How do you trade a great blue chip stock? Answer: don’t try. Focusing on unpredictable share prices and meaningless market-driven financial metrics is a mug’s game. Instead, think like a business owner: concentrate on finding great companies and buying them below fair value.
Granted, the idea of buying “great companies” sounds like simplistic investment preaching. Of course we want to buy great companies. The problem is, the market knows these companies are outstanding and has already (over) priced them for perfection.
But here’s the thing: look at the market’s great stocks over the past decade: Commonwealth Bank (CBA), REA Group (REA), Seek (SEK), Domino’s Pizza Enterprises (DMP) and Blackmores (BKL), to name a few. They had obvious traits of exceptional businesses but many investors resisted them on valuation grounds, confusing price and value. Or they were suckered by market noise and short-term price moves when they should have focused on industry and company fundamentals.
Every stock, of course, has its price. And there’s no magical formula for identifying great companies and buying them below fair value. The market is pretty efficient in blue chip land, much more so than in small caps. If the majority of large-cap Australian equity fund managers struggle to outperform their index over time, what chance do retail investors have? Plenty, if they follow a simple framework for choosing great companies.
Having written on share investing for 25 years, I’m still surprised at how much over-promotion of low-quality companies occurs. And how too many retail investors scour the market for “hidden gems” and become obsessed with short-term share price moves, when they would do better by narrowing their search to 100 of the highest-quality companies.
I use an eight-part framework to identify great companies. It will not suit all investors: for example, I prefer growth over income stocks, believing companies with a high return on equity (ROE) are better off reinvesting those dollars to magnify growth, than returning them to shareholders as dividends.’
My approach is grounded in long-term industry analysis and sustainable competitive advantage – identifying companies that have a so-called “economic moat”, and being prepared to pay more for them. Here are the 7 things to consider, plus a bonus step for good measure!
1. Start with the industry
Bad industries can kill good companies. And good industries can make bad companies look better than they are. Start your blue chip research with analysis of the company’s industry. Does it have good long-term growth prospects? Will it grow faster than the economy? Does the industry have favorable characteristics: for example, low or fragmented competition or other factors, such as regulatory barriers, that make it attractive?
Simple industry analysis can be the difference between huge gains and losses. Those who knew print media would struggle, while online media would boom, would have sold Fairfax Media and bought Seek or REA Group, years ago.
They might also have sold Myer Holdings because traditional retailing has unfavorable long-term industry characteristics. Or they might have bought Blackmores, The A2 Milk Company (A2M) or Bellamy’s Australia (BAL) – stocks exposed to the middle-class consumption boom in China, as diets include more dairy.
2. Sustainable competitive advantage
Only one thing is better than a great industry: a sustainable competitive advantage in an industry growing faster than the economy. It means companies can enjoy higher profits for longer, and better capitalise on their “window of opportunity” before rivals erode their advantage.
For established companies, sustainable competitive advantage gives a precious commodity: the ability to lift prices. REA is a good example: its price rises a few years ago weren’t popular, but what else could property advertisers and real estate agents do?
Sustainable competitive advantage comes in many forms. For BHP Billiton, it is arguably the strength of its balance sheet. For the Commonwealth Bank, it’ CBA’s technology head start over rivals. For Seek, REA and Carsales.com (CAR), it is a powerful “network effect”: more buyers attract more sellers, and vice versa, making their platforms impossible to overtake – or even get close to. For Domino’s, it is scale, brand and technology.
What gives the companies in your portfolio a sustainable head start over competitors? If the advantage is hard to identify, you might have a lower-quality company.
3. The business model
A strong business model is the key to exploiting a sustainable competitive advantage and favourable industry conditions.
I seek three core characteristics: recurring, annuity-style income with high certainty; a capital-light business model; and high customer switching costs. Put another way, companies that don’t need a lot of capital to grow, get paid when they are sleeping and make it hard for customers to leave for a rival.
Carsales is a good example. Like many Internet stocks, it has a capital-light business model because it is essentially a website. Unlike mining-service stocks, it does not have vast sums of money tied up in machinery that depreciates as it sits idle. Or big factories to build, or inventory that is less valuable the longer it is unsold. And it does not have to raise huge slabs of capital to expand offshore.
Fund managers such as Platinum Asset Management and Magellan Financial Group, benefit from recurring, annuity-like income. Customers sign up for one product, and pay fees on it, month after month, year after year. It makes for beautiful business when the product works.
Commonwealth Bank benefits from high switching costs. You open an account, get a credit card and take a mortgage. And because it takes ages to move to a rival bank and open new accounts, you stay put. With customers locked in, these companies have greater scope to lift prices, cross-sell other products and spend more time attracting new customers than keeping existing ones.
Do your stocks have recurring income, capital-light business models and high switching costs? They don’t need to tick all three boxes. But if your company only makes money every time it sells something, is a price taker, requires huge capital to grow, and can be dumped easily for a rival, it is probably of lower quality.
4. If you use only one financial metric, choose…
… Return on Equity (ROE). By showing the return on each dollar of shareholder funds, ROE is the most insightful and useful financial metric. It will tell you if the company has a clear sustainable advantage. ROE is:
- Net profit after tax and before abnormals/ shareholders equity.
Unlike the Price Earnings (PE) multiple, ROE does not have a market input (price) that can be right or wrong, depending on market sentiment. And unlike focusing on net profit alone, ROE evaluates the profit in relation to the resources required to earn it.
Ideally, look for companies with ROE of at least 15% and a history of rising ROE. High and rising ROE is usually a precursor to a higher intrinsic or true company value, and rising share price.
REA Group is an example: ROE rose from 15% in FY06 to 28% at the end of FY16. That says REA is working each dollar of its shareholder funds pretty hard (although not as hard as in the past few years when ROE was above 30%).
As ROE rises, the company’s intrinsic value rises and the share price ultimately follows it higher.
5. The balance sheet and capital structure
Some look at the balance sheet from a “margin of safety perspective” to ensure the company is not overloaded with debt. Fair enough. I also look at the balance sheet for clues on the strength of the company’s sustainable competitive advantage and business model.
High ROE gives the company surplus cash flow and greater ability to fund growth without excessive debt or share issuance that dilutes owners. I seek three main things:
- Rising cash flow generated from operations, and a funding surplus. Ideally, so that companies fund all or more of their growth internally.
- A net debt-to-equity ratio (debt less cash, as a percentage of total equity) below 40%. The lower the better. No debt is usually a great sign.
- The capital structure, in particular share issuance over the past decade, and options and other securities to get a true sense of the enterprise’s value. I like companies that are mean with share issuance and don’t treat equity like confetti to raise funds.
6. A global footprint
An attractive industry, sustainable advantage, strong business model, high ROE and strong balance sheet are great signs. But they only last so long in a small market such as Australia, where blue chip companies can quickly exploit their advantage.
With the exception of the big four banks, I like companies with a global footprint and an ability to leverage their skills to larger markets. The share registry, Computershare, is a good example of an Australian company with a valuable global footprint, as are Macquarie Group and CSL.
Offshore exposure for small- and mid-cap companies is particularly important, given the limited size of this market for fast-growth ventures in niche markets.
7. Management
Every company says they are well managed and most CEOs are impressive and persuasive. So how do you tell good managers from bad, so that you back the best-run companies?
Management is crucial. But analysing the boat they row, rather than those pulling the oars, is more beneficial. Put another way, focus first on finding exceptional companies in attractive industries, then consider the CEO implementing the strategy.
Spend time examining the board; that is, the directors who choose, incentivise and monitor the CEO, and hopefully are not ‘captured’ by them (a “patsy board”).
A good board will be diverse, have directors with genuine industry experience and preferably some “skin the game” through their shareholding in the company.
A bad board may be stacked with professional company directors, the “gifted amateurs” who do governance for a day job, but have shallow expertise in the company or its industry. And less ability – or gumption to stand up to underperforming or reckless CEOs.
Some independent non-executive directors are needed, but a board with more than 60% independence may compromise firm performance in the long run (compared to boards with more executive directors or others who are not considered independent and may have interests that are better aligned with shareholders).
The Executive Remuneration report offers the best clues on whether the board is captured by management; that is, the CEO effectively runs the board and gets his or her way on everything.
Executive pay that is relatively fair compared to other CEOs in the industry, has sufficient performance hurdles, and rewards CEO for outperformance and punishes them financially for underperformance are good signs.
Also, watch executive turnover levels. Often, the best judge of a CEO are the executives who report directly to them. If talented people are leaving, not to bigger jobs but because they appear to have lost confidence in the CEO, it could be a warning sign.
Most of all, stick to the numbers when assessing CEOs. Don’t fall for media profiles or other marketing gloss: the return on equity will tell you how hard the company is working shareholder funds under the CEO’s leadership, compared to its rivals.
BONUS STEP: Valuation
I could write about PE multiples, discounted cash flow valuations, or valuing companies based on future ROE and a required rate of return. Here’s the truth: trying to value complex, multi-billion dollar companies, such BHP Billiton and Commonwealth Bank, from scratch is impossible for most retail investors. In some ways, it is dangerous to try.
Over the years, I’ve found the most effective strategy is buying the highest-quality companies during market corrections and share-price pullbacks, while keeping a close eye on consensus broker forecasts.
It’s not a foolproof formula, but identifying great companies and buying them during irrational bouts of market weakness can handsomely reward long-term, patient investors.
For years, I have suggested buying the big internet advertising stocks (Seek, REA and Carsales) during market corrections or pullbacks. There’s no valuation science behind that strategy, simply a recognition that the highest-quality companies usually need a market shakeout to get back towards fair value or, rarely, well below fair value.
And if a correction turns into something more serious, I take comfort from holding great companies – not the riff-raff that is dumped first and is last to recover.
– Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at 25 October 2016.
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.