What company fundamentals matter most to the UK's top professional investors? I've spent the quiet summer months finding out some of the must-have investment essentials for three of Britain's best fund managers. These investment criteria provide a great insight into the process that drives the outperformance of their funds, as well as representing a great list of top stockpicking tips for private investors.
So, without further ado, let's introduce our three stockpicking luminaries, and discover their investment essentials.
GOING FOR GROWTH (BUT ONLY AT THE RIGHT PRICE)
Mark Slater
Mark Slater's investment essentials are based on the screening process he uses for the MFM Slater Growth fund (GB00B0706C66), of which he says: "We're looking for businesses that are growing faster than average and are cheaper than average and generate cash. Once we've found all that, we would probably do quite well even if we didn't do the rest of our qualitative research."
Mr Slater co-founded Slater Investments in 1994, and in 2005 launched the flagship growth fund, which has gone on to win many industry awards. The principles behind the growth fund's approach to stock selection build on the ideas set out by Mark's father, Jim Slater, in his classic investment book "The Zulu Principle", which Mark edited. Before moving into fund management, Mark wrote for this magazine as well as Analyst plc.
Here's how Mr Slater's MFM Slater Growth fund has done over the past 10 years.
Mark Slater's Investment Essentials
1. Price-earnings growth (PEG) ratio
The PEG ratio is calculated by dividing a stock's price-earnings (PE) ratio by its earnings-per-share (EPS) growth rate:
PE/EPS growth
The idea behind the ratio is an attempt to assess the price an investor is paying for earnings growth. The PEG is a two-dimensional measure, whereas the PE is one-dimensional. The ratio was popularised for many UK investors by Jim Slater in "The Zulu Principle".
Several other famous investors are also strong advocates of the PEG ratio, including US investment doyens John Neff and Peter Lynch. These investors use a slightly different formula for the PEG as they combine the EPS growth rate used in the denominator of the formula with the stock's dividend yield (see below). The combination of earnings growth with yield is often referred to as a stock's 'total return' - this is not to be confused with the performance measure of the same name, which is a combination of share price movement and dividends paid over a given period.
Neff/Lynch PEG ratio
PE/(EPS growth + DY)
The general rule of thumb with the PEG ratio is that a value of less than one indicates that a stock is potentially cheap. Mark Slater's approach is more nuanced.
Mr Slater says: "We want to be buying growth cheaply and the quick-and-dirty method we use for this is the price-earnings-growth (PEG) ratio. This is very effective if it is applied in the right way. If the PE and growth rate are within the normal range - a PE between eight and 20 and a growth rate between 10 and 25 per cent - the ratio works better.
"We ideally want a PEG ratio of less than one for leading companies, which we consider to be mid-FTSE 250 and FTSE 100 stocks, and for smaller businesses we look for 0.75 or less.
"We favour faster-growing businesses but occasionally find slower-growing (10 per cent or so) companies attractive if they have a very low PE. We will also look at businesses with a higher PEG if they are very reliable or very cash-generative.
"We are always looking forward with our PEG ratio and we use next-12-month growth figures to calculate the PEG. This enables comparison between companies with different financial year-ends."
2. Earnings growth rate
On the face of it, the idea of an EPS growth rate is straightforward enough. However, there are a few factors pertaining to EPS growth that investors need to consider. A key question is what type of earnings are being looked at. Companies and brokers often report or forecast adjusted EPS. These figures are provided to give a better underlying picture of a company's performance by ignoring one-off items that would cause an unfair assessment of the year's achievements or failings. However, EPS adjustments can turn into an exercise in unwarranted corporate flattery, which is why some investors prefer to look at the warts-and-all statutory numbers reported by a company. The assessment of what numbers to use is best judged on a case-by-case basis. Mr Slater uses normalised earnings as his kick-off point when screening for ideas, but stresses the importance of looking beneath the bonnet carefully later in the process.
Another major consideration with earnings growth rates is the period over which growth is being assessed. Historic growth rates give investors hard facts about what has actually happened, whereas forecast growth rates offer an opinion about the future. However, this opinion is often very wrong and frequent revisions will occur during the course of a year.
Earnings data relates to different financial year-end dates for different companies, so better comparisons can often be made between companies by using trailing-12-month (TTM) figures and next-12-month (NTM) forecasts.
Mr Slater says: "We are ideally looking for dynamic growth that can be sustained. We start off by targeting companies that are forecast to grow by at least 10 per cent and ideally over 15 per cent on a next-12-month basis. Later in the process, we focus on the crucial question of reliability and sustainability. We want businesses that can grow at an above-average rate for a long time.
"We like businesses with a decent growth track record, but we also like to look forward. Forecasts aren't perfect and near-term ones are better than long-term ones. What we want is a growth number that is sustainable on a multi-year basis and identifying this is where our qualitative research comes in.
"We also look at track record. If a company has very erratic earnings all of the time but good forecasts, we're not interested.
"People get fixated with the year-end and there can be a tendency not to look forward to the next year until after results. There can be opportunities that come from this market tendency."
3. Cash flow
Most investors know the phrase 'cash is king', but the practice of analysing cash flow is arguably underused. It's not hard to understand why many investors don't like to grapple with cash-flow statements. For many reasons, cash flows can vary significantly from year to year, making the progress of a company far harder to interpret than the more manicured version of events investors receive from a company's income statement. A good finance director should ensure the earnings statement is a smoothed-out but fair reflection of cash coming through the door. However, intentionally or otherwise, this does not always turn out to be the case and poor cash conversion can be a warning of problems to come. Likewise, high levels of cash generation can mean a company is more attractive than the income statement suggests.
The cash conversion measure used by Mr Slater compares net (after tax) operating cash inflows per share with earnings per share. Specifically, Mr Slater wants to see cash flow per share (CFPS) that is higher than EPS.
To put it another way: CFPS/EPS > 1
Generally speaking, it should not be considered too much of a push for CFPS to come in above EPS given the advantage of adding back depreciation and amortisation.
Mr Slater also looks at free cash flow (FCF) - a ratio also highlighted by Jeremy Lang - see below.
Mr Slater says: "We look for profits turning into cash and we also look at free cash flow. We typically favour companies that have good cash flow that are not capital intensive. We find capital-intensive businesses less interesting.
"We like a good FCF yield. We regard FCF as the cash flow that is available to the board after the maintenance of the business and we try to distinguish between maintenance and expansionary capital expenditure.
"When you have a company converting its profits into cash, you are unlikely to find serious accounting problems. "
THE KING OF BUY-AND-HOLD
Nick Train
Nick Train is arguably the UK's foremost practitioner of buy-and-hold investing, with an average holding period of about 18 years. He has produced stunning returns for investors in his fund, thanks to his unflinching focus on the long-term quality of the companies he invests in. His investment philosophy is based on his belief that investors undervalue durable, cash-generative business franchises. Other principles that underpin his style are his belief that a concentrated portfolio can reduce risk, his view of transaction costs as a "tax" on returns which should be avoided, and his conviction that dividends matter even more than everyone thinks.
Mr Train co-founded Lindsell Train in 2000 with Michael Lindsell. Mr Train manages UK equity portfolios and jointly manages global portfolios. He has more than 30 years' experience in investment management and held prominent positions at M&G Investment Management and GT Management before setting up in business with Mr Lindsell.
Here's how his CF Lindsell Train UK Equity fund (GB00B18B9X76) has done over the past 10 years.
Nick Train's Investment Essentials:
1. Dividend growth and share buyback record
The importance of dividend growth to investors is such that whole indices have been designed around the concept, which can be invested in through tracker funds and exchange-traded fund (ETFs). Popular examples of such indices include the Dividend Aristocrats, an index of companies that have consistently increased their dividend payouts for a quarter of a century or more, and Dividend Achievers, made up of companies that have managed a decade or more of increases.
From the perspective of stock analysis, the value of looking for impressive dividend growth is that a strong track record can indicate that a company has a number of other characteristics that will make it a high-quality investment.
Mr Train's views on the value of dividend growth records chime somewhat with the famous quote of US investor Peter Lynch: "Go for a business that any idiot can run - because sooner or later, any idiot is probably going to run it".
Mr Train does not restrict his analysis to money returned to shareholders solely through dividend payments. He also looks for a company's record of buying back shares. Share buybacks are a more contentious issue for many investors than dividends due to concerns that companies can be guilty of paying too high a price for their own shares, thereby not making the most effective use of cash. Investors also often voice suspicions around the motivation for share buybacks, citing cases where managements have been incentivised to grow EPS and buybacks may have been used as a means to achieve this aim (by reducing the number of shares in issue) without achieving much profit growth at the company level. Well-managed and judicious buybacks can be hugely advantageous to shareholders over the long term, though, and retailer Next (NXT) is often given as an example of the value creation that can be achieved.
Mr Train says: "Do I actually understand how this company makes profits? Are there credible reasons to believe the company has a sustainable competitive advantage in doing what it does?
"Looking back - preferably 20 years or more: has this company either grown its dividends a very great deal or retired a lot of its shares outstanding? These are signs that a company is not only a long-term winner, but that it has been run in the interests of shareholders.
"Then looking ahead: if I invest and forget about my investment for 10 years, do I think it highly likely the company will after that decade not only still be recognisably doing what it does today, but will the prices it charges for its products or services have increased by more than the rate of inflation? If the answer to this turns out to be 'yes', it is almost guaranteed to be a winner."
2. A recession-ready balance sheet
What constitutes a strong balance sheet is a mutable concept, but there are a number of commonplace measures investors can use. Interest cover (operating profit/net interest expenses) and the current ratio (current assets/current liabilities) give an indication of how well-placed a business is to settle upcoming bills - only debt financing bills in the case of interest cover. Gearing (net debt as a percentage of net assets) is used to see how comfortable debt looks compared with a company's asset base. Not all companies require a large asset base, though, which is one of the reasons for the popularity of the cash-profits-to-net-debt ratio. This ratio attempts to compare debt with the profits that are theoretically available to pay off borrowings.
What level of debt is appropriate for a company to carry depends very much on the characteristics of a business. For example, investors can take less solace from the large asset bases of companies that tend to become unproductive during a recession, such as housebuilders or equipment hire companies. Indeed, this type of company often finds earnings dry up and the value of its capital plummets at times of crisis, which means debt becomes far more risky than it appears when trading is buoyant. By contrast, a utility company that requires a large asset base to operate can be confident that its assets will continue to generate good returns during a downturn, which means it makes sense to take on larger amounts of debt to fund growth and improve shareholder returns.
Meanwhile, some companies throw off cash when business deteriorates, such as recruiters which no longer have to deal with payments to temporary workers that tend to be made before the wages are collected from the employers.
Mr Train says: "Is the company conservatively financed? This is hard to be sure about because definitions of financial conservatism vary from industry to industry. But try to play it safe because debt is a company killer, particularly during recessions. And no one - not economists, not the companies themselves and certainly not you or me - can predict when the next recession will hit."
3. Take-out multiples
Mr Train is famed as an investor whose success has been built on buying quality companies while putting relatively little weight on the question of valuation. A classic 'quality will out' philosophy. However, he does pay attention to the take-out multiples of the peers of companies he is interested in.
Take-out values are of particular interest for long-term buy-and-hold investing. Bidders tend to be less focused on the short-term sentiment-driven concerns of the market, which tend to lead to unjustified pricing extremes. Instead, acquirers have to make an assessment of the true long-term value of a company, which requires them to think like business owners - an approach to valuation espoused by Warren Buffett, perhaps the most celebrated of all living investors.
The different perspective helps explain why take-out multiples are often based on ratios, which are not so commonly used to value listed companies. For example, while the most ubiquitous valuation measure applied to listed companies tends to be the PE ratio, the equivalent when it comes to takeovers tends to be the enterprise-value-to-cash-profit (EV/Ebitda) ratio. The big distinction between the two ratios is that enterprise-value-to-cash-profits is a profit-based valuation that takes into account all claims on the company from both its shareholders and creditors, whereas a PE ratio is a profit-based valuation that only looks at the equity portion of a company's value and ignores debt.
The ubiquitous takeover ratio:
Enterprise value (market capitalisation, plus debt minus cash)/earning before interest, tax, depreciation and amortisation (Ebitda)
Or EV/Ebitda
Mr Train says: "Investors can overrate the importance of 'valuation'. Or put another way: plenty of apparently 'expensive' companies go on to be great investments and many ostensibly 'cheap' ones disappoint.
"However, there is one valuation signal we watch attentively. Whenever there is a takeover deal in the same industry as a company we are interested in we look closely at the price paid and the implied valuation. Boards of public companies that sanction a takeover bid for a rival are giving a clear and helpful marker about what they, as experts, think is the true strategic value of constituents in their industry."
BACK ONCE AGAIN WITH THE ILL BEHAVIOUR
Jeremy Lang
Jeremy Lang's investment approach takes its cue from the field of behavioural finance. Specifically, Mr Lang attempts to exploit the biases that results from the behaviour of three participants in equity markets: company management, analysts and investors. Mr Lang's 'Investment Essential' focuses on identifying good management.
His interest in irrational investor behaviour centres on the tendency of investors to overreact by placing too much weight on a narrow range of information to draw black and white conclusions. This leads him to look for stocks with unusually high levels of anxiety attached to them, which gives his investment approach a 'value' focus. He is also interested in irrational behaviour by analysts who he believes tend to underreact to events. He aims to profit from this by studying past patterns of forecast errors to try to find companies that are likely to receive forecast upgrades from analysts in the future. This gives his approach a 'growth' focus.
Mr Lang spent over 13 years at Liontrust before setting up Ardevora Asset Management alongside long-time colleague William Pattisson in 2010.
Here's how Mr Lang's Long/Short Ardevora UK Equity fund (IE00B431SY72) has done since he launched it in February 2011.
Jeremy Lang's Investment Essential
Free-cash-flow return on assets
Mr Lang's investment essential focuses on assessing the quality of a company's management through a clever analysis of fundamentals from the cash-flow statement and balance sheet. Mr Lang's objectives in his analysis has some similarity to Mr Train's interest in looking at dividend growth records as it attempts to get to the nub of how a business is being run and who it is being run for. Central to Mr Lang's analysis is a version of the return on assets ratio, but one that looks for returns based on free cash flow rather than profits. While free cash flow is classically considered to be the amount of cash generated after capital expenditure for maintenance but before expenditure on growth, the rough-and-ready shorthand calculation often used is:
FCF = operating profits (Ebit) adjusted for company's tax rate + depreciation and amortisation - changes in working capital - capital expenditure
To calculate the free-cash-flow return on assets FCF is divided by total assets (TA).
FCF/TA
Mr Lang says: "We believe that the people who run publicly quoted companies can be susceptible to overconfidence. This can create problems when a business is either under stress, or running out of opportunities to grow. We look for companies where management is behaving conservatively; this is the best way to control risk.
"Conservative behaviour can be revealed from financial statements. Balance sheet and cash-flow statements reveal how patient and how effective a company's investing has been. One of the things we pay particular attention to is a company's free cash flow in relation to its growth.
"Free cash flow can be tricky to calculate: in the three parts of a company's cash-flow statement are the sources of cash coming into a business (which mostly reside in the cash-from-operations (CFO) part of the statement) and where that cash goes (mostly in the cash-from-investing and cash-from-financing parts).
"We prefer companies that spend less than they make most of the time - they consistently generate free cash flow - but are still able to grow. This combination usually means management is disciplined in its investment, but also runs a business where their investment decisions are unusually effective; conservative rather than overconfident behaviour.
In summary, we want positive free-cash-flow-to-total assets (FCF/TA) with reasonable TA, CFO or revenue growth."
