Go with financially strong stocks

July 29, 2014 8:04 AM

We measure a company’s financial strength using four individual factors: External Financing; Debt-to-cash flow; Debt-to-equity and 1-year change in debt. We equally-weight the four factors to create our Financial Strength Composite and rank all of the stocks in the universe from 1 to 100, with 1 being the stocks with the best financial strength and 100 being those with the worst financial strength.  Companies that have to rely on external financing instead of internal cash flow or pile on debt are generally a bad investment.

While the results are not nearly as dramatic as the ones we see from our value composite, (see my last post) they still show that investments in the stocks with the worst financial strength are a lousy investment. Had you consistently bet on the 25 stocks from our Large Stocks Universe (currently stocks with market cap’s greater than $7.5 billion) for the 50 years ending 2013, your $10,000 investment—adjusted for inflation—would have grown to just $38, 635, an average annual compound return of just 2.74%. Compared to the $200,600 you’d have had by investing in all large stocks, you can see just how destructive investing in financially weak stocks can be to your portfolio.

Interestingly, the most financially conservative stocks are not the best investment—indeed, the data shows that companies that sensibly use debt are the best bet. $10,000 invested in decile 3 of Large Stocks based on financial strength grew to $406, 891, more than double an investment in the Large Stocks Universe.  

So the lesson from the last 50 years is simple and straight forward—avoid the 30% of stocks that score the weakest on financial strength.

Naming Names

So which stocks are currently among the most financially weak? I hate to beat up on Tesla ($TSLA) because I love the cars, but it in addition to being one of most expensive stocks in the Large Stocks Universe, it also scores a perfect 100 on our Financial Strength Composite, making it one of the most expensive and financially weak stocks in the large Stocks Universe. Other stocks that are in the worst 10% of large stocks based upon our Financial Strength Composite are SNC-Lavalin Group ($SNCAF): Constellation Brands ($STZ); SBA Communications ($SBAC); FMC Corporation ($FMC); Nomura Holdings ($NMR) and State Street Corp. ($STT). History shows that names like these are best avoided. 

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