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Boost Your Investment Returns with This Effortless Quality Yardstick

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Boost Your Investment Returns with This Effortless Quality Yardstick

Surprisingly, this single ratio has the potential to elevate your returns by 5% annually.
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Numbers-Driven-Investment

This piece is an online rendition of our popular Best Ideas Newsletter distributed on 09.05.2023. Stay in the loop and receive it directly every Tuesday.

 

While I was revamping a blog post recently, I stumbled upon information that holds significant value.

What if I told you that there exists a simple quality metric that can enhance your returns, regardless of your investment approach? It's a reality, and it's known as the External Finance Ratio. (We leverage this when we search for potential selections for the crash quality portfolio)

 

What exactly is the External Finance Ratio?

Before delving into its efficacy, let's provide some context.

The External Finance Ratio (EFR) divulges whether a company can fund its investments with internally generated cash or if it necessitates external capital (debt or share sales) to meet its investment requisites.

It's calculated as follows:

(Change in total assets for the year – net cash generated from operations) / Total assets at the end of the year.

 

A positive value implies a need for external financing

If the ratio is positive (greater than 0), it signifies that the company failed to self-finance its asset expansion while if the ratio was negative (less than 0), it indicates that the company managed to generate adequate cash to fund its asset growth.

 

 

Does it deliver? Back testing the External Finance Ratio

As you're aware, we don't merely integrate a metric into the screener without first assessing its potential to boost our returns.

We conducted extensive testing, which you can explore further in the link below, but to keep this information concise, I'll simply present a condensed version here.

Here's the full article:  Utilizing this uncomplicated quality metric to refine your returns

 

We tested the ratio over the 12-year duration from June 2000 to June 2012.

In the evaluation, we categorized companies into two cohorts.

  1. A cohort necessitating external financing (positive External Finance ratio) and
  2. A cohort that did not (negative External Finance ratio).

 

This is what transpired:

1 = Firms that didn't require external financing (negative External Finance ratio)

2 = Firms that needed external financing (positive External Finance ratio)

CAGR = Compound annual growth rate

 

 

Augmented returns of 5% annually over 12 years!

As you can observe, firms that didn't require external financing on average yielded +8.1% annually over 12 years, significantly surpassing firms necessitating external financing, which averaged just +3.1%.

At first glance, it may not seem substantial, BUT bear in mind that this constitutes a 5% higher annual return over 12 years, a considerable enhancement.

Hence, it's undoubtedly advantageous to factor in the External Finance Ratio when sifting through potential investment prospects.

 

Recap and conclusion

  • The external finance ratio reveals whether a company can fund its investments from internally generated cash or if it required external funds
  • The ratio enriches your returns, delivering a +5% annual boost over 12 years in our back testing
  • The optimum method to leverage it is to omit the bottom 40% of firms with the least favorable ratio (highest positive values). For our crash portfolio, we exclude the least promising 50% of companies (setting the sliders from 0% to 50%)

 

Once again, here's the link to the complete article:

Utilize this effortless quality metric to bolster your returns!

 

In your service to maximize returns,

 

PS To promptly integrate the External Finance Ratio into your portfolio, sign up here

PPS Why not sign up now before you lose focus?

 

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