Here’s a sobering thought: more than 70% of Australian general equity funds underperformed their benchmark index over 10 years to the end of 2016, Standard & Poor’s latest SPIVA Australia Scorecard shows.
Put another way, seven in 10 actively managed funds achieved a lower return than the S&P/ASX 200 index. Smaller investors who bought exchanged traded funds (ETF) over the ASX 200 would have beaten an army of professional investors, after fees.
Remember, many of these funds have talented chief investment officers and research teams who live and breathe stocks. They analyse companies, competitors and industries, and build spreadsheets that NASA would be proud of, to identify attractive stocks.
If these fund managers cannot beat the market average, what chance is there for small investors? Plenty, if you have realistic investment expectations, stick to high-quality companies and have the discipline to buy them when they offer value.
The Switzer Super Report team this week asked me to write on “three tips for picking stocks”. Although that brief appears dangerously simplistic, I’ve come to realise over the years that some basic investment tenets are the most powerful, enduring – and profitable.
In the ‘90s, I edited the old Shares magazine, a terrific product that had almost 300,000 readers at its peak. Most subscribers were hungry for our views on “the next big thing”. We obliged with features on micro-caps, but it was more about speculation than investing.
A decade later, having completed a Master’s Degree in Entrepreneurship and Innovation, and lectured in the subject, I developed a new appreciation for identifying high-growth companies. Those with entrepreneurial teams, who could spot an opportunity, run faster than the competition, scale the venture and sustainably manage rapid growth.
That thinking rings true in my weekly column for the Switzer Super Report, where I tend to focus on stocks outside the ASX 100 that have higher growth prospects and an ability to maintain supercharged growth rates for longer than the market appreciates.
My aim: to identify, for readers, exceptional companies when they trade below their intrinsic or true value. Here are my top 3 tips for picking stocks:
1. Start with the industry
I firmly believe that good industries can beat a bad company, and vice versa. Even weak companies can deliver attractive returns for a while, if they are in hot industries, just as well-run companies can struggle, if they are in a declining industry.
Readers who have followed my columns over the years will recall my suggestion to buy internet advertising companies early on, and to keep buying them on any price correction. It wasn’t rocket science, simply a view that more advertising would migrate from print to online and that new media stocks had years of high growth ahead.
Selling Fairfax Media and buying Seek, REA Group or Carsales.com was an obvious strategy, yet many investors resisted high valuations for internet advertising stocks and underestimated the power and duration of this industry megatrend.
Another of my favourite themes in the past few years is companies exposed to inbound tourism growth – a topic I have written on many times in this column. One forecast after another predicts a boom in inbound tourism to Australia form Asia, a trend any investor could validate with a trip to Sydney’s Circular Quay or Melbourne Airport.
The tourism trend underpinned my positive view on Sydney Airport (SYD), The Star Entertainment Group (SGR), Mantra Group (MTR) and SeaLink Travel Group (SLK). I went cold on Sydney Airport and SeaLink in the fourth quarter of 2016 for valuation reasons, but their time will come again.
Agriculture is another sector that appeals. I doubt the market fully appreciates how agriculture technology, through robotics, drones and big data, will drive huge productivity gains and the next stage of industry growth, as Asian demand for Australian produce rises. Treasury Wine Estates (TWE) (in viticulture) and Costa Group (CGC) are among my favoured ag stocks.
Granted, not every stock exposed to a hot industry will benefit, and the market has a habit of pricing in megatrends (often excessively so) in stocks. And, yes, some companies in struggling industries deliver excellent returns. But I’d rather own companies that have strong industry tailwinds than those constantly battling headwinds.
2. Focus on exceptional companies
Most ASX-listed companies think they are exceptional in one way or another. The truth: very few are. Don’t fall for market, media or management hype about why a company is exceptional, or not. Let the numbers speak for themselves.
Look for companies in attractive industries that have a genuine, sustainable competitive advantage. That’s a fancy way of saying a company has an advantage that it can maintain as competition increases, thus achieving high rates of return for longer.
Sydney Airport is an example. Its competitive advantage is based on an airport that is a fabulous monopoly asset. REA Group’s competitive advantage is its network effect; more eyeballs on its property advertising website (realestate.com.au) means more advertisers, and more advertising inventory attracts eyeballs.
When searching for exceptional companies, ask: “What is it about this company that is hard to replicate?” It could be the organisation’s brand, balance sheet, management team, intellectual property, asset base or another factor. If the business is easier to copy, any competitive advantage will be whittled away as rivals move in, leading to average returns.
Exceptional companies with a sustainable competitive advantage – or economic moat as some call it – tend to deliver a high and rising return on equity (the return on each dollar of shareholder funds invested). A rising ROE is invariably a precursor to a rising intrinsic company value and thus a rising share price, as the market catches up.
There’s no hard and fast rule, but 15% for ROE is a reasonable benchmark. The consistency and trajectory of ROE is key: a steadily rising ROE over several years is a great sign, for it suggests the company is working each dollar of shareholder funds harder.
Domino’s Pizza Enterprises has had a ROE above 30% for much of this decade. CSL’s ROE has averaged above 40 % for the past four financial years. A decade ago, CSL’s ROE was 23% – consistent ROE growth was a signal to buy the stock.
Exceptional companies tend to have another characteristic: low or no debt. High surplus cash flow allows them to fund business growth internally rather than take on loads of debt or issue equity like confetti, to raise capital. Too much debt or equity issuance weighs on ROE.
Another sign of exceptional companies is management alignment. Forget the CEO sales spiel and look at how management is incentivised and their “skin in the game”.
I like CEOs who have a big chunk of their wealth tied up in the stock – not so much that they can run the company like a dictatorship – but enough that their interests are strongly aligned with shareholders and that they will hurt if the company underperforms.
Taken together, exceptional companies should have a clear competitive advantage that drives a high, rising return on equity; an ability to fund growth internally rather than constantly raise capital; and management who are heavily invested in the company’s outcomes.
These factors are no guarantee of an exceptional company. But it’s amazing how the small group of exceptional companies on the ASX tend to tick all four boxes above, and how retail investors can identify these traits if they know what to look for and get in early.
3. Valuation
I worked in investment banking for five years, spending long days with a team of stockbroking analysts and brokers. Our firms’ analysts built complex spreadsheets, projected a company’s future earnings and used a variety of stock-valuation techniques.
These techniques, and the time required, are beyond most retail investors. How many investors could realistically pull BHP Billiton (BHP) apart, forecast commodity prices, project the earnings of BHP’s giant divisions and form a view on the miner’s valuation?
Get used to using valuation data, rather than doing the valuation itself. I use several share valuation services for background research. For example, the excellent Skaffold service, StockDoctor, Stocks in Value and Morningstar (for research). These services are far from infallible, but they are a useful starting point on understanding stock valuations.
Consensus analyst forecasts are another insight. Some online brokers provide basic consensus information, as do sites such as Yahoo Finance. This data provides a snapshot of the market’s view of the stock; how many firms have buy or sell recommendations, their target share price and how their earnings forecasts have changed in the past few months.
Beware consensus forecasts based on a small number of analysts, for data can be skewed. And remember that the “consensus” view is well known in the market. My aim is to spot exceptional companies that can grow faster than the consensus view expects.
Another technique I use is filtering. Using online databases, such as Morningstar, I build parameters for stocks. For example, companies with a ROE of 15 or more, a PE below 12 and a yield above 4%. Again, the automated list is a starting point for further analysis in finding undervalued companies rather than a “tip sheet”.
Sometimes, the best way to spot exceptional companies trading below their intrinsic value is through sheer patience and having a decent chunk of cash in portfolios. That is, waiting for market corrections or share-price pullbacks that are more about overall market sentiment and irrational selling, than company specific factors.
You have a watchlist of exceptional companies in growth industries, watch the market for periods when share prices fall and have the cash and courage to pounce.
This simplistic approach will not please fund managers who pore over every detail of company valuations. But spotting exceptional companies in growth industries – and buying them during broad market sell offs – is within reach of any retail investor. It’s a consistently profitable, lower-risk strategy over long periods.
Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at April 12, 2017.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
