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How to spot the best shares
Failing to pick the right stocks is one of the biggest reasons why individual investors struggle to make money on the stock market. Don’t despair; we are help to help.
We believe an investment journey can be greatly enhanced by following a few simple steps in order to filter out the bad stocks and leave you with a universe of more interesting – and hopefully profitable – shares.
In this article we discuss five ways to check if a company could be a good or bad investment. You will arguably need to apply all five to your research process in order to get the best results. Please note there are many other ways to pick shares. We’ve merely picked five of the most important ones.
Furthermore, we haven’t touched on valuation in this article as that warrants a whole discussion on its own. We’ll write about how to spot if a stock is cheap or expensive in Shares very soon.
Our stock picking guide is not guaranteed to always produce positive results. However, it will certainly help to strengthen your stock picking skills and get you thinking about companies in a more analytical way.
Helping both newbies and experts
Don’t be scared if some of our guide is new territory with regards to how you select investments. We’ve written the article in a way that even an absolute beginner will be able to understand the procedures and thought process.
If you’ve already got plenty of experience under your belt, think of it as brushing up on your skills. After all, a good investor is one who is continuously learning new skills and keeping their mind sharp.
1. QUALITY OF EARNINGS AND BALANCE SHEET
One description of a perfect investment is a stock that enjoys growth in revenue, profit, cash generation and dividends year in, year out. You would assume their share price keeps rising and the dividends become more generous as the business gets bigger.
It is rare to find companies with an unblemished track record. Inevitably most companies will go through a difficult period. This could be down to unfavourable macroeconomics conditions, changing consumer tastes, technological advancements by rivals or a multitude of other factors.
A strong company should be able to bounce back. For that reason, it is important to look at the long-term earnings track record of a business. Analysing 10 years’ worth of earnings should help you spot whether a company just suffered a short-term blip or whether earnings can be lumpy, moving up and down on many occasions through the course of a decade.
Being paid again and again
We like companies with long-term contracts as these could help them generate recurring levels of revenue every year.
A good example is small cap services business Restore (RST:AIM). It looks after important documents for the likes of banks, lawyers and the police – the customers pay a storage fee and further money if they need to consult the documents.
Ultimately most of the documents just need to be kept safe long-term, so Restore collects regular fees to look after them. It also boasts a very sticky customer base as most clients can’t be bothered to move to a different supplier as it is a hassle shifting thousands of boxes for the sake of few pennies.
You can often find companies with recurring revenue in the technology sector. For example, Sage (SGE) – Britain’s biggest software group – has fast-growing subscription revenues which are helping to offset a decline in traditional software sales.
Cloud services group Iomart (IOM:AIM) enjoys ongoing payments from the likes of SuperGroup (SGP), Universal Music Group and Virgin Media as its job is to manage companies’ desktops, email systems, servers and phone systems among many other functions.
The clients have to spend money
We like companies that benefit from non-discretionary spend – namely customers who have to spend money on certain activities to comply with, or help others meet, laws and regulations.
One example is engineering services group Renew (RNWH:AIM) which works in areas such as the water, gas and rail markets which have committed funding from regulated entities like utility firms.
Look for pricing power
Companies with pricing power can be very good investments. By this, we mean firms in a strong enough position to raise prices without losing business.
You’re already seeing this trait in action as weaker sterling is pushing up input costs for many companies, thus they need to pass on extra costs through higher prices in order to protect profit margins.
Whitbread’s (WTB) Costa coffee chain recently pushed up its prices because of higher costs. Kitchens seller Howden Joinery also did the same.
Both these companies are considered by analysts to have very strong market positions and command pricing power. They’ve also got very strong brands, another plus-point when we seek good investments.
It is too early to see if demand for Costa’s coffee has been hit by higher prices. However, Howden has already reported ‘encouraging’ early signs from raising prices.
Make sure you study the cash flow statement
We love to see plenty of free cash flow and a growing stream of dividends from a business. Free cash flow is the amount of cash generated from operations minus any money that is needed to be reinvested in the business to keep it competitive.
The remaining cash is the pot of money to fund dividends, pay down debt and also provide firepower for any strategic opportunities such as value-enhancing acquisitions.
Free cash flow is a really good gauge of corporate health. A steady improvement in free cash flow is great sign; it can be followed by higher earnings and ultimately a higher share price.
Debt can be problematic
A gradual reduction in free cash flow can be a warning signal that a company cannot sustain earnings growth and/or potentially could be forced become more reliant on debt.
Highly indebted businesses can be trouble for investors if there is a downturn in their end market(s), as a drop in earnings can make it harder – or in a worst-case scenario, impossible – to service debt repayments.
2. HIGH RETURNS
Another way to find a good investment opportunity is to look for companies that make a good profit on the money they invest in their business. The technical term is making a high ‘return on capital employed’ or ROCE if you like acronyms.
Imagine a firm which makes great returns on money invested in its business. That money has made the business stronger and larger – so it can then use the enlarged profit generated as a result of the earlier investment to plough even more money back in the business. Those benefits can work magic over time, thanks to the effects of compounding.
One of our favourite examples of a business with superior ROCE is FTSE 100 energy and healthcare products distributor DCC (DCC). It has an average 17.8% return on capital employed over the past 10 years, according to our calculations.
As a rule of thumb, companies with ROCE consistently above 15% are very good businesses. DCC only once dipped below 15% in the past decade (14.2% in 2012). Its most recent ROCE figure was 21% in 2016.
How to find other examples
You can easily find companies with a good track record of ROCE by using stock screening systems. Phil Oakley, an investment analyst at software provider SharePad, recommends you strip out any banking or property companies as they don’t suit ROCE analysis.
We’ve followed his advice and stripped out those sectors. We’ve also adjusted for rented or leased assets so companies which rent rather than own assets don’t look better than they really are.
The results from this screen appear in the accompanying table; the list has been restricted to stocks currently in the FTSE 350 index.
3. DIFFERENTIATED PROPOSITION
‘Does another company offer something similar to what you do?’ That is a very important question to ask when considering a company as an investment. We want to see a unique selling point, not a ‘me-too’ proposition.
Paddy Power Betfair (PPB) is the same as Hill and Ladbrokes, up to a point. While it has websites and shops, its real edge lies in the person-to-person betting exchange element of its business. Furthermore, it excels at engaging marketing which ultimately makes the business far superior to its peers, in our view.
Failing to keep up with market innovation
Another example is restaurant business Tasty (TAST:AIM). Its flagship brand is Wildwood which sells such unoriginal items as spaghetti Bolognese and ‘homemade lasagne’. Yes, these are classic dishes – but you can get them down the local café. Eating out in a restaurant should be a treat, so the menu should be exciting.
We’ve expressed a bullish view on the stock in the past because it was able to self-fund expansion and its main owners come from a highly successful family of restaurateurs. That positive view now deserves reappraisal due to significant changes to the market.
The food industry is now over-saturated thanks to a surge in new brands and investment by existing players to modernise their estate. The weaker brands don’t stand a chance and we fear Tasty could get left behind.
Ask yourself if you think Wildwood is going to be a classic restaurant brand that will prosper for decades to come? We think not.
4. EASY TO UNDERSTAND BUSINESS
Many investors are happy to buy shares in a company without any understanding of the business and how it makes (or hopes to make) money. This can be a foolish move, in our opinion, particularly if the company operates in a very complex area such as mining exploration, financial markets or biotechnology.
You need to be able to identify the risks to the business which requires thorough understanding of what it does.
If you are determined to access a certain sector but don’t understand the relevant businesses, an alternative would be to invest in a specialist investment fund run by someone who does know the subject matter well.
5. EASY TO UNDERSTAND ACCOUNTS
We want to see a company present a clear set of accounts every six months and not have them riddled with asterisks and footnotes. The latter items tend to point towards financial adjustments and exceptional items which the company wants you to quietly ignore.
Many companies are serial offenders when it comes to exceptional or one-off items. Rentokil Initial (RTO) used to be one of the worst companies in this regard, but has finally got its act together.
As a more recent example, take a look at Utilitywise (UTW:AIM) whose half-year results in early April 2017 contained 44 mentions of the term ‘restatements or restated’. That’s not a good sign.
The model citizen when it comes to crystal clear accounts is retailer Next, in our view. Its accounts are always easy to understand. It lays out the objectives for the year ahead and goes into a lot of detail including commentary for each part of its business.
Discover how fund managers pick stocks
Some of the best fund managers follow strict criteria when seeking stocks and you can often piggyback on this information to help spot interesting companies. For example, a fund manager might discuss their investment process in an article or on the fund’s website.
If you like the sound of how they pick stocks, why not take a look at the holdings in their portfolio for investment ideas – or just invest in the fund itself.
Asset manager Liontrust (LIO) explains various investment processes on its website and says which of its funds follow certain investment criteria.
For example, one of its investment processes is to look for stocks that possess ‘durable economic advantage’. It wants to find companies with at least one of the following advantages: intellectual property, strong distribution and recurring business that represents a minimum 70% of annual turnover.
Relevant funds using this investment process in its product range include Liontrust Special Situations Fund (GB00B57H4F11) and Liontrust UK Growth Fund (GB00B56BDS09).
Taking a more rounded view
Evenlode, another asset manager, says there is nothing ‘fancy, radical or exciting’ about its investment philosophy – but says it does involve being ‘steadfast and single minded’.
It says: ‘We look for a particular type of company. They may or may not be household names, but they need to have a certain reputation for quality, and sell products or services that people come back to buy time and time again. They also travel light — by which we mean they don’t have a lot of capital assets.
‘There is more risk attached to companies that own lots of real estate or planes or oil rigs, as with so much money invested in physical stuff, an attractive return on capital is much harder to achieve.
‘We also make it our business to get to know the boards and management teams of our companies. Finding out how they operate and understanding their long-term plans is imperative. We don’t flit and dabble with fads and fashions. We keep the faith.’
The good, the interesting and the ugly
Andy Brough-managed Schroder UK Mid Cap (SCP) investment trust has a very interesting process where it separates the market into three silos.
It looks to invest in A-category stocks, trade B-category stocks and avoid C-category stocks. Let’s now take a closer look at how it defines these three categories.
Characteristics of ‘A’ stocks:
• Pricing power
• Very strong business franchise
• Scarcity value
• Operating in areas of secular growth
• Quality of management
• Ability to finance growth internally
• Balance sheet strength
Speaking at a recent conference in London, Brough said a good example of an ‘A’ stock is Dechra Pharmaceuticals (DPH) which makes products for veterinarians.
The Schroders fund manager notes there are two pets for every person in the UK, illustrating the large scale of the pet drug and products markets.
Dechra’s share price has approximately doubled in the past two years and the business is now worth £1.5bn and it is a member of the FTSE 250 index.
Characteristics of ‘B’ stocks:
• Change of management strategy
• Withdrawal of industry or stock market over-capacity
• Cyclical upturn of re-rating in prospect
Characteristics of ‘C’ stocks:
• Industry over-capacity
• Experiencing long-term decline
• Not providing investors with successful growth opportunities
TalkTalk Telecom (TALK) was cited as a ‘C’ stock by Brough, noting that its dividend is funded out of debt which is never a good sign. ‘It also has creative accounting with liberal use of exceptional items’.