Recently, we have added new names to our coverage universe, including Procter & Gamble, Corterra Energy and Humana. In this post, we would like to use the example of Procter & Gamble to discuss the criteria we look for in a stock when adding a new name to the portfolio. 

1. What is the investing backdrop?

Put simply: What do the investing conditions mean for the various sectors of the economy? Right now, the Fed’s potential willingness to engineer a recession to control inflation is on the table. So, everything about picking stocks in this treacherous market needs to be put through a stress test of how rate hikes will impact business.

Nowadays, investors are in a defensive posture, rewarding companies that make stuff and do things profitably and shunning sky-high sales-based multiple names for a good story that may or may not materialize over the next decade.

Knowing that defensive names are the ones in favor — such as those in utilities, health care and consumer staples — led us to P&G. The company dominates in products that consumers need to use every day regardless of marco considerations. In fact, P&G accounts for roughly 16% of the entire S&P 500 consumer staples sector.

2. Does the company have durable revenues?

We need to consider the demand elasticity of the company. How easy is it for consumers to buy an alternative or not buying at all? Essentially, how sensitive is demand for the company's products relative to macro-economic conditions?

For example, we believe that consumer products such as those made and sold by Procter & Gamble are about as durable as they get. As we stated in our initiation analysis: “People don’t stop buying toothpaste, toilet paper, paper towels, and laundry detergent in an economic slowdown.”

3. Does the company have pricing power?

Pricing power is going to dictate to what extent a company can pass through costs to protect profit margins. Regarding P&G, we do think they have the pricing power as management has invested heavily both in innovation to create superior products and in marketing to ensure consumers know that they’re getting a superior product.

4. Is there a competitive moat?

The question we are trying to answer: How easy is it for competition to enter the market, steal market share and erode profits by competing on price?

On this front, the risk to P&G is generic products (very cheap, unbranded toilet paper, toothpaste, ...). However, as noted in our initiation, we think management is well prepared for this scenario and on track to launch many new products this year focused on mid-tier offerings and more affordable pack sizes.

5. How does the valuation stack up?

We must consider valuations against the overall market, interest rates, the stock’s own historic valuation and, of course, peer valuations. These will provide us some basis from which we can establish a price target. From there, we can adjust accordingly based on the pros and cons of the business as it stands today.

In the case of Procter & Gamble, we acknowledge we are paying above the five-year historic average valuation. But with the Fed intent on stamping out inflation despite any residual demand destruction — actions that could result in a recession — we believe the premium is not only warranted but will increase toward the five-year highs of nearly 27 times earnings. In other words, we view that investors will be willing to place a higher value on the company’s recession-resilient earnings stream.

6. What are the shareholder return programs?

We’re specifically looking for initiatives such as buyback authorizations and dividend payments. On buybacks, we want to consider the level of repurchase plans against market caps and the consistency with which our target company repurchases shares. While dividends will pay an investor for patience, a strong buyback program serves to provide an additional level of support for the stock. On dividends, we want to consider the consistency of payouts and the payout ratio and the percentage of earnings being paid out. The lower the ratio, the more capacity there is to continue payouts should profits take a hit.

Procter & Gamble expects to repurchase $9 billion to $10 billion of its common shares in fiscal 2022, but it’s also considered a “Dividend Aristocrat,” increasing its annual payout for 65 consecutive years.

7. Is the financial health of the company strong?

The balance sheet will tell us the true health of a company. In addition to monitoring trends from quarter to quarter, we want to look at items such as net debt, liquidity ratios, credit ratings, and the timing of liabilities.

In the case of Procter & Gamble, one potential red flag would be that current liabilities, those due within the next 12 months, exceed current assets. Current assets divided by current liabilities is a liquidity metric called the “current ratio.” Ideally, you are looking for a ratio over 1 as this indicates an ability to cover all near-term liabilities with assets on hand. 

Since P&G is less than 1, we need to do some digging. The best place to look for an explanation on this is the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the annual report. Here we find a sub-section called “liquidity,” in which management acknowledges the poor ratio but comments that excess liabilities is “largely due to short-term borrowings under our commercial paper program,” adding “we anticipate being able to support our short-term liquidity and operating needs largely through cash generated from operations.”

In our view, the combination of recession-resilient product sales, a strong credit rating and the company’s incredible history of dividend payments gives us confidence that management can and will manage liquidity effectively. Of course, this also depends on cash flows.

8. Is management operating at a high level?

While the balance sheet is the health record of a company, the income and cash flow statements will provide insights into management’s execution. The income statement tends to get the most attention as that’s where we find sales, earnings and margin results. But the importance of cash flows can’t be overstated. At the end of the day, sales and earnings are great but cash is king and high-quality earnings are cash backed. After all, you can’t repay debts with accounting earnings — those that are earnings on paper but aren’t backed by cold hard cash in hand.

At Procter & Gamble, we want to look at what the company calls “adjusted free cash flow productivity,” which is defined as the ratio of adjusted free cash flow to net earnings. Long term, management is targeting a ratio at or above 90%. In the last quarter, management raised its forecast to the 95% level for fiscal 2022. In other words, these are not only resilient earnings but high quality and nearly entirely cash backed. This further bolsters our view that the team will adequately manage liquidity.

9. What is the catalyst?

In a volatile market like what we have today, one that often has no memory from one day to the next and lacks any meaningful trend, we like to buy stocks with catalysts. A catalyst is a company-specific or macro event that materially impacts a company’s business prospects. If a catalyst works in the way an investment thesis intends, a positive stock price reaction will follow as sales and earnings estimates are revised higher and sentiment on the stock improves, leading to price-to-earnings multiple expansion.

Some well-known company-specific catalysts are mergers/acquisitions, break-ups to unlock value, and new product launches. Macro event catalysts can be supply/demand disruptions in commodity markets, or even something we view as more theoretical — such as an aggressive Fed needing the economy to slow down could increase investor demand for recession-resistant stocks. 

In the case of P&G, our catalyst blends company-specific and macro events. First, we believe the Fed’s hawkish pivot has increased investor appetite for companies whose sales will remain resilient to an economic slowdown. Additionally, we think the recent price increases P&G has pushed through on its products will remain sticky, creating a situation where you could see margins expand if and when input and freight cost pressures roll over.