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Elementary: Simon Thompson's guide to stock picking

Elementary: Simon Thompson's guide to stock picking
November 9, 2012
Elementary: Simon Thompson's guide to stock picking

I am more fortunate than most as I had a head-start in the finance world a quarter of a century ago when I was taught how to rip through a set of company accounts. But being able to analyse a company's accounts is one thing; being able to decide whether shares in a company are a good investment is a different matter entirely. So to improve the chances of screening out the best investment opportunities for loyal readers of Investors Chronicle, I go through a methodical process on every single company I research in order to have the best possible chance of making a profitable trade. This involves considering 10 key areas before deciding whether the risk:reward favours making an investment.

Balance sheet strength

Some of the most spectacular gains I have racked up on my stock picks have been made by screening for companies valued on large discounts to net asset value and where the intrinsic value in the company's assets is not being accurately reflected in the share price. As a secondary screen I try to avoid highly geared companies for the simple fact that I am happy to take on operational risk, but really don't want to expose myself to the financial risk of a company being unable to service its debts at the same time. In fact, I like companies with net funds so there is minimal financial risk. But even if I do recommend a company with significant borrowings, I always assess the cash generation of the business to decide whether underlying cash flows are strong and sustainable enough to comfortably service debt. As a result, I very rarely recommend shares in any company where net debt is above 80 per cent of shareholders' funds.

This means that any improvement in the trading performance can act as a very strong catalyst for a rerating to narrow the share price discount to book value without investors fretting about levels of balance sheet gearing.

A classic example of this was Walker Greenbank (WGB), the luxury interior furnishings outfit, whose brands include Morrison & Co and Zoffany, which was being valued on a 30 per cent discount to net asset value when I first spotted the investment opportunity ('Luxury at a bargain price', 8 Feb 2010). The company only had gearing of 17 per cent but, importantly, the business appeared to be in the very early stages of recovery and an earnings upgrade cycle. It was the real deal and by the time I advised banking profits 18 months later ('Time to bank some gains', 23 Aug 2011), we had made a 118 per cent profit on the holding as other investors had also cottoned on to the fact that Walker Greenbank's strong cash-flow-generation was not only rapidly reducing the company's borrowings, but paving the way for sharp increases in the dividend, too.

 

Luxury furnishings company Walker Greenbank was valued at 30 per cent discount to NAV.

 

Cash-flow generation

I always look at a company's cash-flow generation and reconcile this with operating profit to see how much profit is actually being converted into cash. The higher the figure the better as strong cash flow can not only be used to cut debt, but also enables boards to raise dividends and support investments. My optimal rate for cash conversion is a ratio of 85 to 100 per cent.

Adjusting earnings multiples

Sometimes valuing companies on a simple price-earnings multiple gives a misleading view of the value in the underlying business since some companies retain significant cash holdings. In the current low interest rate environment these cash balances yield very little, if anything, in the way of interest income, so make the standard PE ratio look artificially high when, in effect, it isn't if you adjusted for these cash holdings.

For instance, one of my best tips this year is Netcall (NET), a small-cap company offering software to make telephone call-handling more efficient and one that has net cash on its balance sheet equivalent to almost a quarter of its current market value. This healthy financial position offers customers reassurance that the company will be around to fulfil its obligations on what can be long-term contractual agreements. But it also offers scope for Netcall to redeploy some of this cash pile to make earnings-enhancing acquisitions. And that is exactly what it is doing.

So if you strip out net cash from a company's share price, adjust the EPS figure for any loss of investment income and then recalculate the PE ratio, you get a far more accurate idea of the earnings multiple you are actually paying for the shares. In the case of Netcall, the forward PE ratio falls sharply from 13 to 10 on this 'net of cash' basis, which remains a very attractive valuation for a growing business in an earnings upgrade cycle.

Moreover, this process can throw up some bargain basement investment opportunities, such as Indigovision (IND) - the star performer of my 2012 Bargain Shares portfolio and a pioneer in internet protocol network-based security surveillance systems. When I strongly reiterated the investment case in the summer ('Tech stocks rack up gains', 6 August 2012) the share price was 350p and I calculated that the company was sitting on 100p-a-share of net cash at the time. Strip this out and the forward PE ratio fell from a reasonable 11 times EPS estimates of 32p for the year to July 2013 to a bargain basement 7.5 times EPS net of cash. Our first-mover advantage here paid big dividends, quite literally, because at the end of September the company not only announced bumper financial results, but also that it was paying out a hefty 75p a share of dividends to shareholders. This sparked a 50 per cent rerating of Indigovision's shares as the obvious value on offer, which we had recognised early, became abundantly apparent to a wider investment audience.

 

Indigovision: a star performer.

 

Cash is king

Another process I undertake in my financial analysis is to calculate the cash profits of a company, which in City speak is known as earnings before, interest, taxation, depreciation and amortisation (Ebitda). I then work out the company's enterprise value (EV), which is the sum of its market value and net debt or market value less net cash, and then work out the ratio of EV to Ebitda.

This multiple is far more relevant to companies that are in recovery mode and have high cash balances yielding very little in the way of interest income, so may look ludicrously priced on a simple earnings multiple of basic EPS when, in fact, they offer great value.

A good example of this was my call to buy shares in Moss Bros (MOSB) at 39.5p earlier this year ('Dressed for success', 20 February 2012) when I spotted that the sale of the company's Hugo Boss franchise had left the balance sheet in a very cash-rich position. Management also had a plan to spruce up the estate of stores and invest heavily in a new internet offering. This was going to be funded by recycling operating cash flow from the business in order to upgrade 90 stores over the next three to five years at a cost of around £11m. On inspection, I realised just how cash-generative Moss Bros's underlying business is, so much so that the company's cash pile has actually grown by £3m to £26.3m this year alone and that's after making significant investments. Moreover, this capital expenditure in store refits is having an immediate impact by raising like-for-like sales and, importantly, is entirely funded from cash flow.

So although on the face of it Moss Bros's shares, at 55p, look ridiculously priced on 45 times January 2013 EPS estimates of 1.2p, this is misleading. That's because, once you strip out the £26.3m cash pile from the market value of £55m, the company's enterprise value of £28.7m is only 4.2 times cash profit estimates of £6.8m for the current financial year, falling to 3.3 times the year after. This is why I continue to rate them a buy even after a 40 per cent rerating.

Anticipating newsflow for recovery situations

Ultimately, it doesn't matter how lowly rated a company is as you need a spark for the share price to rerate. The one most likely to act as a catalyst is the most obvious: an improvement in the trading performance on a relative basis year on year.

So to gauge how well a company is doing relative to how it performed six or 12 months ago, I meticulously go through the last 18 months’ interim reports, preliminary results statements and trading statements to work out the underlying trends and pinpoint key growth drivers. This includes anticipating what company-specific newsflow is set to be released over the coming months and estimating the likely implications for the share price based on a series of likely outcomes.

This can be a very useful exercise, not to mention one that can also be financially rewarding, especially for companies that have gone through restructuring and have slimmed down their cost base. That's because modest increases in sales can have a disproportionately large impact on profitability as the operational gearing of the business kicks in. As a result it can pay big dividends to buy into these special situations before other investors cotton on to the accentuated positive impact on profitability from an improved trading performance and prior cost-cutting.

A great example of this was home shopping retailer Ideal Shopping Direct (IDS), which had cut its cost base significantly and was generating cash profits despite reporting reported pre-tax losses. Add to this director share buying (see 'Follow the leader: director share deals' below) and this was good enough for me to recommended buying the shares ('Investing in an Ideal world', 12 October 2009) as it was a dead cert that any improvement in the company's sales performance would lead to a sharp return to profitability. Not only did this scenario pan out perfectly, but IDS succumbed to a private equity bid 18 months later ('Ideal offer arrives', 4 May 2011) to generate us a bumper 130 per cent gain on our investment.

 

 

Seasonal investing trends

In my book, Trading Secrets: 20 hard and fast ways to beat the stockmarket (FT Prentice Hall, December 2008), I reveal how certain trading patterns can influence share price performance at various stages of the year. We can exploit these trends to our advantage.

For instance, the outperformance of the housebuilding sector in the first quarter of the year is a standing dish and one we can capitalise on. In fact, the sector has risen in 28 of the past 33 years in this three-month period, generating an average quarterly return in excess of 10 per cent. This year was no exception and, if you followed my advice to buy a handful of companies in the sector at the start of January ('Solid foundations', 4 January 2012), within six weeks your holdings were showing an average gain of 15 per cent and, if you ran your profits to the end of March you will have made an eye-watering 26 per cent profit.

This is not an isolated example either because in the second quarter of the year, defensive stocks - tobacco, pharmaceuticals, utilities, personal care and beverages - have a habit of outperforming the market and cyclicals, or growth stocks, underperform. Similar trends occur over the summer months, too, before reversing over the winter months. So by focusing on companies in specific sectors at certain points of the year, I can generate a tail wind for my stock picks by buying a good company in a seasonally strong period and avoid facing a headwind by buying shares in a company that is in a seasonally weak period for its sector.

In the same way, certain segments of the market do better at certain times of the year. For instance, as I discuss at length in my book, the 10 worst share price performers in the FTSE All-Share (calculated over the three-year period to end-December) have a habit of performing very well between the middle of December and through into January. Also, in bull markets, companies that drop out of the FTSE 100 at the time of the quarterly FTSE International Committee Review, have a habit of outperforming the index as soon as they leave the blue chip index. Again, this offers us trading opportunities in specific company shares throughout the year to exploit the reversal of a negative momentum effect at the precise point when the share prices are expected to bounce.

 

Smart moves: look behind the headline figures to uncover buying opportunities, such as Moss Bros.

 

Chart break-outs

Buying shares based on sound fundamental analysis is not always enough as we need to make sure that the company's share price is exhibiting positive momentum, too, or at least is showing signs of basing out if we are going to try to catch the bottom after a period of underperformance. One of the simplest ways to do this is to screen your watch list of companies for those that are close to, or have just signalled, a chart break-out. I do this on a daily basis using the screening tools from Investors Intelligence (www.investorsintelligence.com).

I use both swing charts and point-and-figure charts to identify potential investment opportunities to investigate. Moreover, if a company has a sound investment case and is undervalued on fundamentals, the chances of a chart break-out proving a profitable entry point is far greater. As soon as this happens, other momentum investors will be tempted to buy the shares to profit from a potential rerating.

This also explains why some of my stock recommendations move so dramatically as I am targeting shares that have the potential to break out of previous trading ranges. I can skew the odds in our favour by also screening for shares on the verge of chart break-outs where the price moves have been underpinned by high trading volumes. In other words, there is conviction among the buyers which makes it more likely the break-out will hold rather than prove to be a false signal.

I also screen companies for those showing positive share price momentum by keeping a close eye on shares registering 12-month highs and those where daily and weekly share price movements have been on above-average trading volumes. In addition, I monitor shares that have shown key day and weekly share price reversals or high and low poles which can be major indicators of a major change in momentum and share price trend.

 

Takeover targets and merger arbitrage

My balance-sheet-based approach to stock picking has the benefit of regularly uncovering investment opportunities that are also potential takeover targets. This is particularly the case when companies are being valued on large discounts to book value even though there are few signs of any financial distress. Rest assured, if my analysis highlights that a company is being miserly rated well below the current value of its assets, and potentially on a far deeper discount to their replacement value, then predators with deep pockets will be doing the same exercise, too.

The catalyst for a bidder to pounce and take advantage of the valuation anomaly on offer is more often than not an improvement in underlying trading in the target company which mitigates the investment risk for the acquirer even further. Hence, my approach is to seek out good-quality companies underpinned by sound balance sheets where there is potential for an earnings recovery, or ongoing earnings momentum to continue, but where I can pick up the assets below book value. The rewards can be mightily impressive, too, as readers who followed my advice to buy into Aim-traded sweet manufacturer Zetar (ZTR), which received a bid only a few weeks ago, will testify ('A sweet investment', 8 October 2012).

This approach to investing also explains why my annual Bargain Shares portfolios, which are based on the writings of the grandfather of value investing Benjamin Graham in his classic book, The Intelligent Investor, have been littered with companies that have subsequently succumbed to takeover bids. To name but a few, these have included housebuilders Ben Bailey and Crest Nicholson; computer components distributor Fayrewood; recruitment company Quantica; industrial group Delta; and clothing retailer Jacques Vert.

 

Ideal Shopping Direct had cut costs and was generating cash profits despite reporting pre-tax losses.

 

Merger arbitrage

The main point to note is that most bids are made at a premium to book value to tempt existing equity holders to part with their paper. However, if a company is being valued below book value in the first place, then we can get a double whammy of gains when it is taken over. That's because we benefit from both the share price discount to book value, implicit in the price we paid when we first acquired the shares, being realised as well as the premium to book value the acquirer is willing to pay.

We can also make money by playing the bid arbitrage game by buying shares in companies where there is a good chance of a formal bid being launched once the company has announced it is in bid talks after receiving an indicative offer from a suitor. To make life easy, Investors Chronicle publishes a list of all live bid situations on a weekly basis to cast your eye over.

Therefore, in any bid situation it's imperative to weigh up the risk:rewards to ascertain whether the risk you are taking on by buying shares in a target company after the initial bid approach has been made, but before a formal bid is launched, offers you adequate compensation. To do this you have to work out whether the difference between a bid target's share price and likely level of a recommended offer is wide enough to compensate for the risk that a formal bid may not materialise and how much the target’s share price would fall in that event.

We certainly do, which is why earlier this year we recommended buying shares in African oil explorer Cove Energy (COV) after three bidders made takeover approaches. True, sometimes the bid doesn't go through even after a formal bid has been launched, as was the case with my advice to buy shares in Goals Soccer Centres (GOAL), but more often than not there is a profit to be made playing the M&A game.

 

Macro backdrop

Investors who ignore the macroeconomic backdrop do so at their peril as this has a great influence on how certain sectors will perform at various stages of the business cycle. For instance, in the early stages of a bull market expect higher-risk assets to perform best and small and mid-caps to outperform large caps. Break down the sectors within these groups and financials, media and early cyclical sectors more often than not lead the stock market charge while defensives trail behind.

It is equally important to decide whether the interest rate environment favours allocation of assets in inflationary or interest rate sensitive sectors. This is more crucial now than ever before because the effects of three-and-a-half years of quantitative easing means that markets are moving from periods of 'risk on' to 'risk off' trades characterised by sector rotation from higher-beta stocks and cyclical sectors ('risk on') into defensive and lower betas ('risk off'). This means screening for companies in the right sector at the right point in the cycle has never been more critical for a stock picker. It also explains why for all of this year I have focused on small caps - the one segment of the equity market that benefits most from a 'risk on' trade underpinned by easy monetary policy.