Value Metrics Add up for Simulations Plus

09/06/2019 5:00 am EST

Focus: HEALTHCARE

John Reese

Founder and CEO, Validea.com And Validea Capital Management

John Reese selects stocks based on the strategies of some of the stock market's most legendary long-term investors. Simulations Plus (SLP) is a buy in the model portfolio of his Validea newsletter based on the "Patient Investor" strategy of Warren Buffett.

Simulations Plus develops and produces software for use in pharmaceutical research and for education, and provides consulting and contract research services to the pharmaceutical industry.

The company offers five software products for pharmaceutical research. Predictor is a computer program that takes molecular structures as inputs and predicts over 140 different properties for them at the rate of about 200,000 compounds per hour.

MedChem Designer includes a small set of ADMET Predictor property predictions, allowing the chemist to modify molecular structures. MedChem Studio is a tool for medicinal and computational chemists for both data mining and for designing new drug-like molecules.

 DDDPlus simulates in-vitro laboratory experiments used to measure the rate of dissolution of the drug. GastroPlus simulates the absorption, pharmacokinetics, and pharmacodynamics of drugs.

Buffett likes companies to have solid, stable earnings that are continually expanding. This allows him to accurately predict future earnings. Buffett would consider the company's earnings predictable.

In fact EPS have increased every year. SLP's long term historical EPS growth rate is 15.4%, based on the 10 year average EPS growth rate, and it is expected to grow earnings 14.2% per year in the future, based on the analysts' consensus estimated long term growth rate. For the purposes of our analysis, we will use the more conservative of the two EPS growth numbers.

Buffett likes companies that are conservatively financed. Nonetheless, he has invested in companies with large financing divisions and in firms with rather high levels of debt. SLP has no long term debt and therefore would pass this criterion.

Buffett likes companies with above average return on equity of at least 15% or better, as this is an indicator that the company has a durable competitive advantage. US corporations have, on average, returned about 12% on equity over the last 30 years. The average ROE for SLP, over the last ten years, is 19.1%, which is high enough to pass.

It is not enough that the average be at least 15%. For each of the last 10 years, with the possible exception of the last fiscal year, the ROE must be at least 10% for Buffett to feel comfortable that the ROE is consistent.

In addition, the average ROE over the last 3 years must also exceed 15%. The ROE for the last 3 years is 22.2%, thus passing this criterion.

Buffett likes companies that do not have major capital expenditures. That is, he looks for companies that do not need to spend a ton of money on major upgrades of plant and equipment or on research and development to stay competitive.

SLP's free cash flow per share of $0.16 is positive, indicating that the company is generating more cash than it is consuming. This is a favorable sign, and so the company passes this criterion.

Buffett likes to see if management has spent retained earnings in a way that benefits shareholders. To figure this out, Buffett takes the total amount of retained earnings over the previous ten years of $0.83 and compares it to the gain in EPS over the same period of $0.34.

SLP's management has proven it can earn shareholders a 40.8% return on the earnings they kept. This return is more than acceptable to Buffett. Essentially, management is doing a great job putting the retained earnings to work.

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