When analyzing stocks I always begin the process by analyzing them by their industry group. This allows me to see the big picture on how the industry is doing and then select the best stocks in each industry for further analysis. I then go to the next step and do a qualitative analysis using the methods of Philip Fisher but that requires a lot of work, so I must first narrow down the list and only take those with excellent quants:

I use three ratios in doing my quantitative analysis and they are:

1) Price to Owner Earnings

2) FROIC

3) CapFlow

Price to Owner Earnings (my own version of Price to Free Cash Flow)

Price per share/Cash Flow per share-Capital Spending per share

I have back tested this ratio on the DJIA going back 60 years and you can find my research paper on it by going here .

I was able to determine in my back test that buying a stock selling for 15 times or less its Price to Owner Earnings, increases the probability of success dramatically in most cases. I originally discovered the ratio from reading Warren Buffetts 1986 letter to shareholders where he defined the term owner earnings as the cash that is generated by the business operations, regardless of the earnings the company reports to Wall Street. Mr. Buffett:

we consider the owner earnings figure, not the GAAP [earnings] figure, to be the relevant item for valuation purposes-both for investors in buying stocks and for managers in buying entire businesses.

[Owner earnings] represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash chargesless ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.

FROIC is basically Free Cash Flow Return on Invested Capital or:

(Cash Flow — Capital Spending)/(Long Term Debt + Shareholders Equity)

I look for companies that achieve Owner Earnings returns of at least 15% on Main Street for every $1 of Total Capital invested. Basically in the real world of Main Street, far from Wall Street companies that achieve 15%+ on this ratio are making a lot of money, so logically if you have a business whose cash register if overflowing continuously, there is a great probability of making some serious money someday.

The third ratio that I use to pick stocks I call CapFlow. CapFlow is basically:

Capital Spending/Cash Flow

This ratio allows me to identify elite management teams that achieve very low costs in relation to their cash flow. Very simply they are usually the low cost producer in their industry because of their management great attention to detail in their cost control management. They also use things like Economies of Scale, where as their sales increase their cost per unit decreases.

So to summarize we search for the following ideal for each ratio;

1) CapFlow = less than 50%

2) FROIC = greater than 15%

3) Price to Owner Earnings = less than 15

In doing my industry analyses I end up giving a stock a rating of four possible outcomes of 0-3 and then gather the ones scoring perfect 3s and place them on my list for further analysis for potential purchase.

Here is my Mycroft Research Analysis of the Aerospace and Defense Industry

(Click to enlarge)

As you can see only four stocks of the twenty eight actually achieved a perfect score:

• Lockheed Martin (NYSE:LMT )
• General Dynamics (NYSE:GD )
• Rockwell Collins (NYSE:COL )
• Boeing (NYSE:BA )

I have always been a big fan of these companies and have owned each of them from time to time. I dont today as we have a lot of Macro-Economic concerns that are not reflected in their numbers. For one we have just ended the war in Iraq and are winding down the war in Afghanistan, therefore a downsizing of the military is definitely in the cards and with governments in Europe experiencing economic turmoil, we will definitely see cuts in their defense budgets.

Here in the USA, the industry is facing a potential across the board cut of some $600 Billion as a result of the failure of the Super Committee to reach an agreement. Therefore even though the quants show that these four companies are incredible bargains, it is a big mistake to buy stocks just on their numbers without doing a macro-economic analysis. I proved this when I analyzed the Homebuilder Industry in 2006 and in that analysis I found that the homebuilders had impeccable quants from every possible angle you could look at, but that did not stop their stock prices from collapsing as much as 70% due to the depression in Real Estate that soon followed and that we are still dealing with some 5 years later.

Because I did the macro-economic industry analysis I was able determine that the Federal Reserve raised rates too fast and too many times and that there was an over-abundance of for-sale signs in a specific area (Mercer Island) that just two years earlier had homeowners selling homes faster than they could put their for-sale sign up. These results didnt flow through to the quants for almost a year and by that time it was too late to save the ship.

Therefore when doing an industry analysis you also have to do a macro analysis as well. Boeing for example has an incredible backlog of orders but those are from an airline industry that is in dire straits and worst of all Banks are so broke that they are unwilling to finance the new airplane deals, so most of the orders you hear about in the press are actually financed by Boeing itself. This is not a good sign and it brings up images of Whimpee in the Popeye cartoon series when he says I will gladly pay you Tuesday for a hamburger today. So Boeing may have the orders, but if the airlines that put those orders in go bankrupt then Boeing will be stuck with the bill.

In looking at the table above you may notice that companies like Transdigm Group (NYSE:TDG ) might have the lowest CapFlow on the list, but you will also notice that their FROIC is only 8%? How is that possible? If you go back and research the company further, you will notice that they are estimated to have a debt to equity ratio of 295% in 2012, which tells me that they are leveraged heavily and that always sends up a red flag in my book.

In doing this analysis on the methodology I use in my work as an Analyst, I hope to help my readers understand that outperformance is only achieved by working very hard and by discovering what actually works in the real world. I get very worried when I see millions of investors buying entire industry groups through ETFs, because as you can see from the list above that not all companies are created equal and only four actually came out as real potential winners.

When you invest in indices it gets even worse because you end up buying the jewels along with the crap and thus end up riding wild roller coasters and practicing group think. By doing some simple analysis like I have done above you can invest using the actual theories that Warren Buffett used to buy companies like Coca-Cola (NYSE:KO ) and MasterCard (NYSE:MA ). Investing can be fun, but it is by no means easy and if you dont have the desire or the time to do the work yourself at least find a portfolio manager who actually analyzes stocks and not one who instead chooses to follow the crowd and lazily buys ETFs and Indices for you. They say that most portfolio managers cannot beat the averages, but if you find ones that actually do the analysis involved you will find that the statement is false. At least the ones I know, who are also analysts, beat the averages over the long term.

Hopefully I will be able to find the time and do more of these, so you can see my work in real time and have fun learning how to take a different road from the crowd and thus avoid roller coasters like I try to do for my clients every day.

Disclaimer: Always remember that these are the results of our research based on the methodology that I have outlined above and in other articles previously published. This research is provided as an educational tool and should not be considered investment advice, but just the results of our research. There are many ways to analyze a stock and you should never blindly follow anyones work without doing your own due diligence or by seeking the help of an investment advisor, if you so need one. As Registered Investment Advisors, we see it as our responsibility to advise the following: We take our research seriously, we do our best to get it right, and we eat our own cooking, but we could be wrong. Please note, investments involve risk and unless otherwise stated, are not guaranteed. Past performance cannot be used as an indicator to determine future results. Strategies mentioned may not be suitable for everyone. We do not know your personal financial situation, so the information contained in this communiqu represents the opinions of Peter Mycroft Psaras, and should not be construed as personalized investment advice. Information expressed does not take into account your specific situation or objectives, and is not intended as recommendations appropriate for you. Before acting on any information mentioned, it is recommended to seek advice from a qualified tax or investment adviser to determine whether it is suitable for your specific situation.