## Introducing the “Boss Score” part 2 – building the model

After introducing the goal of the Scrrener / Score with the last post, let’s jump directly into the calculations:

Building the model – Step 1: Total Return on equity

Before starting to build the model, one has to define how to identify a stable, value adding business. One could use many variables, past earnings, free cashflows etc.

I personally view the long term developement of shareholders equity (including dividends and buybacks) as the best indicator if true “value” was created. This is of course not my original idea but essentially how Warren Buffet is reporting his yearly results at Berkshire.

In the times of modern IFRS accounting, one should mention that EPS (adjusted for dividends and buy backs) does not have to be equal the developement of equity from year to year. The real number usually is hidden on the second page of the P&L under “comprehensive income” which includes all kind of effects which get booked directly into equity (I.e. defined benefit pension plan valuation changes etc.)-

As comprehensive income is not very well maintained in the bloomberg historic database, I calculate “Total return on equity” with the following “basic” equation:

Total Return for (t) = Equity per share (t) – Equity per share (t-1) + Dividend paid (t)

A little bit trickier are capital increases and stock repurchases. As long as they are executed at book value, nothing changes on a per share basis. However if they are executed belw or above one will have direct impact on the per share equity and should be adjusted.

For the time being, I will stick with the “basic” formula and adjust on a case by case basis. In general I would assume that shares with significant capital increases or massive share repurchase programs don’t fit my “boring but sexy” category anyway.

The final computation than is relatively easy:

Total Return on Equity % (t) = Total return on Equity (t) / Equity (t-1)

If I do this for 10 years for example, I get TROE’s for those 10 years. With those 10 Yields, I can then calculate the average TROE in %

So the result of Step 1 is: Average Total return on Equity for period (t; t-x) where X can be 10 or 5 or any other period.

In theory the following applies: The higher the average TROE the better.

The TROE average itself does not mean a lot. If we have for instance a company which has 20% TROE in one year and 0% in the next year, the average TROE will be the same as a company which shows 10% in both years.

As I am looking for “boring” companies, I have a high preference for stable TROEs. In contrast to classical CAPM, I will completely ignore stock market volatility (“Mr. Market”) and focus only on fundamental volatility.

So in order to account for fundamental volatility, I will use the standard deviation of the single period TROEs calculated above.

If we calculate the standard deviation of the TROEs, we can then in a next step calculate something similar to a Sharpe ratio which I would call the “fundamental sharpe ratio” for a company which is:

Fundamental Sharpe Ratio = Average TROE (t;t-x) / standard deviation TROE (t,t-x)

As an example, I have calculated those numbers for 4 random German DAX companies:

Avg 10 Y TROE 10 Y std. dev Fundamental sharpe
BASF SE 12.6% 8.1% 1.5
BAYER AG-REG 5.4% 13.2% 0.4
BAYERISCHE MOTOREN WERKE AG 11.5% 9.7% 1.2

We see some significant differences here. On a first look, BASF and Adidas look very attractive, whereas Bayer looks rather bad. However, the fundamental Sharpe Ratio says nothing about how the volatility of the results is related to the valuation of the stock.

Step 3: Valuation model

In order to determine if a stock is attractively valued compared to the volatility of its business model, we have to build a simplified valuation model.

For the Boss Score I assume the following:

– the company will earn constantly its average past TROE going forward (without any growth) based on its current book value

So for Adidas for example: Adidas had a book value of 26.33 EUR and a average TROE of 17.7%, I will assume (26.33*17.7%)= 4.66 EUR per share for every year in the future, howver on a constant basis without any growth. This is somehow a similar perspective to the “EPV” from Greenwald.

In order to come up with a real value, I have to discount the future cashflows with somthing. And here comes the trick:

I use the CAPM formula to determine the discount rate, but intead of the market based “Beta” factor, I use the “fundamental Sharpe ratio” to determine the final equity ratio. I am not sure if this is mathematically correct in any way, but the intuitive idea is that the better the relationship between TROE and volatility of the TROE, the lower the discount rate.

As we all (hopefully) now, the CAPM calculates teh discount rates in the following way:

Discount rate (x) = risk free rate + Beta x (Equity market premium)

For the “Boss Score”, this changes into

Discount rate (x) = risk free rate + (1/fundamental sharpe ratio) x (Equity market premium)

With the discoutn rate we can then easily calculate the “intrinsic value” of any share under our model which is:

Intrinsic value = Assumed constant Profit / Model discount rate

As a final step, in order to have a direct relation to the current market Price, the “Boss Score” is then calculated the following way:

Boss Score = (Intrinsic Value / Market price) – 1

The final Boss Score can be interpreted the following way:

Boss Score > 0: Stock is based on the model undervalued

Boss Score < 0: Stock is based on the model overvalued, does not earn its cost of capital

The higher the Boss Score the better.

Before actually applying the screen to “live” data, it might make sense to define expectations in order to be able to “test” the outcomes of the “Boss Sore”. I would expect that (among others)

– companies with high leverage and / or cyclical business models will score relatively badly
– companies which a lot of one off write offs should score badly
– companies which earn below their cost of capital or which are in terminal decline should score badly
– “boring” comanies with stable returns and low P/B should score well
– the screen should bring up companies which might not show up in other screens

In the next post I will test the “Boss Score” first with the German DAX companies to see if the results make sense.

• Winter

Hello MMI,
I remember that you already introduced a similar model in my home forum, at least with the same basic ideas: return on equity, mean over ten years, and the volatility of these returns.
The earnings power component is similar to my idea of “KPV” (variation of pe10), but I still have a problem with the assumption of a constant return on equity, i.e. with its exprapolation in the future. The case for contrarian investments is, that – at least from a mechanical point of view – the market should level out the different capital returns. Some firms will be able to defend their ROE, of course, but these are particular cases and therefore rather irrelevant for an automated investment. It’s different with the margin: One can expect, that very different margins will persist between different sectors, but not within one sector.
I suppose, that the difference is not that big, whether you calculate the earnings power component with a mean ROE and the P/B-ratio or directly with the past earnings (or the margins), but it’s more complicated, anyway, and I can’t see the advantage – except that you define the earnings more broadly (but that does not depend on the ROE).

• Hi Winter,

you are right, I experimented with different versions.

The major advantage of the “Boss Score” is that it is mathematically “cleaner” as the final result is actually a “real number” which is baicallly the multipliere for the book value. In the old version in theory the unit was somethin divided by % or so.

In the old version, I also tried to incorporate intangibles and leverage explicitly, which made results even mor “unstable”. The current version however seems to work uite well.

In the introduction, I have pointed out that I am not looking for an automated system but that I actually want to find the “particular” cases.

So far I find the results are quite interesting and sometimes unexpected.

MMI

• Setla Suah

AKTIVA
7.4 Coke
2.5 Gillette
2.4 Capital Cities/ABC
2.4 GEICO
2.0 Amex
—–
16.7
—–
12.0 Other stuff
——
28.7
=====

PASSIVA
16.7 Equity
12.0 Other stuff
——-
28.7
=====

This is BRK’s 1995 balance sheet (some details got lost in transmission…).
Top 5 investments got 100% of the money. Viva la concentration!

I’m still curious which of your investments you would put in the above 5 slots… đ

• #settla,

first of all I am not Warren Buffet and secondly I invest in different stocks. With globally active stocks like Coke you definitely need a lesser amount of positions than with stocks like Poujoulat or SIAS which are small stocks exposed to very specific risks.

I will have a post up soon on position sizing, but my advice is: If you are Warren Buffet, concentrate, if you are not Warren Buffet, diversify.

I think even Warren Buffet recommended to “Normal” investors to buy ETFs.

mmi

• I donât agree with 5 stocks u have a quite good diversification. The additional diversification for more stocks than 10 is minor.

• Setla Suah

What if you can only choose among the companies you already own in your current portfolio?

đ

• same asnwer. There are no 3 singel investments which would produce a meaningful portfolio.

• ok, so I answer on both, the three and 5 stock questions:

Sorry, Bill, I do not know 3/5 stocks which could create a portfolio with an attractive risk/return profile over 5 years. I need at least 20 “slots”.

If you insist on 3 investments, then I would recommend to put 90% into a MSCI World ETF and 10% into cash.

MMI

• Setla Suah

Or let’s put it this way: Let’s say Bill inherited âŹ1mln and wanted you to invest it in plain-vanilla stocks on his behalf. Naturally, he’s looking for the highest long-term rate of return you can get. And the good thing about it is: He will split half of the profits with you. But profits only, no management fee here.

Next, he will tell you that he doesn’t care much about the details of your investment biz so he’ll be off to Hawaii tomorrow (ok, he inherited more than âŹ1mln and what’s the use of money if not to spend it?) and will come back in five years, at the earliest. He will NOT ask you about the value of his investments until he is back from Hawaii (there are nicer things to look at over there, anyway…) — sounds good?

Oh, one last thing: Bill wants you to keep it simple. You’re only allowed to invest in 3 stocks at any time. You can switch, but you will first have to sell one to buy a new one. Three names is the limit.

Now, which ones would you choose?

• Setla Suah

Regarding looking into the future, I totally agree with you. Isn’t history the best guide to it, given the right business model? When Buffett invested in Coke, given the right price, my bet is 99% of his decision was based on what he saw happening in the past. The knowledge of management (wasn’t Don a neighbor in Omaha?), and seeing it perform since taking over, was a plus. But the essence was he was sure the business model couldn’t miss, long-term.

So, at least in my humble opinion, what it boils down to is seeing the future. If you’re sure about that with your selection of companies, why not double up (make the quadruple up!) on the cheapest one?
You must have some conviction on the future of all of your portfolio companies, otherwise you wouldn’t own them, right?

What are the five positions where you’re most sure about future business results?

• Setla Suah

Bei Schritt 1 stimme ich mit dir ĂŒberein. Ich verstehe aber nicht, wieso du das Eigenkapital/Aktie bezĂŒglich KapitalerhĂ¶hungen bzw. AktienrĂŒckkĂ€ufen anpassen mĂ¶chtest. Spiegelt dieses diese im Normalfall nicht korrekt wider? Als Ausnahme fallen mir sehr sehr gute Unternehmen (z.B. Moody’s) ein, oder welche mit “unkonventionellen” Kapitalstrukturen. Hier wird die Berechnung des “Total Return on Equity” schwierig. Die Bilanz ist in solch einem Fall weniger aussagekrĂ€ftig.

Ich lese und schĂ€tze deinen Blog schon seit dem Abgang von valuematze aber bei Schritt 2+3 hast du mich verloren. Insbesondere beim Thema VolatilitĂ€t/Standardabweichung als Massstab des Risikos sowie der Herleitung des Abzinsfaktors bin ich entschieden anderer Meinung. Stell dir z.B. eine quartalsweise – statt jĂ€hrliche – Beurteilung der Ergebnisse von H&R Block oder sonstigen saisonalen GeschĂ€ftsmodellen nach Sharpe vor… ich glaube nicht, dass sich das tatsĂ€chliche GeschĂ€fts- bzw. investmentrisiko daran messen lĂ€sst.

Risiko entsteht nicht durch die VolatilitĂ€t der Ergebnisse, sondern durch die Nicht-EinschĂ€tzbarkeit zukĂŒnftiger Ergebnisse. Die Eigenkapitalrenditen, die Standardabweichung, der fundamentale Sharpe Faktor, all das war ziemlich ansehnlich z.B. fĂŒr die Fa. Citigroup, wenn man sich die zehn Jahre bis 2006 ansieht. Der Preis wahrscheinlich auch nicht ĂŒberzogen. Das Risiko lag in der EinschĂ€tzung der zukĂŒnftigen Ergebnisse und damit der EinschĂ€tzung des GeschĂ€ftsmodells.

Aufbauend auf Schritt 1 wĂŒrde ich das Modell sehr viel einfacher gestalten (wozu komplizierte Mathematik, wenn die EinschĂ€tzung der Zukunft schon kompliziert genug ist).

“As easy as ABC”-Modell

A = ZukĂŒnftige Eigenkapitalrendite (Comprehensive income eingeschlossen)
B = Wie sicher bin ich mir ĂŒber A? 1=sicher, 0=nicht sicher (nur diese zwei Werte erlaubt)
C = Preis/Buchwert

Zu erwartende Rendite = A * B / C

Als regelmĂ€Ăiger Leser deines Blogs kriegt man den Eindruck, dass du verstehst, was du tust. Was ich nicht verstehe ist, warum du dein Portfolio nicht mehr in deine besten Ideen konzentrierst. Ich glaube nicht, dass Diversifikation dir hilft.

GrĂŒĂe,
Setla

• Hallo,

danke fĂŒr die detailierten Kommentare, ich versuche mal ein paar Punkte zu beantworte:

– KapitalerhĂ¶hungen / AktienrĂŒckkĂ€ufe: Effekte gibt es immer dann, wenn solche Aktionen deutlich ober oder unterhalb vom Buchwert stattfinden. Bei einem AktienrĂŒckkauf deutlĂ¶ich ĂŒber Buchwert, geht der Buchwert pro Aktie relativ stark zurĂŒck, wobei die Summe selber ja aber direkt an die AktionĂ€re geht. Deshalb muss man das adjustieren.

– zu Deinem einfachen Modell: An sich eine sehr schicke Sache, allerdings kann ich persĂ¶nlich zu Deiner Variable B keinerlei Aussage machen. Ich traue mir eben nicht zu, ĂŒber die zukĂŒnftige GeschĂ€ftsentwicklung eine Aussage zu machen. Deshalb begnĂŒge ich mich mit dem zweitbesten, der Vergangenheit.

– insbesondere bei Banken wie Citigroup funkioniert der Score besonders gut. Da ich die EK Rendite nicht auf die Gewinne sondern die tatsĂ€chliche EK Entwicklung rechne, kommen insbesondere Finanzinstitute trotz “schĂ¶ner” Gewinnreihen sehr schlecht weg, da Sie vieles ins EK buchen.

– PostitionsgrĂ¶Ăe: Das ist ein Thema, wo ich maleinen eigenen Post machen werde. Nur so viel: Es gibt hier m.E. kein richtig oder falsch bzw. den “idealen” Wert. Das muss jeder selber entscheiden. FĂŒr meinen Stil und RisikoprĂ€ferenz (PortfoliovolatilitĂ€t niedriger als der Markt) ist eine PositionsgrĂ¶Ăe von max. 5% durchaus angemessen. Warren Buffet hat eine andere Meinung dazu, aber ich verfĂŒge leider nicht ĂŒber die hellseherischen FĂ€higkeiten von ihm.

• Winter

… und wie soll sich die zukĂŒnftige Eigenkapitalrendite berechnen?
Aus Sicht eines antizyklischen Investors, d.h. aus der Sicht meines Weltbildes, ist die Erwartung an die zukĂŒnftige Eigenkapitalrendite bei allen Firmen gleich. Nicht ganz, genaugenommen ist die Gesamtkapitalrendite gleich; die Eigenkapitalrendite ergibt sich dann ĂŒber die Hebelung.
Die Formel fĂŒhrt im ĂŒbrigen schlicht auf das bekannte KGVe … (mathematischer Zusammenhang!).

• Setla Suah

Hallo Winter,

“ist die Erwartung an die zukĂŒnftige Eigen-/Gesamtkapitalrendite bei allen Firmen gleich” habe ich nicht verstanden. Bitte erklĂ€re mir, was du damit meinst.

Die zukĂŒnftige Kaptialrendite ist nicht das Problem. B ist das Problem.
Worauf ich mit obiger Formel hinaus mĂ¶chte ist, dass man nur in Firmen investieren sollte, bei denen man sich der zukĂŒnftigen Ergebnisse sicher ist. Die wenigen, die dabei rauskommen, solltest du dann nach GĂŒnstigkeit gewichten.

Wo ist das B in KGVe?

Wo finde ich deinen Blog?

GrĂŒĂe,
Setla

• Stefan

Hi,
I think that companies that grow their equity with high pace (e.g. Yara International) will also score poorly. Am I correct?

• not necesserarily so. If they grow at high pace with low volatility, than they score incredibly well. It is a function of ROE and volatitility

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