Right now is the best environment to invest in, but you can’t rely on the greater fool theory; you need to be disciplined and extremely thorough with your analysis. As an investor, these are my favourite markets.

In a strong ‘bull’ market, anyone and everyone can make money. You can buy a share, knowing virtually nothing about it except its name with the hope that a greater fool will buy it off you at a higher price, and this usually occurs.

In a ‘bear’ market, when all the news is bad and the market is extremely volatile or falling, you need to be extremely thorough with your analysis and you can’t leave anything to chance.

Investing is a very personal pursuit. It is a combination of what you believe and what you’ve learnt over years while you’ve been involved in the stock market.

A few core beliefs which underline my investment process are:

• Company management is extremely important;
• It’s easier to make money investing in a business that has a high return on its equity and generates positive cash flow;
• Movement in share prices have the greatest correlation to changes in Earnings Per Share (EPS); and
• If you work hard and smart, you can deliver extremely good returns investing in the stock market.

With this information at Wilson Asset Management, the investment managers of WAM Capital (WAM), WAM Research (WAX) and WAM Active (WAA), built a ratings template which we use to identify companies as potential investments. We are focused on investing in ‘growth’ companies that are well managed and well priced.

Understand your investments

Before we rate a company we need to understand how they make money and how they generate cash. We need to understand what drives revenue (sales) with respect to volume and price and we need to understand all the costs of the business and what impacts these costs. With that information, you have a chance of forecasting the company’s profit and you get an understanding of how the company funds its growth, with either cash or debt. This process is the foundation for our ‘research driven’ approach to investing.

Each company we analyse as a potential research-driven investment, we rate. The unique ratings system is our black box. We rate management and EPS growth over two years. We have a valuation matrix, which is EPS growth to Price Earnings Ratio (P/E), and then we rate the industry and the company’s position in that industry. Our rating system is based on the fact that a company’s share price has a close correlation to EPS growth.

When to buy

Once the company rates a ‘buy’, we won’t buy it until we can identify a catalyst or an event that we believe will re-rate the company’s share price. A catalyst could be an earnings surprise, a structural change in the industry, a change in management, the selling of a loss making division – anything that we believe will change the valuation of a company.

Usually a company will rate if it is on a low P/E and growing at 1.5-times its price to earnings ratio. For example, a company on a P/E of 10-times, with EPS growth for the next two years of 15%-plus per annum and is well managed and well positioned in its industry will rate.

Two stocks rated buy

Two companies that have rated well are Breville Group Limited (BRG) and FlexiGroup Limited (FXL).

We started buying Breville around $2.60. It rated a buy and the catalyst was a positive earnings surprise resulting from the stronger than expected growth of its American business. Breville now, at $4.34, just rates. Our current price target is $4.90.

More recently, we have been buying FlexiGroup. We rate FlexiGroup’s management 8/10, the next two years EPS growth we forecast to be 15% per annum, it is trading on a P/E of 10.3-times and its industry and positioning we rate 7/10. A recent catalyst has been the acquisition of Lombard Finance, which they’ve purchased for $10 million, and which we believe will add significantly to earnings and help grow the company’s earnings at an annualised rate of 14-16% over the next three years.

Our research-driven process takes time and involves over 800 company meetings each year. If we can’t find a suitable investment, we will continue holding cash.

Cash and term deposits

While holding cash, we also look for low-risk shorter-term trading opportunities that can provide a higher return than cash (its currently 5.2% per annum for 90-day term deposits). This part of our investment process is called our ‘market-driven’ process.

One type of market-driven trade that we utilise regularly is trading takeover arbitrages. This process involves heavily researching takeover documents after a takeover is announced to minimise risk.

Two market-driven stocks

Two current market driven positions are Talent2 International Limited (TWO) and Spotless Group Limited (SPT). If you buy Talent2 shares at 76 cents assuming the takeover bid goes through, your annualised return is 11.5%. As part of the 78-cent takeover consideration, it is expected you will receive at least 6 cents fully franked.

Another market driven play is Spotless Group, which assuming the takeover bid succeeds, will deliver an annualised return of 29.5%.

I hope this gives you a flavour of how we invest. What I’ve learnt over the years is flexibility is paramount with regards to investing. You must learn from your mistakes and remember – the best time to buy is when everyone is selling.

Important information: 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. Anyone should, before acting, consider the appropriateness of the information in regards to their objectives, financial situation and needs and, if necessary, seek professional advice.