The changing role of investment analysts

When I started training to be an investment analyst in the 1990s, the key areas of focus were on using company annual reports and accounts and talking to company management. Both are still very useful things to do, but these alone may not be enough to give you a chance of stock-market beating returns.

Eventually everything boils down to numbers, but the numbers reported in company reports are down to the success or otherwise of the businesses they own. Yet today’s analysts are arguably spending too much time on number crunching and not enough time trying to understand businesses and industries and their role in the world going forward.

I have spent a lot of my career crunching numbers to make investment decisions and have even written a book about it. The process can be extremely useful in helping you understand businesses and the opportunities and risks that they face but it took me a long time to realise that a broader and deeper approach to company research is needed.

What is your edge?

In a bull market you can be forgiven for thinking that research is irrelevant when you see people making lots of money by just buying stocks that are going up. If you are investing for the longer term rather than gambling then it’s usually the case that you need to do some homework before you part company with your money.

It’s important to understand that these days it is now very difficult – but not impossible – to get an information edge over others by researching companies. Financial results, presentations and even conference calls that used to be the preserve of professional investors are now freely and rapidly available to everyone. Yes, you will know more by reading and listening to these than those that don’t but you will still be in a very large and crowded space in terms of your knowledge base.

If you are going to succeed in trying to get an edge it helps to have a plan. For example, are you going to concentrate on very small companies, spin-offs or beaten up stocks that often get ignored? Or are you going to concentrate on very big companies that have already become successful or new technologies?

The former set of companies have traditionally been fruitful hunting grounds for investors but it is the latter set that have prospered hugely in recent years despite the uncertainties associated with new technologies and the fact that big companies are well known and generally tend to find it harder to get bigger.

How to get an edge

Before you commit to spending time and effort researching a company you need a source of ideas. There’s no shortage of places to look. Generally speaking, the more companies you look at the more chance you have of stumbling across something that is interesting and promising. Try to be open minded as well and focus on facts. It’s very easy to let your prejudices and preconceived ideas about something dismiss a company when it might actually be a very good investment.

Financial newspapers and magazines have their place and are also good for keeping up to date with what’s going on, but you should also not be afraid to cast your net wider.

The internet is a great resource for reading about and researching companies, but needs to be used with care. They can be great places for getting an edge. I find that product and industry forums can be really useful. Here you can often find customers of a product or a business writing very candidly about them which can reveal opportunities and risks. 

Bear in mind that the internet is a great place for people with a grudge or talking their own book, but if you see more than a few different different sources saying something positive or negative about a product or company you might want to look into it further. Many years ago, I used to cover a company with a very profitable product that was apparently protected by patents. On an internet forum, installers of the product started to chat about the company losing court cases against competitor products. Shortly afterwards a profit warning followed and its profits collapsed over the next 18 months.

You should be very wary of stock market bulletin boards and sites like Twitter. There are some very good people on there who share intelligent insight but there are also plenty who have set themselves up as judge and jury on a company and just overly ramp its future prospects and say how cheap the shares are. 

Quite often, the companies concerned are high risk and do badly when the economy turns down. I’ve seen plenty of people on social media that all own the same stock, but unsurprisingly don’t when things turn sour. The golden rule here is do your own research, form your own ideas and don’t blindly copy others. 

The bad thing about using the internet is that you become too dependent on it and become detached from what’s going on in the real world. I still think there’s great deal of value for getting out there and walking the streets and talking to people. A walk around your local neighbourhood can be very useful in gauging changes in the economy and trends in industries such as construction and retail.

I find it really useful in talking to people who run their own businesses. They are usually quite happy to talk to you about them and you can often learn a great deal about general economic activity and trends which can give you a different insight into the prospects for companies listed on the stock exchange.

Young people are very good sources of new and developing trends, particularly in areas such as technology or fashion. Asking your teenage children what the latest cool thing is may give you an insight into a trend before it becomes more well known in the mainstream media.  

It also pays to read the non-financial media. The weekend newspapers contain many supplements that go straight into the recycling bin without being read. However, from time to time you will find articles about businesses or a new trend in society that will give you an idea. The adverts in these publications can also alert you to new businesses and products with investment  implications for shares you already own.

Wherever you get your ideas from, make sure you understand what a company does and how it makes money. If you can’t explain this to a friend in two minutes it might be a good idea to consider another company instead.

Spend more time analysing businesses rather than crunching numbers

When you have found a company you like the look of, resist the temptation to start crunching numbers from its accounts or looking at analysts’ forecasts for future profits straight away. The real value in researching companies to identify winning shares and avoid losing ones comes from taking the time to work out what makes them tick and the opportunities and threats that they may encounter.

Put simply, you need to focus on two main things. Can the company keep on doing what it has been doing successfully and above all else, can it keep on growing? The ability to keep competition at bay and to grow sustainably are the key drivers of the long-term value of any businesses. These two issues are what you should keep referring back to when researching any business.

Analyse a company’s competitive position

Many businesses have become great investments because they have been able to consistently grow without competitors eating their profits. There are many reasons for this such as great products, scale economies, patent protection and network effects (which explain why the more people use something the more valuable it becomes). This makes them hard to copy.

This kind of scenario has been playing out with the big technology companies on the US market which has led to some saying that they have become too dominant. Whether this will lead to some of them being broken up remains to be seen but the risk is something that investors need to be aware of.

Competitive strength is a constantly evolving situation that can be disrupted. The high rates of profitability that often come from some form of dominance can disappear. For example, Amazon sees the high profit margins made in some industries as a source of opportunity to grow. Asking yourself whether the business you are looking at could be of interest to Amazon (US:AMZN) is a useful thing to do.

Where will the future growth come from?

Without growth that can compound over long periods of time it is difficult – other things staying the same – for companies to become more valuable. You therefore need to spend time working out how a company can grow its revenues, profits and cash flows in the future. Not all sources of growth are as valuable.

Revenue growth is the key measure to focus rather than profits that grow from cutting costs.

Selling more to existing customers is usually the best form of growth followed by entering new markets and selling new products. Growth is rarely costless and therefore growing by investing heavily in new assets or by buying companies is usually not as valuable as growing from existing assets (often referred to as organic growth).

You also need to take into account the relationship between volume (selling more stuff) and prices in delivering revenue growth. A company that jacks up its prices every year risks upsetting its customers and can also be a sign of a peak or declining market for a product.

Look for businesses that put customers before shareholders

The concept of shareholder value where a company is managed first and foremost for shareholders has become badly discredited. I have seen many instances of where companies have cut costs, slashed investment and sacked employees in order to keep shareholders happy. This has come at the cost of the long-term growth of the business with a deterioration in staff morale and customer satisfaction.

I think it’s much better to look for businesses that manage them for the benefit of all stakeholders but with a particular emphasis on putting the customer first. Over the long run I believe that keeping customers happy is the best way to keep shareholders happy. Really good examples of companies that have succeeded by doing this are Spirax-Sarco and Howden Joinery in the UK and the retail giant Costco in the US. These companies have also been good at getting their message as regards their company culture across to investors. Time spent on identifying businesses like this is rarely wasted in my view.

The role of number crunching

There is still a part for number crunching and examining a company’s accounts. You can spend hours on them but you can get a lot of value from just asking some very basic questions and simple calculations:

• Are revenues growing?
• Are profit margins moving up or down?
• Do profits turn into cash flow?
• What is happening to working capital relative to revenues?
• What is happening to return on capital (ROCE)?
• Is a company replacing its assets – spending more than its depreciation expense?
• Are debt levels manageable?

I have written a lot about these topics which can be found on the Investors Chronicle website. The answers to these questions can tell you a lot about the health or otherwise of a company. They also ultimately prove whether the company’s business model is delivering for investors.

You should also spend some time reading the annual reports and crunching the numbers of competitor companies as you will find that this will increase your company and industry knowledge.

Valuation does matter but don’t obsess about it

One of the biggest investing lessons that I have learned in recent years is that the quality of a company and its ability to keep on growing is far more important than the price you pay for its shares. But I do not subscribe to the view that valuation does not matter even though the price increases of certain quality growth stocks in recent years could easily make you think otherwise.

My approach to valuing companies is based on two main tools. The first is to compare what you are getting back in terms of profits and free cash flow per share compared to the share price. This is shown in earnings and free cash flow yields. The lower the yield, the more expensive the stock.

Low yields can be explained to some extent by low interest rates on government bonds and low rates of inflation. Ideally, the yield on a share should be higher than bond yields and inflation as shares are more risky and you need to make a return greater than inflation to grow the buying power of your money.

The big advantage that shares in companies have is that they can grow their profits and returns to investors. The lower the yield on the share, generally the more growth that is needed to give you good future returns from it. Don’t forget that company profits can also fall as well and this can be a recipe for painful losses if you have paid a high price to buy the shares.

Instead of trying to work out the exact value of a share – which is very difficult – it is much better to work out what the current valuation is implying about the level of future profits. In short, high valuations imply high expectations. You tend to make or lose money from shares when profits – or expected profits – move up and down. Having a feel for what is expected is a great tool for the analyst and is much more valuable than trying to work out the value of a share down to the nearest 0.1p. 

You can read my article about how to get a feel for future expectations implied by share prices here.