We are sure that you have heard the same thing time and time again, investing in companies with certain investment characteristics (eg. quality companies with sound management and a strong balance sheet) is the best way to prosper in the share market. This is frequently the story that the average fund manager will tell you (these managers are generally relative return, market tracking fund managers). The Australian share market is only 10% higher than where it was 10 years ago so why should you be interested in professional investors who achieve these returns?
Attractive Characteristics - What To Look For In A Company Before Buying It
Rather than add to the masses of information on what constitutes a ‘high quality company’, James Williamson picks out a few qualities that have proved to underpin successful investments during his career. When going through these qualities, it is a good idea to constantly remind yourself of the importance of the price you are paying for an investment. As Howard Marks says, “Everything is AAA at the right price”. The TAMIM Australian Equity Value portfolio is not restricted to high quality companies only. The price you pay is paramount, and the ability to remain flexible and opportunistic means we can go down the quality scale as long as the risk/reward is, tipped in our favour. Sometimes an investment will have a number of these qualities, and sometimes they will have few.
In the following weeks we will provide real examples and tutorials, on how to put the investment techniques described below, into practice so that your portfolio’s performance isn’t as closely correlated to the average as it may currently be. A little bit of extra work on your behalf goes a long way to improving investment returns. We hope you enjoy! 1.Free Cash Flow Generation We strive to invest in companies that have a long history of strong cash flow generation, and, contrary to much of the wider market, pay less attention to P/L earnings, which sometimes do not present a realistic picture of what a company is actually earning. To calculate free cash flow, we typically take cash flow from operations in the cash flow statement (adjusting for any changes in working capital), and deduct our estimate of maintenance capital expenditure. This maintenance expenditure number is extremely important, and it can be less than or more than the actual outflow for any one year. For example, a company might have a large outflow for investing activities due to upfront capital needed to grow certain parts of the business, and this may not be repeated for a number of years (e.g. upgrading machinery or buildings that have a long life), meaning the actual capital needed to maintain current operations is much lower than that year. Alternatively, a company might have a cash outflow from investing number that has been comparatively low for a number of years because it has not reinvested back into the business, meaning actual maintenance capex will be higher in coming years. The only way to come up with a realistic forecast is to understand the business and industry extremely well.
Additionally, the reason we use cash earnings and not P/L earnings is because EPS does not always give a true picture of what the company is earning. For example, any changes to a company’s depreciation schedule can have a dramatic impact on their bottom line, both positively and negatively, and this can have little to do with the operations of the business. Also, depreciation and amortisation can often be very different to the actual cash needed to run the business, meaning the net income number can both overshoot and undershoot the actual amount earned. Once again, only a thorough understanding of the company and industry can determine whether EPS is a good proxy for a business’ underlying earnings; remember that there are numerous ways a CEO can ‘juice’ earnings, but cash in and cash out is harder to manipulate. 2.High barriers to entry Simply speaking, the nature of competition dictates that, when a company is able to achieve above average margins, new participants will attempt to challenge this business until all participants are pressured down to an average level of profitability. This is especially the case with commoditised products, where businesses are unable to differentiate their offering from that of competitors, and in reality, you will find that there are very few businesses able to maintain a long term, sustainable competitive advantage, which is why even the biggest and most successful companies in the world consistently spend on innovation and try to constantly adapt their offering. We are typically very wary of businesses achieving very high margins relative to history, and alternatively often find attractive ideas when margins are much lower than the past and there is a clear plan to improve profitability.
However, we ideally try to find businesses that operate in an industry with high barriers to entry or obstacles that prevent new competitors from easily entering an industry. Some include high start-up costs or high customer switching costs, patents or government regulation, and a strategic geographical location that lends itself to producing at a lower price point (i.e. low cost mine close to a port). The hope is that, if buying these companies at an attractive price, the favourable economics of the business will compound your wealth over the long term. 3.Satisfactory customer and supplier concentration matrix Quite simply, we prefer companies that have a well-diversified customer and supplier base. If a company has one or 2 clients that make up a large part of their revenue, they would be left exposed should a customer leave or switch to a competitor, and will often have their margins squeezed if they want to retain the business. Similarly, if their supply is concentrated to one or 2 main suppliers, they have little bargaining power should they be forced to absorb price increases, etc., and may have trouble sourcing products if a supplier faces issues affecting their ability to operate. 4.Conservative leverage Generally, we aim to invest in companies that have net cash or use conservative gearing, because debt can be a killer (think Arrium, as a recent example). Companies with little to no debt, or net cash, typically have the ability to ride out tougher times, but companies with debt are always required to meet repayments or refinance at maturity, which can be at less favourable terms if the business isn't performing as well as it had in the past. However, once again there is no one amount that is necessarily too high. Certain companies can accommodate higher amounts of leverage due to the nature of their business, which may include easily saleable assets, long term contracts, etc., while some businesses should never have any debt. Again, only a thorough understanding of the drivers of the business and its competitive environment will allow you to determine what level of debt you feel is conservative. Furthermore, we have in the past invested in companies hated by the wider community which appear to have high debt levels when we are confident that this debt is on a downward trajectory and that cash flows can comfortably service debt and significantly reduce this number in the near term. 5.Capable owners / managers It is very important that when making an investment, you are entrusting your capital to a good operator who is passionate about the business, has aligned interests with shareholders, and will stick around for a meaningful amount of time. There are certain things that we like to see when it comes to management. Firstly, we spend time digging into the CEO/Managing Director’s past to see if they have industry experience and a reputation for performing the task at hand; when investing with hopes of a turnaround, it can offer some comfort if the person in charge has been responsible for successfully turning around a business in the past. Another factor we like to see is whether remuneration is aligned with shareholders’ interests. This can be achieved in numerous ways, including being granted stock bonuses or having performance targets linked to return on capital and total shareholder return, rather than purely EPS growth. Another thing we like to see is large insider stakes, or insider buying. Within the TAMIM Australian Equity Value portfolio, we often invest alongside large or majority family stakes, where the free float is limited and large institutions aren’t able to invest. We like it when a large proportion of the family’s wealth is tied up in the business. Similarly, we like to see insider buying, where management invest their own money into the business and ‘eat their own cooking’. 6.Mispricing by the market There are various reasons why stocks may be mispriced by the market, but most of the time, stocks are fairly priced and you need patience waiting for when the odds are meaningfully stacked in your favour (hence, our small number of holdings and low turnover). There are numerous examples where we have found mispricings in the past. Often as a start we like to look at a company’s broker price targets and ratings over time. It is unbelievable to see the raft of positive reports and target price upgrades as the price increases – the short term orientation of the sell side typically means they follow the price up and down. A price fall is exactly what we are looking for, with brokers cutting their price targets and changing their call to a sell, and other brokers dropping coverage. We want to focus on parts of the market that have disappointed time and time again, because that is typically where the most value lies. We take a long term view on a stock in a market where many focus on the next set of half year results.
Also, as discussed previously, we sometimes find mispricing when companies are forced to cut their dividends, those investing for yield will typically sell their position and push the price down. Sometimes, a low free float means larger institutions cannot invest in a business, resulting in lower coverage, and thus, more chance for a mispricing. Whatever causes a mispricing, it is extremely important to only start buying at a meaningful discount to your calculated intrinsic value. You should also have the confidence in your research to average down your investment price should the share price fall further than expected.
Over the 12 months to the end of April the fund underlying the TAMIM Australian Equity Value portfolio has delivered a 19.1% return versus a market that returned -4.9%. If you would like to discuss how TAMIM can help you with you retirement portfolio's in this low interest rate environment, then please contact us at email@example.com.
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