Rainbow Investing a methodology applied when analyzing a business. It is a useful for screening and cherry picking stocks based on a spectrum of parameters and criteria’s that help differentiate between companies from a fundamental angle.
What is Rainbow Investing?
Acronym RAINBOW stands for
R = Return on Equity and Capital
A = Accountability of Management
I = Information Transparency
N = Net Profits B = Battle Readiness (Competitive Landscape)
O = Obligation Analysis (Debt, Liabilities)
W = Winning ability of Business Model
Let us breakdown each of these points in detail
R – Return on Equity and Capital
Return on Equity
The return on equity is a measure of the profitability of a business in relation to the equity. Because shareholder’s equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on assets minus liabilities.
ROE = (Net Profit / Shareholder’s Equity)
Return on Capital Employed
Return on capital employed is an accounting ratio used in finance, valuation, and accounting. It is a useful measure for comparing the relative profitability of companies after taking into account the amount of capital used.
ROCE = (EBIT / Total Capital Employed)
ROCE = (EBIT / (Equity + Debt))
ROE & ROCE are very important Return Ratios. According to Mr. Warren Buffett, ROCE & ROE of a company should be more than 15% on a consistent basis.
A – Accountability of Management
A business has to take umpteen decisions for the short term, medium term and long term. Nobody is perfect and all of us prone to making mistakes. In the same way a company may end driving decisions that don’t take off as expected and end up damaging the future growth of the overall business.
The thing that investors should keep a watch out for is that whether the management of the company is candor in accepting accountability and taking full responsibility for the unsuccessful decisions. Instead, if the senior officials tend to play the blame game and make excuses then investors should keep away and reconsider their investment decision.
I – Information Transparency
This is where Corporate Governance comes into the picture. Corporate governance is the collection of mechanisms, processes and relations used by various parties to control and to operate a corporation. Corporate governance is necessary because of the possibility of conflicts of interests between stakeholders, primarily between shareholders and upper management or among shareholders.
There should be complete transparency in corporate details, facts & figures. Interest of Minority Shareholders should always be properly addressed and there should not be any hidden agenda from the management’s side.
N – Net Profits
Profit (i.e. Operating Profits, Margins and Net Profit) is one way outsiders measure the effectiveness of the management team. Lenders, investors, and vendors all use profit as a tool to measure how good management is in running their business. Profitability, if not used to grow assets, can pay down debt. Businesses without profit cannot retire debts.
Profit is one of the elements that improve working capital. Businesses that are consistently profitable have consistent improvements in the ability to fund working capital needs, such as increased labor costs, etc.
Before taking a decision investors should possess the knowledge if the company is able to generate free cash flow and how the future growth outlook is.
Future Growth outlook of a company can be gauged by its Earnings Visibility & Earnings Growth Potential.
B – Battle Readiness (Competitive Landscape)
Battle readiness refers to a company’s competitive landscape and market positioning. If the company is a market leader in a particular, how does it plan to maintain its dominant position and simultaneously fend off any potential disruptions or competitors.
Phil Knight the founder of Nike once said, “Business is like a war without bullets.” In business, we battle for territory—whether that’s mastery over a geographic region or a particular vertical market. We study the competition’s strategy, learning their winning ways and identifying their weaknesses. We take aim at conquering their territory. Coca-Cola and Pepsi have been at it for years, introducing new ad campaigns and new brands to take consumers away from the enemy. Both have had victories and epic failures. Yet, their battle wages on.
Questions like – How ready is the company to take the new challenges? and Is the company ready to face any disruption in the industry? are paramount in determining the long term profitable sustainability of a business.
Another example could be the way discount brokers disrupted the market which was once upon a time reigned by traditional brokerage houses. Within a short span of time, discount brokers easily managed to seize market share from the big players.
O – Obligation Analysis ( Debt, Liabilities)
Obligation Analysis includes understanding the Debt to Equity Ratio trend of the company.
The interest coverage ratio measures a company’s ability to handle its outstanding debt. It is one of a number of debt ratios that can be used to evaluate a company’s financial condition. A good interest coverage ratio is considered important by both market analysts and investors, since a company cannot grow—and may not even be able to survive—unless it can pay the interest on its existing obligations to creditors.
For Capital-intensive Industry Interest Coverage Ratio is usually more than 2.5. Interest Coverage Ratio should have an upward trend.
W – Winning ability of Business Model
If a company is able to establish a solid business model which helps it attain majority market share and thwart competitors by furnishing high barriers of entry then it can sustain for generations.
Investors should research on how a company plans to acquire new market share whilst protecting its existing market share (if it is a market leader).