A simple and powerful approach to stockpicking – but will it still work?

For me the whole purpose of investing is to grow the buying power of your savings. To do this you have to get a return on your money that is greater than the rate of inflation. If you can do this then your money will buy more things in the future than it will today.

Before the financial crisis it used to be much easier and safer to achieve this. The rate of interest on savings and accounts and government bonds was more than the rate of inflation, but it hasn’t been for a long time. 

The best instant-access savings accounts currently pay around 1.2 per cent, while lending your money to the government for 10 years – by investing in government bonds – pays a measly 0.3 per cent. The current rate of inflation is 1.5 per cent (based on the consumer price index).

Unsurprisingly, lots of people have been forced to turn to the stock market to get inflation-beating returns on their money. But the recent sharp falls in share prices have served as a harsh reminder that the levels of risk involved can be very high. Shares that were once seen as safe have been found to be anything but. 

One of the most successful stockpicking approaches over the past decade – and in the recent market turmoil – has been one of the simplest. It has been to find very good companies, try not to overpay for their shares and hold on to them.  

This has been the strategy of Terry Smith, whose FundSmith investment fund has delivered superb returns for its investors. A similar strategy is also followed by high-profile fund managers such as Nick Train and newer funds such as the Blue Whale Growth Fund. 

Identifying very good companies 

Lots of things go into making a good company. First and foremost, it must make and provide good products and services that add value or satisfaction to its customers. 

This might take the form of performing a task, solving a problem, saving money, making something more efficient or providing pleasure or enjoyment. Very good businesses will do this better or cheaper than competitors and will often have some form of edge – often referred to as competitive advantage or an economic moat – that keeps things this way.

The other characteristic that it must have is a capability to grow its revenues and profits in the future. Without this the business is very unlikely to increase in value, which is what investors ultimately need.

These are the type of things that you should be trying to identify when looking at a company. You don’t find this out just by looking at numbers in its accounts.

That said, companies with the type of desirable characteristics that investors seek often have hallmarks that can be spotted by looking at its accounts. They tend to be very profitable and are very good at generating lots of surplus or free cash flow.

Getting back to the subject of interest rates, it is possible to identify a company that might be a very good investment by calculating the interest rates from its business activities. In my opinion, the best way to go about doing this is to calculate two ratios: Return on capital employed (ROCE) and free cash flow margin.

Return on capital employed (ROCE) 

An interest rate tells you what the amount of money you are getting back (or paying) as a percentage of the money you have invested (or borrowed). 

As far as investment is concerned, ROCE compares a company’s trading or operating profit with the money invested in it or capital employed. 

Most investors tend to use adjusted or underlying operating profit as their profit number. Calculating money invested or capital employed is not as straightforward and is open to debate.

You get all the numbers you need to calculate capital employed from a company’s balance sheet. You can calculate it from the asset side or financing side of the balance sheet to get the same number. 

To give you a simple example of how this works, you can think of capital employed in a very similar way to buying a house with a mortgage (debt) and savings (equity). If you buy a house for £100,000 with a mortgage of £90,000 and savings of £10,000, the capital employed is the £100,000 value of the house asset or the sum of the mortgage and your savings. The number is the same. 

To calculate a company’s capital employed from the asset side of its balance sheet:

Capital employed = total assets minus non-interest-bearing current liabilities.

What this means in practice is:

Capital employed = total assets minus current liabilities + short-term borrowings.

From the financing side of the balance sheet:

Capital employed = total equity + total borrowings + other non-current liabilities.

Let’s take a look at consumer healthcare, hygiene and infant nutrition giant Reckitt Benckiser (RB.) as a practical example of this.

Reckitt Benckiser: capital employed

Source: Annual reports/Investors Chronicle

We can see that the asset and financing side numbers are the same. One important thing to note here is that a company’s cash balances are not netted off when calculating capital employed. Many investors net them off; I do not in order to be conservative. Most cash balances are often not freely available to pay off debts, they are often an issue of timing because expenses are unpaid at the year end and these have already been subtracted in current liabilities.

If you are confident and knowledgeable enough to estimate a company’s true excess cash balances then by all means net them off assets and total borrowings. Otherwise leave them alone and be safe in the knowledge that you are being conservative with your estimate of ROCE.

Reckitt Benckiser: ROCE

Source: Annual reports/Investors Chronicle

We can see here that ROCE based on the year-end capital employed in 2019 was 12.5 per cent and on average capital employed was 11.3 per cent. These are reasonable but not great numbers. As a rough rule of thumb, anything over 15 per cent is good.

As capital employed numbers tend to be based on year-end balance sheets they can be distorted by heavy investments or acquisitions close to the end of the year. To reduce this effect you can calculate ROCE based on an average of opening and closing capital employed or just opening capital employed.

Using year-end capital employed is also useful as it tells you how profitable a business is with its current level of operating profits.

However, this is measuring the return on the total amount of money invested in the business, which is essential – but you also need to get a feel for how much it is making on the operational capital employed.

Reckitt has spent a lot of money over the years buying companies. In doing so, it has paid large amounts of goodwill – a premium in excess of the value of the net assets bought. If this is taken away from capital employed, we can calculate return on operating capital employed (ROOCE).

Reckitt Benckiser: ROOCE

Source:Annual reports/Investors Chronicle

This number is much better and shows that there is a very decent business here, but perhaps the company paid too much for its acquisitions. The 2019 accounts confirm this as the company wrote off over £5bn of goodwill because it could not make an acceptable return (profit) on its acquisition of infant formula company Mead Johnson in 2017.

You should always look at ROCE over a reasonable period of time to see how a business performs over an economic cycle. We can see here that Reckitt Benckiser’s ROCE and ROOCE has been very high and quite consistent, which is a good sign, but it has come down significantly in recent years, which is grounds for concern.

Free cash flow margins

Good businesses are not only very profitable, but turn those profits into free cash flow which can be used to make shareholders better off by paying dividends, making acquisitions and paying off debts.

One of the best measures of a company’s cash generating ability is its free cash flow margin. This compares a company’s free cash flow as a percentage of its revenues.

Free cash flow margin = free cash flow/revenues

The calculation of Reckitt Benckiser’s £2,093m of free cash flow for 2019 is shown in the table. It does not include the cash inflows from asset sales as I see them as unrelated to the day-to-day operating of the business.

Reckitt Benckiser: free cash flow calculation

Source: Annual reports/Investors Chronicle

Its free cash flow margin in 2019 was an impressive 16.3 per cent.

The consistency of Reckitt Benckiser’s free cash flow margin over the years is very impressive and is one of the reasons why investors like its shares.

Valuing shares – free cash flow yield

ROCE and free cash flow margins are a good way of confirming whether a business is good or not. Now you have identified the interest rate on a business, you need to work out the interest rate on buying the shares at their current price.

In order to give us a chance of earning inflation-beating returns on an investment in shares it is important not to overpay for. We need to get an interest rate higher than inflation, and the higher the better. One very popular measure of the interest rate on a share is free cash flow yield:

Free cash flow yield = Free cash flow per share/Share price x 100%

Free cash flow has been increasingly seen over the years as a better and truer measure of company performance than earnings per share (EPS). I agree with this, but it does need to be used with care and I’ll write about this in the future.

You have two choices when calculating free cash flow per share. You can use the weighted average number of shares in issue for the last financial year, which is the same basis for calculating EPS, or use the total number of shares outstanding instead. You can find this number in the share capital note in the accounts. Remember to only use the shares outstanding, which means subtracting any shares that are currently held in treasury by the company.

RB: FCF per share & FCF yield

Source: Annual reports/Investors Chronicle 

Based on its current share price of 6,601p, Reckitt Benckiser offers investors a free cash flow yield of 4.5 per cent.

Making sense of free cash flow yields

Once you have calculated a company’s free cash flow yield you need to compare it with other key numbers to see if it indicates whether its shares may be under- or overvalued.

The first two numbers to compare it with are the yields on government bonds. 4.5 per cent is very attractive compared with the 0.3 per cent on government bonds and is also helpfully more than the current 1.5 per cent rate of inflation.

Yet just because bond yields and inflation are currently low does not mean the shares are cheap. Stocks should offer higher yields than bonds because they are more risky and they should also offer a decent buffer over inflation.

Not so long ago government bonds used to regularly yield 2-3 per cent more than inflation. We may be in a different world now, but if that relationship returned then 10-year government bonds would offer yields between 3.5 per cent and 4.5 per cent today. Put another way, Reckitt Benckiser shares are offering a yield that under normal conditions (where central bankers don’t keep interest rates artificially low) less risky government bonds should offer.

4.5 per cent may not seem great, but if we calculate Reckitt’s free cash flow yields for the past 12 years it’s actually not far off its average value. The question is: has paying these valuations been a good investment in the past?

The simplest way to work this out is to look at the changes in share price and dividends received (total shareholder return) over periods of time. The other thing you can do is look at how much free cash flow per share you are getting now compared with the price you paid for the share – the free cash flow yield on cost.

Over the past five years, returns to shareholders have been poor, with free cash flow per share barely growing since 2017. Reckitt’s share price is around the same as it was five years ago, although shareholders have pocketed dividends as some form of compensation.

Anyone who bought the share five years ago on a free cash flow yield of 4 per cent is only getting a 5.1 per cent free cash flow yield on their purchase price now, which kind of explains why the share price hasn’t gone up much.

Longer-term owners have fared better. Someone who bought the shares 11 years ago on a free cash flow yield of 6 per cent is now getting a free cash flow yield on their purchase price of 11.3 per cent, which is a much better result. Unless profits collapse or interest rates soar – and free cash flow yields with them – they are unlikely to lose money on their investment. This is a good example of why much you pay for a share is very important – sometimes the future expected growth that you had hoped for does not materialise.

Are UK quality shares too expensive?

For some time, many investors and commentators – including myself – have asked whether the valuations of highly profitable and dependable shares are too expensive as the free cash flow yields on many have been very low.

The short answer is that what seem like very low free cash flow yields can be justified by low interest rates, low rates of inflation and above all else an ability to keep on growing free cash flows per share.

The coronavirus-led lockdown of the economy means that future growth – in the short term and perhaps even the long term – is very uncertain. Forecasts of future profits are even more guesswork than usual.

All we have to go on is what companies have produced in the recent past and whether the direction of future free cash flows is up or down from this base. On this basis, I can see possible attractions in shares of accounting and business software provider Sage (SAGE), which looks to have a business model suited to a changing world. I struggle to see how Unilever (ULVR) will double its free cash flow per share again in the next five years’. Other UK quality shares have big questions over their businesses – Rightmove (RMV) – or valuations: Spirax-Sarco (SPX) and Halma (HLMA).

UK quality shares

Source: SharePad/Investors Chronicle

What about US tech shares?

US tech shares look expensive, but in a low interest world they are better than many alternatives. Many are very profitable and above all else you can believe that they have the potential to keep on growing their free cash flows.

US tech: free cash flow yields

Source: SharePad/Investors Chronicle

The key issue is this: They need to keep growing strongly to give investors who buy the shares today a reasonable yield on cost in the future. If growth falls short of expectations or interest rates on government bonds were to spike up (for instance because governments are borrowing unprecedented amounts of money) then these shares would struggle and perhaps suffer big share price falls (along with the rest of the stock market).