How to find a great stock – part 2

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How do you find a blue-chip company? It’s hard but some basic metrics and information about the company is a good place to start.

Last week we looked at the industry, sustainable competitive advantage and business model. To that today we add four more factors worth analysing when trying to find good companies for your portfolio.

For the first three factors, click here.

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 a good example: ROE rose from 15% in FY06 to 36% in FY14. That says REA is working each dollar of its shareholder funds harder and harder. Consequently, REA’s intrinsic value rises and the share price has to follow 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 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.
  • 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. Ainsworth Game Technology is another, as is Macquarie Group. If your blue-chip company depends mostly on Australia for profits, it will have a more challenging time in the next two years.

7. 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 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. It’s not a foolproof formula, but identifying great companies and buying them during 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 September 24, 2014.

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.

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