Once you have assessed how growth, risk and quality stack up at a company, made yourself aware of the catalysts in place that could power upside or the red flags which could trigger downside, you can further tilt the investment odds in your favour by carrying out a series of litmus tests.
These may cover some less tangible issues, such as corporate governance and the consensus view of a stock, and taken in isolation none will be decisive, but these added ‘scratch and sniff’ checks can help you to avoid the ultimate investment failure, namely permanent loss of capital. Our sixth checklist is designed to help you judge whether a prospective investment feels right.
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The market cannot always be right but you must respect its views. If you are going to turn buyer of a firm whose shares are plunging or seller of one where they are jet-propelled you had better have a clear idea of why.
You are competing against thousands of smart, well-informed people, so if a stock is cheap and the share price is ebbing away you must consider what the market is telling you. By doing that, you can assess what needs to happen for market perception to change and the stock to rise again.
If a stock is on a price/earnings ratio of one, for example, the market is telling you the earnings forecasts are miles too optimistic. To be a buyer of that stock, you need therefore need to be sure the estimates are correct, or at least in the right area.
If it looks too good to be true, it usually is. Equally, if a stock drops on a couple of sets of great numbers, the market is telling you it is all in the price and the valuation too lofty.
In these cases, paying heed to the market can help you time your entry point and avoid being too early or even getting the stock wrong altogether. Share trading volumes can also help here. A share rising on slim volumes could be the market’s way of telling you a sustained period of outperformance is running out of puff, while one emerging from a steep nosedive amid a jump in activity can signal a turn in the tide of sentiment.
Sometimes, the simplest tests of all can help you in your search for portfolio profits. Legendary investor and philanthropist John Templeton once noted the best type of research involved the application of shoe leather. After all it would not have required too much imagination to see how Nokia (NOK1VE:HE) had starting to lose gobs of market share to Apple (AAPL:NDQ) and Samsung (005930:KS). All you had to do was look at what your friends and family were using. A similar comparison of music and book-buying habits would have told you a lot about where shares in Amazon (AMZN:NDQ) and HMV were going, at least before the latter fell into administration. Investment analysis does not always have to be complicated and a firm that is taking market share at the expense of its rivals is often a very good investment. We would argue Sports Direct (SPD) is a good example.
Ambitious management teams, typically schooled in smooth presentations, can talk a good game when it comes to long-term strategy and growth promise. Yet firms with a profitable growth track record stretching back many years, proof-positive of a business model able to survive and thrive across numerous economic cycles, should remain highly-prized. Family flooring specialist James Halstead (JHD:AIM) has an enviable 37-year record of increasing its dividend and its 3.5% taxable profits decline to £41.2 million for the year to June was the first fall for over a decade.
Geoffrey Halstead is the executive chairman and Mark Halstead the chief executive at the Manchester firm and the family still owns a chunk of stock for good measure. As such management’s interests are aligned perfectly with those of shareholders. It is always nice encouraging when the board has ‘skin in the game’. Examination of annual reports or company websites, where Aim Rule 26 means firms have to list major shareholders, can be factored into your analysis.
Family run firms such as James Halstead will tend to take a patient approach, to ensure their grandchildren’s grandchildren will inherit a sound, well-financed business. Management teams who are in a hurry should be treated with much more circumspection.
A good litmus test is to watch out for a series of acquisitions which could suggest the core business is ex-growth and the acquirer urgently needs to take over other companies to camouflage what is going on or to meet earnings targets. A further vital check is to root out serial offenders when it comes to how they report results. Figures which are regularly littered with restructuring charges and costs treated as exceptional, or one-off, items are generally to be avoided. Many companies and analysts use pre-exceptional, pre-amortisation numbers to give a truer reflection of the earnings progression of the underlying business, although you should be wary of companies overly keen to include as exceptional those items which are simply a cost of doing business. Firms do not trade on multiples of earnings before bad stuff (Ebbs), as the Wall Street Journal once wrote, and warning bells should ring if these charges occur year in year out, which by definition means they cannot be deemed ‘exceptional’.
This accounting sleight of hand will often draw the attentions of an activist investor or hedge fund, who could come to the conclusion a firm is poorly run and performing below its potential. These market participants can get a poor press for what can sometimes be short-term investment horizons, yet their presence often occurs following prolonged periods of share price underperformance and can often provide a catalyst for change and the creation of shareholder value. The track record of Sherborne Investors Edward Bramson speaks for itself and wherever he pops up next after successful stints at Spirent (SPT) and F&C Asset Management (FCAM) will be a source of great interest, as something is almost bound to happen.
No list of litmus tests would be complete without reference to the balance sheet, where weakness if often the chief cause of corporate failure. Diligent investors must take the time to calculate the gearing, or net debt to equity, ratio. This metric is expressed as a percentage and measures the level of debt a business carries relative to shareholders’ funds.
Another critical measure is interest cover, which will allow you to test a prospective investment’s ability to service its debts. Calculated by aggregating operating profit and interest income and then dividing the result by interest paid, interest cover is a telling indicator especially if a firm has high operational as well as financial gearing. The higher the result the better and anything less than two at a firm where earnings swing around a lot as the economic cycle rises and falls is usually a bad sign.
This is an edited version of an article first published by Shares in October 2013.