a portfolio of businesses that perform at a very high level.
Here’s my thinking: A concentrated portfolio of super high-quality businesses that are growing intrinsic value at a reasonable rate should do very well. The reason the stock prices don’t matter to me is that on any given day, week, month, or year, the stock market can be completely wrong about the value of a stock.
Why would I validate my performance based on the incorrect evaluations of the masses?
Warren Buffett and Benjamin Graham have said that investing like a business owner is the best way to invest. A business owner does not care what others think his business is worth. He worries about running the business and making sure it’s running very well, and improving. Therefore, my goal is to run my stock portfolio like a business owner!
I track quite a few fundamentals, but these are the 7 I have deemed most important (in no particular order):
Free Cash Flow Margins
Returns On Invested Capital
Free Cash Flow/Debt Ratio
Interest Coverage Ratio
Any business analyst can make up his or her own mind as to which metrics would best articulate the performance of their portfolio. So today we’ll cover why I track these and the simple calculations I use to track them if you want to use them yourself!
Let’s get to it.
Improving revenue is great, but it needs to make the business more profitable as well.
This is why I like to focus on net margins. How many businesses in 2020-2022 skyrocketed in stock price because of rising:
A company like Carvana had investors salivating due to its high and clearly unsustainable revenue and gross profit growth. But what has happened to the stock price?
It hasn’t been pretty, and I don’t blame it. The problem with unprofitable companies is that a lot of time they can increase the top line by spending a tonne of money on acquiring new customers. That’s all fine and dandy until you realize that:
The company must keep spending large portions of revenues in order to grow or maintain their revenues
The business isn’t actually creating shareholder value by increasing its top line.
Carvana is a great case study in this as they were able to increase revenue and yet, cost of revenues and SG&A were both increasing at a faster pace than revenue growth.
This is important to understand because it shows that the top line doesn’t mean anything if a business doesn’t produce profits for shareholders.
Net income margins show me that a business is able to produce profits.
It’s calculated by dividing Net Income by Revenue. I don't care too much about increasing net margins, but I do care that they are stabilized. As long as my businesses don’t have decreasing net margins, this is a good filter to make sure that the business is performing well.
Perhaps an even better metric of a business’s profitability is…
Free Cash Flow (FCF) Margin
As a business owner, I want to own businesses that are shedding cash to business owners.
FCF margin does a great job of showing how profitable owning this business on the private market would be. Net margins and FCF margins are both great. The reason I like both is that specific businesses optimize for specific metrics.
The gold standard is usually net income (in profitable companies at least)
But there are other businesses that are more focused on generating FCF. A business like BABA 0.00 or $TOI.V are great examples from my portfolio. They are both profitable but have even more FCF than profits. In a business like Topicus, it has additional adjusted metrics that make this number much more attractive than I have listed above.
But I don’t want to get on a tangent.
As a business owner, free cash flows are the cash that you could take from a business and have the business continue running at a normal level. It even includes growth into the equation. So if a business is growing and has a good FCF margin, it’s simply a really good business.
FCF margins are FCF as a percent of revenues.
FCF Margins is a great example of showing when a business has a moat, which leads us to our next metrics.
Returns On Invested Capital (ROIC)
My favourite measure of moat & capital allocation.
ROIC shows me how much profit is produced by the business as a percentage of debt and equity (while removing cash, which isn’t invested into the business). There are many ways of calculating this. I use a slightly customized version. I use Net Operating Profit After Tax / [Total Shareholders’ Equity + Total Liabilities - Cash].
This is a number I’d like to be greater than 15% for all my businesses. The reason is simple. Shareholder returns over long-time samples tend to follow the average ROIC per year. My goal is to make 15% CAGR for my investing. So if I can keep the ROIC of my businesses equal to or greater than that benchmark, I should be able to make some pretty decent returns.
ROIC isn’t very complicated: it’s the profits a business makes on the money invested into it.
The problem with sky-high ROICs is that they’re rarely sustainable. A business such as QFIN 0.00 in my portfolio will not retain this high of a number and that's fine. But I do believe it will remain above my hurdle rate. For a business with a ROIC that is just high, it will eventually be eroded by competition.
Other business people will see the ROICs being made in an industry and pile money into similar assets. This usually culminates in the ROIC regressing to the mean.
So the goal is to find:
Companies with a ROIC equal to or above my hurdle
A durable ROIC
A preferably lower volatility ROIC
It is important to remember that a durable ROIC is more important than a high ROIC.
Staying on the topic of capital allocation, we look at the least talked about metric in investing.
99% of investors have probably never heard of look-through earnings, or have read it about from reading Buffett’s annual letters.
Look-through earnings are a Buffett invention. He wanted to show the economic reality of his equity positions in public companies. According to accounting standards, he only needed to report dividends paid to Berkshire from the equities he owned. But…
This wasn’t an accurate depiction of economic reality.
Retained earnings could have easily been translated into dividends paid to Berkshire. But due to accounting standards, these never showed up on Berkshire books. So, he wanted to explain the importance of this number to shareholders. Look through earnings are the parent company (or in a single investor’s case, their owned amount) of retained earnings less taxes (as dividends are taxed).
Let’s go over an example:
You own 5% of a company that had a net income of $10 million dollars last year. It paid our 50% of net income as a dividend and retained 50% of net income as retained earnings. This means that $5 million was paid out as dividends and $5 million was retained by the company to reinvest in itself.
Since you own 5% of the business, you would have received $5 m * .05 = $250,000 dollars.
For Buffett and Berkshire, this was what they would record on their financial statement. But Buffett saw that the retained earnings had massive amounts of value for Berkshire shareholders. But these were not required to be disclosed.
(I’d highly recommend reading this thread if you want to learn more about the importance of retained earnings.)
Buffett theorized that if a business was able to retain earnings and earn at least a dollar of market value for each dollar retained, it was in the best interest of shareholders to let the business continue reinvesting.
Here is why it works:
A business invests its own profits into its own business
The business earns returns on this investment
The increased returns compound as the business grows the profits for the next year
Here it is in action:
Do you see how simply earning 20% on equity results in earnings per share (assuming no share dilution) grew from $2.00 to $16.27 over 15 years? This is intrinsic value being compounded via retained earnings. They matter, and they matter a lot.
To find Look-through earnings you’ll need to know the following:
What were the retained earnings (RE) per share that you bought when you first purchased the stock
How many shares do you own
What are the retained earnings per share today
You subtract 1 from 2 and you’ll get your share of retained earnings. Then you multiply this by the number of shares you own
Apply a dividend tax rate (to remove taxes if they’d been paid to you as a dividend)
Here’s a quick example of a fictitious business known as Company QPB:
RE per share at the time of purchase: $2
500 shares were purchased
RE per share today: $4
$4-$2 = $2. Multiply this by our shares owned of 500 and we get $1000
Let’s say our dividend tax rate is 15% and we are left with 1000 * (1-.15) = $850.
So our look-through earnings would be $850. This could’ve been dividends paid to us but has been reinvested by the business. As long as they are making a dollar of market value for each dollar retained, we are golden!
Drop a comment if you want me to dig into this even deeper.
Lastly, we are left with 3 financial health numbers that are very important to the health of a business.
Free Cash Flow/Debt Ratio
As I mentioned above in the FCF margins portion, FCF can be used to go directly into the owners’ pockets, or…
It can be used to wipe the debt off the books without impairing operations in any way. This is why I like to use FCF as a percent of debt rather than EBITDA. EBITDA contains expenses that must be used to run the business effectively. If a business has to sacrifice its operations to pay back debt, it means that all numbers from the top to the bottom will likely be affected.
I don’t want my businesses to be impaired due to debt.
So all I look for is a number of .33 or higher for FCF/Debt and I’m happy. As you can see I have 3 businesses that aren’t currently meeting that benchmark. I have reasons to believe that they will have zero issues with this going into the future. If I believed this was going to be an issue that wasn’t going to go away, this might indicate that the fundamentals of the business are deteriorating.
Needless to say, I pay attention to this situation in all my businesses.
This is the standard way to measure the financial health of a business.
I want to minimize bankruptcy risk, this ratio helps me determine how much debt is financing its assets and operation. I’m looking for this number to be less than 1. As you can see, Most of my businesses beat this by a country mile.
As a business owner, you must understand that some businesses will leverage debt to run their business.
So it is your job to understand which of these businesses are in perfectly fine financial health vs. being in danger. For instance $DRM.TO is a business that uses debt heavily in order to grow. It has debt levels much higher than my other businesses, but I understand it well enough to realise that this is how asset management companies work.
It’s not out of the ordinary for the metrics to be this way.
If a situation were to arise where a business that shouldn’t require much debt to run all of a sudden saw a spike in this number, then just like FCF/Debt, you’d want to monitor for changes in fundamentals. These debt numbers can save you a tonne of money.
Getting out of a business before it starts deteriorating will save you many headaches.
Interest Coverage Ratio
This is probably the least important metric that I’ll discuss today. But since my businesses do have some degree of debt, I want to know that they can service their debt payments.
As you can see I have two businesses with no debt. I have to put in “1” for debt otherwise this number would be an error. Is this the correct way to do it? Not sure, but it’s the best solution I have currently. (Please let me know if you think there is a better way, I’m all ears!)
Anyway, I want businesses that are going to be able to easily pay off their interest expenses. If you can’t pay your interest expenses, then how are you ever going to pay down your principal?
I want businesses that are so damn good, they don’t have to worry much about debt. This is the last number that helps me solidify a business’s debt situation.
THanks for this article Kyle!! Very good way to check for performance metrics for our portfolio, the only thing that I would love to deep a little bit more is retained earnings, that concept makes me scratch my head!
Enjoyed this work. Thank you!