In addition, I have written no fewer than 320 investment columns since the start of last year including updates on previous buy recommendations virtually all of which have been small- and micro-cap companies. My efforts have not gone unnoticed as I was humbled to receive the Small Cap Journalist of the year award at that prestigious Small Cap Awards, supported by The London Stock Exchange. The nomination also reflects the educational element to my writing.
Indeed, I have attempted to pass on some of my well practised investment techniques to readers who follow my investment columns. It’s not just about picking companies that do well, as important as that clearly is, but to understand why this is the case so that the knowledge learned can be used to good effect to pick out winners in the future. Equally important is to understand why companies which offered potential for share price gains failed to live up to my expectations and not to repeat the same mistake in the future. That is something I certainly spend time considering, albeit the vast majority of the companies I follow have delivered both operationally and from a share price perspective so I have been in the fortunate position of updating my followers with good news for the large part.
That’s not to say that I ignore the losers. For instance, the investment case of Aim-traded companies Polo Resources (POL), Global Energy Development and Bezant Resources (BZT) have all been updated numerous times and far more than the vast majority of my winning trades. It is equally important for all of my followers to realise that although there is a ‘Simon Thompson’ effect which has a bearing on the short-term performance of my recommendations, ultimately the companies have to deliver for the share price to produce the long-term rewards to warrant a re-rating to my target prices. It’s also fair to say that readers who have taken a disciplined approach to investing, and ignore the short-term ‘noise’ in the market, will reap the greatest gains.
Clearly, when it comes to the individual stock selections there are dozens of factors to consider. That’s why I have written a book, Stock Picking for Profit, on the very subject to pass on the knowledge I have accumulated over the past 25 years following equity markets. But if I had to pick out certain techniques I regularly use when analysing companies to screen out the winners from the losers, the following 16 tips would be top of my list:
■ Mitigate financial risk. Lowly geared companies underpinned by strong balance sheets and substantial asset backing reduce the financial risk associated with any investment. This is why a vast number of the companies I have picked out in the past 18 months have either cash-rich balance sheets, or modest gearing with comfortable interest cover.
■ Target improving operational performance. In my view it is far easier to create a virtuous circle whereby operating cash flow is recycled back into the business, used to pay down debt, or returned to shareholders through share buybacks and dividends, for lowly geared or cash-rich companies than for highly indebted companies. Moreover, investors are more willing to recognise strong cash-flow performance by attributing a higher rating to such companies while staying clear of those draining cash. So by identifying highly cash generative companies at a reasonable price then it is possible to benefit from greater shareholder returns.
■ Understand operational gearing. This works both ways as falls in profits in periods of poor trading can be easily reversed when sales pick up again. I always estimate the impact on operating profits of changes in sales to determine the level of operational gearing a company offers. This is critical if a company is showing signs of a recovery in trading.
■ Cash conversion. Almost without fail, I will avoid companies with poor cash flow performance – especially those where increases in operating profits are not being converted into improving operating cash flow. That’s a warning sign to me that the business is sucking in more capital to fund its operations and shareholder value is being eroded due to the negative impact on the company’s return on capital employed.
■ Expansion of earnings multiple. By reducing financial risk, improvements in operational performance can feed through to an expansion of the earnings multiple investors are willing to pay for a slice of a company’s earnings. The key here is to identify companies offering decent recurring revenue streams and visibility of sales to underpin earnings estimates. Companies exhibiting such characteristics are far more likely to appeal to a wider group of investors, and in turn may in time attract a premium rating for a slice of their earnings.
■ Identify potential drivers for earnings upgrade cycle. Potential drivers I look for include growth opportunities to exploit new markets; restocking cycles; new product launches; structural changes in an industry; growth in emerging markets; changes in fiscal and monetary policy.
■ Net asset value growth per share. Most corporate websites give a breakdown of the financial performance of the company over a five-year period. But you can easily build up a track record of the long-term performance of profits, earnings and dividends by tracking back through the annual reports and accounts. You can also find out how much value the company has added over the years by calculating the growth in net asset value per share. This is a far better reflection of how much net profit has been retained by the company after paying out dividends and so how much value has been actually created for shareholders over the years.
■ Management track record. To ascertain the quality of a management team I always look at a company’s annual report and accounts to view the history of the board members. Specifically, I take into account their length of service – the longer the better; roles undertaken at previous employers and the degree of success in these positions; and assess the level of corporate governance.
■ Succession risk. When a founder or chief executive has been the driving force behind a company for many years, it raises questions as to how the business will cope once the director steps down from that position. Moreover, when this change of management happens, it can signify the point at which the growth story is starting to lose its appeal. I am wary of companies where the succession risk is too great.
■ Shareholding structure. It’s always worth finding out whether a company is being run for the benefit of outside shareholders, or for the benefit of a small number of large shareholders who are main board directors. This can create a major conflict of interest where the minority of shareholders have little influence over how the company operates. That’s not to say that companies where the main board control over 50 per cent of the issued share capital can't offer attractive investment opportunities. It’s just that you have to be aware of this risk which is why I always point this out in my analysis.
■ Acquisition risk. Not all acquisitions create value and I am wary of buying shares in companies that have been on a massive spending spree, funded by issuing new shares like confetti. There is also the issue of deferred consideration for these acquisitions, based on earn-out agreements, which can lead to even more shares being issued to the vendors at a later date. As a result, shares in companies that have made several acquisitions may appear to offer value by being lower rated than peers, but more often than not this is a ‘value trap’.
■ Pricing power. The ability of companies to pass on higher input prices varies enormously across industries. Companies in regulated sectors, such as water utilities and transport operators, are more restricted in their ability to raise prices since the government regulator factors in the cost inflation and investment needs of the companies into the regulated price framework. Therefore, it’s always worth considering the defensiveness of a company’s earnings when assessing the price you are willing to pay for a slice if the action.
■ Currency risk. Most companies do not hedge their overseas earnings against exchange rate fluctuations, so when these international sales are translated back into the currency the company reports in it can have a major bearing on financial results. At the moment sterling is riding high against both the US dollar and euro, so it pays to know what proportion of a company’s business is overseas and whether better pricing on imported input costs can offset potential margin pressure on exports resulting from adverse exchange rate movements.
■ Peer group premium risk. Some companies enjoy significant premium ratings based on their PE ratio relative to their peer group. That can be wholly justified by the company’s track record over a number of years, the quality of earnings and the earnings growth predicted. But there comes a point when the premium rating leaves no room for manoeuvre if trading disappoints. The obvious risk is that any contraction in the earnings multiple from an elevated level can lead to a very sharp de-rating of a share price. If this risk is too high it’s best to avoid the shares. The sharp derating in the shares of online clothing retailer Asos (ASOS), the largest company on the Alternative Investment Market (Aim), is a prime example of this as investors reacted savagely to a slowdown in sales growth rates.
■ Volatility risk. There is a huge difference between making a 10 or 15 per cent gain on an investment when the share price trends up in small daily moves, than on one characterised by wild swings in both directions. Higher share price volatility increases investment risk as the downside to your capital is far greater. So to compensate, you need a much higher return. That’s one good reason to assess whether the fair value target price is sufficient enough to compensate for the risk being taken on.
■ Economic risk. At certain times of the year, certain sectors perform much better than others. The first quarter housebuilding effect is a case in point as is the habitual outperformance of my US dog share portfolio in the final quarter each year. It’s also worth noting that growth or cyclical sectors have historically done well in the winter months. That’s because the winter creates economic risks, and to compensate for these, investors can expect higher returns from shares. The reverse is true in the summer, when shares in defensive sectors have performed best.
Clearly, there are many other factors to consider when assessing a company’s investment case and whether to invest or not. You could write a book on the subject as I did. However, assessing risk and looking for specific characteristics in companies showing strong operational performance are undoubtedly key areas to analyse. It has certainly served me well over the years and I will endeavour to try and keep up the good work.
■ Simon Thompson's new book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stock-picking'
