Paul Hill is more than just a smart investor as he is a fine equity analyst, too, at equity research firm Equity Development, a company that specialises in small-cap equity research, my own hunting ground. In fact, it was after reading his equity research note on hospital super bug buster Tristel (TSTL) a couple of years ago that I recommended buying into this special situation. By the time I advised exiting the holding earlier this year, the shares had more than doubled in value. It wasn't an isolated example of successful stock-picking either, as between March 2000 and April 2016 Mr Hill has purchased no fewer than 200 stocks, held them for approximately two years on average, and has achieved a hit rate of winners to losers of 1.6 times.
Importantly, the average gain on those winners is double the financial hit on the losers, hence the thumping 15 per cent average annual gain on his portfolio. To achieve this return, Mr Hill typically buys what he describes as "under-researched" and "out-of-favour" small- and micro-caps (market value less than £100m) where pricing anomalies tend to be greatest. He also follows some hard and fast rules which he has outlined in an in depth 73-page research note that can be viewed for free at www.equitydevelopment.co.uk/doc/1490.pdf . I would advise doing just that because it's full of some of the most sensible observations I have come across in the 25 years I have followed equity markets, and ones that I also follow in my own stock-picking.
For instance, Mr Hill readily admits that taking on greater risk doesn't mean greater return and that adopting a purely "high risk" strategy nearly always ends in disaster, adding that "luck favours the brave, but not the stupid". So to tilt the odds in his favour, he consistently applies value or GARP (growth at a reasonable price) principles to identify quality companies and determine what they are worth; stress test valuations with regards to different scenarios; buys shares which are priced well below their intrinsic value (30 per cent plus discount for small caps and 10 per cent plus discount for large caps), and where he has a 80 per cent plus certainty of generating a positive return.
He defines this as the "margin of safety" or an insurance policy to limit the downside risk and ideally the company will have a pristine balance sheet with plenty of cash, too. And when he uncovers a company that ticks all the boxes and has a high conviction in generating a positive outcome, he will weight his investment accordingly in his portfolio.
Moreover, as regular readers of my online updates on past recommendations will be aware, it pays to monitor companies closely, re-evaluate the investment case regularly and not be afraid to modify views as new information emerges. Mr Hill adheres to this disciplined approach and monitors his investment performance in relation to the ratio of winners to losers to determine his 'hit rate'. He has no problem selling holdings either when they become too expensive or when the rationale behind the decision to invest no longer holds. He also learns from his mistakes and has dedicated a whole section in his report to this area.
Avoiding costly mistakes
To avoid making costly mistakes, Mr Hill adopts strict financial discipline in his approach to mitigate risk. For instance, he avoids companies with significant outstanding debt as defined by net borrowings which are more than 2.5 times cash profits; avoids companies that have heavy working capital cycles (as defined as more than 25 per cent of annual sales) or operate in cut-throat markets; and makes sure that there is not too much stock/sector concentration which "can kill a portfolio especially during black swan events".
Sector exposure is a very important issue, so much so that he has compiled a hit list of industries to tread carefully in including those dogged by over-capacity and 'predatory' pricing - citing steel, solar panels and shipbuilding as prime examples; those suffering from price deflation; environmentally unfriendly sectors (coal mining, chemicals, diesel, solid waste land-fill owners); and where there is a commoditisation risk if China decides to class a market as being "strategically important", as it will inevitably be flooded with new supply. He is also wary of any companies exposed to a backlash against processed foods containing high sugar, fat and salt content, as consumers adopt healthier, all nature diets; those selling capital equipment to the public sector, and to the NHS; and cyclical industries coming off the boil such as commercial property.
Of course, it makes life far easier, and your financial well being far healthier, if you can weed out companies displaying red flags as well as sectors, too. Mr Hill has a list of 27 tell-tale warnings signs to look out for here, including companies with poor cash conversion rates (operating cash flow less than 75 per cent of operating profit) or where trade working capital exceeds more than 25 per cent of sales; are single customer businesses or one with high counter-party risk; are involved in major litigation; can only grow by acquisition and not organically; have large pension deficits that could drain future cash flows or act as a poison pill for potential acquirers; display poor debt collection (defined as debtor days over 60 days) and/or revenue recognition issues; excessively window dress their results; report big one-off costs every year; and capitalise much more research & development costs on the balance sheet than is amortised through the income statement.
He is also wary of companies that have changed their auditor, nominated advisor or finance director more than once in the past two years - suggesting something may be wrong; have completed excessive related party transactions with directors; and have one controlling shareholder, or an overly dominant chief executive. Other red flags include companies listed on Aim, but headquartered in emerging markets, as this raises corporate governance issues; those where management seem accident-prone, thus bringing into question the quality of leadership; and those operating businesses that are too complex to understand.
So having avoided the potential pitfalls, it's just as important to identify the key sectors to consider when hunting out potentially lucrative investment opportunities.
Growth sectors to consider
Mr Hill's hit list of growth areas to consider include many that are on my own watchlist of industries and sectors, so there is a fair degree of crossover here.
Specifically, he is interested in investment opportunities in technology, software, 'internet of things', new payment methods, content digitisation and social media; robotics, driver-less vehicles and automation of corporates/households; combating global warming, climate change and the need for cleaner energy forms; tackling terrorism, migration, tax evasion/avoidance, cyber crime and ID theft; peer-to-peer banking/finance; artificial intelligence; growth of emerging markets and Africa; and population growth and need for water conservation.
He also gives some sensible advice when considering early turnaround situations, an area in which I have a keen interest given that over the years I have managed to produce some eye-watering gains on buy recommendations, including the likes of technology firms Netcall (NET), and consumer-focused companies Ideal Shopping Direct and Walker Greenbank (WGB). In fact, I dedicated case studies on all three in my book Stock Picking for Profit.
In particular, Mr Hill believes turnarounds can take twice as long, and cost twice as much as originally planned - meaning there is usually no desperate rush for investors to get on board immediately. But equally that's where the value of knowing the tell-tale signs of when the best time is to buy. But before then it's necessary to determine a sensible valuation for the business and to understand "what sustainable revenues and operating margins can be achieved under normal conditions". As part of this process, "competitor growth rates and profit margins are taken as benchmarks". He then discounts these back using a suitable "risk-adjusted" rate and relevant valuation multiple (for example 10 times enterprise value to operating profit) to arrive at an indicative valuation range. And only then invests if the upside is substantial, reflecting the elevated risk, and in small amounts initially until the recovery starts to take shape.
Interestingly, Mr Hill prefers 'special situations' which have plenty of cash, or own valuable non-core assets which can be sold, so if there are hiccups there is no need for an emergency fundraising. This chimes with me as I prefer to factor in a decent 'margin of safety' in my own stock selection and target asset-rich companies with little or no debt to mitigate financing risk. Indeed, it was no coincidence that all three companies I mentioned above had strong balance sheets when I initiated coverage. Mr Hill also believes an experienced and strong management is an essential requisite in such special situations, something that is only sensible as strong leadership is clearly required to turn previously poorly-performing businesses round.
What to look out for in great companies
Having identified the sectors and a watchlist of companies within them to target, Mr Hill has a shopping list of key characteristics that make for great companies and investment opportunities.
In particular, he is seeking out companies that meet the following criteria: plenty of pricing power derived from dominant market positions, brands, patents, software, cost advantage and high switching costs; secular and growing demand for products (organic growth rates of more than 1.5 times GDP growth rate); winning market share; recurring revenues at least 50 per cent of turnover; and less dependent on the economic cycle and/or one-off orders.
In terms of the financial metrics, he targets companies generating gross and operating margins in excess of 45 per cent and 10 per cent, respectively; offering a scalable business model with good geographical reach and low counter-party risk; producing strong cash generation - operating cash conversion in excess of 90 per cent of operating profit; and where trade working capital is less than 15 per cent of sales. Ideally, the company should also have a solid balance sheet with borrowings less than one times cash profits, and a pension deficit or other liabilities less than 10 per cent of the market capitalisation.
In terms of management, it's always good to have a top rate team of insiders who own a significant amount of the equity so they have skin in the game, too. To complete the wishlist, and Mr Hill stresses that very few companies possess all the above qualities, he is looking for companies that consistently generate a return on capital employed in excess of 15 per cent through the cycle.
So, having identified the target, it's time to crunch the numbers as "great companies are clearly not worth buying at any price". Interestingly, Mr Hill's preferred metrics of enterprise value to operating profit, price-to-earnings ratio, PEG ratio and cash flow yield are some of my favoured ones, too, although I also use price-to-book value ratios and sum-of-the-parts valuations in my valuation techniques to uncover anomalously priced investment opportunities. For good measure, Mr Hill's research note also includes some worked examples.
Clearly, there is no magic formula to stock-picking, and different techniques or valuation methods have varying degrees of success at different points in the stock-market cycle. However, Mr Hill has proved that his investment techniques have generated returns that the best fund managers would be proud of, and that's why I feel his observations are well worth noting.
Please note that I am now on annual leave and my next online column will be published at 12pm on Wednesday, 25 May 2016. A comprehensive list of the 175 invetsment columns I have written in 2016 is available on my home page of our website.
