Key Stock Selection Concepts

Wildermuth Asset Management employs a concept we refer to as “Economic Margin” Economic Operating Cash Flow - Capital Charge to identify value-creating firms through = Invested Capital identifying and understanding the key driv- Margin ers of corporate performance and market valuations. Economic Margin measures the This calculation seeks to identify value creating firms through analyzing and under- true return a company earns relative to its standing the key drivers of corporate performance and market valuations. actual cost of capital. Operating Cash Flow Capital Charge When evaluating corporate performance, three key aspects are initially considered: + Net Income Return ON and Return OF Capital The cash flow the firm is generating; the + Depreciation & Amortization that captures company specific + After Tax Interest Expense economic circumstances capital base employed to produce the cash + Rental Expense Net Int. Adj. flow; and the opportunity cost of employ- + R&D Expense ing the relevant capital. Positive Econom- Economic +/- Non-Recurring Items ic Margin firms create investor wealth by Margin = Inflation Adjusted Invested Capital generating cash flow greater than their cost of their capital. + Total Assets + Capitalized Operating + Accumulated Depreciation Rentals + Gross Plant Inflation Adjust- + Capitalized R & D Through connecting firm cash generation ment + Non-Debt Current Liabilities to the assets used to produce cash flow, Economic Margin links the balance sheet COMPARISON TO OTHER MODELS nomic margin. Firms with positive eco- to the income statement. Accounting mea- Traditional Discounted Cash Flow Models nomic margin should grow the business sures such as income or earnings fail to do not indicate whether cash-flow during while companies with negative economic make this connection and therefore offer a particular period provides an adequate margin should increase profitability. Firms only incomplete data on corporate perfor- risk-adjusted return to its investors. The creating wealth and profitably adding - as mance. basic business school model provides rea- sets earn the highest management score. sonable project assessments, but is weak COMMON ACCOUNTING METHOD- for enterprises and offers little transparency Companies not creating wealth and divest- OLOGY LIMITATIONS for investors. ing unprofitable assets earn a medium score Corporate earnings generally represent as these firms are divesting unprofitable only about half of a company’s cash flow, Residual Income Model (EVA) is flawed assets. Low scores are given to firms that and earnings do not reflect risk. because the age of the assets changes while are profitable but shrinking because they project dynamics do not. Although EVA should be growing, not contracting. Firms Accounting ratios mix and generally con- projects net present value profitability on with negative economic margins that are fuse different value drivers. Return on a period-by-period basis, economic value adding unprofitable assets receive the low- assets and return on equity don’t reflect changes over the life of the project. est management scores since management wealth creation or destruction. In addition, is destroying wealth. different asset lifespans, asset mix, asset Economic Margin framework enhances the age, and capital structures distort various value of EVA as the basis for valuation by ECONOMIC MARGIN APPLICA- accounting ratios across firms. providing the same project economic prof- TION it regardless of the age of the asset. This Over time, we believe excess returns are Accounting rules misrepresent many as- provides a more transparent and accurate eliminated through competition. Firms pects of economic reality. Long-term valuation. generating excess profit attract competition investments such as research and devel- which generally results in declining profits opment costs are immediately expensed ADDITIONAL MEASURE: for the most profitable firms and increasing under GAAP accounting, and operating Management Quality profits for the least profitable firms. leases which are obligations very similar to Management quality is assessed according debt are not reflected on company balance to firms’ ability to appropriately grow or We perform a four-factor regression on sheets. shrink the enterprise according to its eco- historic economic margin levels to deter-

The presented information is as of the date of publication and is subject to change. This material is not intended to be relied upon as a forecast or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. We may execute transactions in securities that may not be consistent with the report’s conclusions. Investors should consult their financial advisor on the strategy best for them. Past performance is not a guarantee of future results. Investment Advisory Services offered through Wildermuth Asset Management, an SEC Registered Investment Adviser. 11525 Park Woods Circle, Alpharetta, Georgia 30005. Phone: 678/506-3200, Toll Free: 866/525-6726, Fax: 678/356-1105, [email protected] Key Stock Selection Concepts,cont. mine how attractive the company’s line of BUY AND SELL DISCIPLINE business is to competition. The four factors Potential stock purchases are identified consist of profitability, variability, trend, through screening for high company grade, and invested capital. Companies with high high investment grade, attractive target historical economic margins attract com- price, passing management quality, good petition resulting in more rapidly decaying earnings quality, and attractive momentum economic margins. Companies with vola- criteria. After comprehensive screening is tile historical economic margin levels usu- completed, final selection is made from ally lose their competitive advantage faster. the small number of potential purchases If a company’s economic margin trends up- identified by sector according to addition- ward, the competitive advantage period is al subjective measures that seek to identify extended while companies trending down- best opportunity while enhancing portfolio ward are assigned shorter periods. diversification.

The terminal discounted cash flow value All buy signals and holdings are reviewed is determined by decaying the economic weekly. Any firm whose company grade margin to zero over a period based on the or investment grade falls below an “A”, or individual characteristics and competitive whose target price appreciation percentage advantages of that firm. Larger, more estab- declines into single digits is reviewed for lished firms are assumed to have more du- replacement. Declines of a company grade rable profits giving them somewhat greater or investment grade to a “C” or lower, or competitive advantage. a target price below current price normally results in an automatic sale and replace- Historically, the economic margins of top ment, although some market conditions can decile firms decline dramatically over time make replacement very difficult or even while the bottom decile firms move in the impossible. opposite direction. Simply, most growth stocks can’t maintain their economic mar- During times of anticipated or actual ex- gin, while struggling companies eventually treme economic or market duress, we also improve. Using this framework helps avoid add additional measures of company sol- overpaying for growth companies and also vency and financial strength in an effort identifies companies whose stock prices to screen out companies that may perform may have fallen too far because of tempo- poorly or possibly not survive during tur- rary issues. bulent and unpredictable conditions.

Using the Economic Margin multi-factor The combination of algorithmic measures framework, we create a letter grade (A-F) and comprehensive processes based on fun- for each company and an investment grade damental analysis provides a disciplined (A-F) which more heavily weights current approach which we believe offers not only market conditions. significant value to the stock management process, but also provides consistency and DETERMINING TARGET PRICE predictability over various market condi- A discounted cash flow analysis is applied tions. to a firm’s projected economic margin to create an estimated enterprise value from which total debt is subtracted to arrive at total equity value. Once the target price is determined, we calculate the percent-to-target based on the difference between the current price and our calculated target price.