Four new stocks make January’s Exec Comp Aligned with ROIC Model Portfolio, available to members as of January 15, 2019
Recap from December’s Picks
Our Exec Comp Aligned with ROIC Model Portfolio (+1.5%) outperformed the S&P 500 (-0.7%) last month. The best performing stock in the portfolio was up 19.7%. Overall, 8 out of the 15 Exec Comp Aligned with ROIC Stocks outperformed the S&P in December.
Since inception, this model portfolio is up 20% while the S&P 500 is up 19%.
This Model Portfolio only includes stocks that earn an Attractive or Very Attractive rating and align executive compensation with improving ROIC. We think this combination provides a uniquely well-screened list of long ideas because return on invested capital (ROIC) is the primary driver of shareholder value creation.
New Stock Feature for January: Hurco Companies (HURC: $37/share)
Hurco Companies (HURC) is the featured stock in January’s Exec Comp Aligned with ROIC Model Portfolio.
Since 2013, HURC has grown revenue by 9% compounded annually and after-tax profit (NOPAT) by 20% compounded annually to $26 million in fiscal year 2018. HURC has managed this profit growth by increasing its NOPAT margin from 5% in 2013 to 9% in 2018. Further highlighting the strength of its business, HURC has generated cumulative free cash flow (FCF) of $33 million (12% of market cap) over the past five years.
Figure 1: HURC’s Revenue & NOPAT Since 2013
Sources: New Constructs, LLC and company filings
Executive Compensation Plan Helps Drive Shareholder Value Creation
ROIC was added to Hurco’s executive compensation plan in 2014 as a target goal for performance-based equity awards. In 2018, 35% of performance-based equity awards were tied to the firm’s three-year average ROIC. This focus on ROIC has led to Hurco’s ROIC improving from 8% in 2013 (year before ROIC was added) to 14% in 2018. Hurco’s exec comp plan lowers the risk of investing in the company’s stock because we know executives are held accountable for creating real profits.
Low Valuation Provides Upside Potential
At its current price of $37/share, HURC has a price-to-economic book value (PEBV) ratio of 0.7. This ratio means the market expects HURC’s NOPAT to permanently decrease by 30%. This expectation seems rather pessimistic given Hurco has grown NOPAT 8% compounded annually since 1998 and 20% compounded annually since 2013.
If HURC can maintain 2018 pre-tax margins (9%) and grow NOPAT by 4% compounded annually for the next decade, the stock is worth $63/share today – a 70% upside. See the math behind this dynamic DCF scenario.
Impacts of Footnotes Adjustments and Forensic Accounting
Our Robo-Analyst technology enables us to perform forensic accounting with scale and provide the research needed to fulfill fiduciary duties. In order to derive the true recurring cash flows, an accurate invested capital, and a real shareholder value, we made the following adjustments to Hurco’s 2018 10-K:
Income Statement: we made $6 million of adjustments, with a net effect of removing $4 million in non-operating expense (1% of revenue). You can see all the adjustments made to HURC’s income statement here.
Balance Sheet: we made $106 million of adjustments to calculate invested capital with a net decrease of $46 million. One of the largest adjustments was $11 million due to adjustments for other comprehensive income. This adjustment represented 5% of reported net assets. You can see all the adjustments made to HURC’s balance sheet here.
Valuation: we made $75 million of adjustments with a net effect of increasing shareholder value by $53 million. The largest adjustment to shareholder value was $62 million in excess cash. This adjustment represents 4% of HURC’s market cap.
This article originally published on January 25, 2019.
Disclosure: David Trainer, Kyle Guske II, Andrew Gallagher, and Sam McBride receive no compensation to write about any specific stock, style, or theme.
 Harvard Business School features the powerful impact of our research automation technology in the case New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.