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Top Stocks by Roger Montgomery (April 2013)

How to value the best stocks and buy them for less than they’re worth.

What is a top stock?

Is it a company whose share price has doubled in a week, or one that consistently pays a dividend? Maybe it’s the sheer size of the company that leads investors to consider it a ‘top stock’.

Don’t be mistaken, top stocks are few and far between. If you know what to look for though, finding them can be really easy.

When you invest in stocks, you’re buying a piece of a business. If you buy shares in great businesses over the long term you’re share portfolio should do quite well.

Successful businesses tend to be managed by honest and high-performing managers who have a track record of delivering value to shareholders.

And measuring that is really quite simple too. The secret is to find businesses able to sustain high rates of return on incremental equity and strong cash flows with little or no debt. Put together a portfolio of businesses, purchased at rational prices, whose earnings you are certain will be materially higher in five, ten and twenty years for now and so will the market value of the portfolio.

The businesses of great companies tend to be fairly simple to understand. Banks, software developers, drug manufacturers, petroleum suppliers – these are simple businesses that aren’t dominated by complex revenue streams, or too many business models that are difficult to decipher.

Great Businesses

Great companies are able to increase their earnings each year without the need for extra capital or debt. If a dividend is paid, it’s funded by organic growth. You won’t find a top quality company raising capital or using debt to pay your dividend. But be careful, because there’s a plethora of businesses that say they are raising capital for an acquisition but its arguable the acquisition was funded organically and it’s the dividend that required the debt or equity.

Great quality companies also demonstrate, year after year, great profitability. Return on Equity (ROE) is the measure we use to describe a business’s profitability. ROE compares how many dollars of equity were required to produce the company’s profit. Most investors focus too much on the dollars that come out of a business – the earnings and dividends, but business owners take a solid look at what is required to go into a business to get that dollar of earnings out. If a company has $100 million of equity and produces a profit of $5 million, the resulting return on equity is 5%. This is NOT a satisfactory rate given the risk associated with running a business, especially one listed on the stock market! If another company produced a profit of $25 million on $100 million of equity capital, return on equity is substantially higher at 25%.

Ask yourself, would you prefer a bank account earnings 20% or a bank account earning 1%? You are better off investing $1 million into five bank accounts earning 20% than investing $5 million into one bank account earning 1%. It’s the same with a business.

Excellent cash flow is another clear sign of a top quality stock. Companies that need to raise capital, take on debt or pay dividends that they can’t afford should be avoided. Poor and worsening financials can result in falling share prices.

Take a look at the Australian airline Virgin Australia Holdings. In 2003, the company’s owners kicked in $184 million of equity and borrowed $139 from the bank. In that year, the company generated a profit of $110 million. The share price in 2003 was over $2.30. Ten years later, in 2012, the profit has declined to $43 milion. Imagine owning this business outright; That’s a more than 50% decline in profits over ten years! If you owned this business you would be far from happy. If that’s not bad enough though, it gets worse. Not only have profits declined over the last ten years but you have been writing cheques to keep the business going and expanding. By 2012, you have invested over $900 million of your own capital (shareholder’s equity) into the business. And remember profits have been declining. Oh, and there’s one more thing; you have been borrowing more money. Remember when you started the business, you borrowed $139 million? Well since then you have been borrowing a little more each year and now owe the bank…wait for it…$1.7 billion!

So equity capital contributed has gone up, debt has gone up and yet for all this extra commitment and risk respectively, profits have been declining. This is a massive destruction of wealth.

Ben Graham said that in the short run the market is a voting machine, but in the long run, it’s a weighing machine. Unsurprisingly, Virgin’s share price is a quarter of what it was ten years ago. Ben was right! And by the way Virgin scores one of our lowest quality ratings a C5.

Over at Skaffold.com we rate companies all around the world from A1 to C5. It’s called the Skaffold Score. An A1 rating means the company has a strong balance sheet with little or no debt, and its business performance has been consistently impressive. It has the lowest probability of catastrophe between now and the next financial reporting period.

In plain English, what does that mean? Management have done a good job. They’ve grown the business, but not used too much debt or asked for more money from shareholders. The growth has been organic. Maybe they’ve cut administration costs, or found a more efficient way to sell more of their product. Their business has also generated plenty of cash. The products and services they sell either attract a very high profit margin, or it doesn’t cost a lot to produce, or both!

CSL, Exxon Mobil, SAP and Rolls Royce are just a few examples of companies that have consistently achieved a top score from Skaffold.

The Final Step. Valuation

Once you’ve reviewed the track record of a company, and are confident management can continue producing stellar results, you need to estimate what the business is worth to determine an appropriate price to pay for its shares.

Paying too much for a top-quality company can destroy wealth just as quickly as investing in one with excessive debt. Over time, it has been my observation that share prices tend to converge with value. And if that valuation estimate is derived from the economic performance of the business, the convergence simply proves what Ben Graham had observed – that the market does a good job over the long run of weighing a business.

Estimating intrinsic value is pretty simple. It goes something like this; If a bank account with $1 million deposited, earning 20% per annum and paying out all the interest, was put up for auction, buyers would be willing to pay much more than the equity in the bank account. AN investor seeking a 10% return could pay $2 million for that $1 million bank account. And if the bank account did not distribute all of the earned interest but retained some of the interest and earned 20% on the new increased balance every year, that some investor would be willing to pay something more than $2 million thanks to the present value of the compounding equity. It’s the same with a business. The intrinsic value is based on the equity, the rate of return that equity is expected to generate and the way in which it is distributed and paid out.

To mitigate some of the risks associated with paying too much, It is essential that shares are only purchased below intrinsic value. Buying shares in a company for $50 when the underlying value is $20 is dangerous.

Ideally, you want to buy shares when some of the existing shareholders are willing to sell them to you for much less than they are worth. They will inevitably do this when something completely unrelated to the business – Cyprus – for example causes them to fear the prospects for the world, the economy and the markets. Conversely you should desire to sell shares when other members of the investing public are happy to pay you much more than their underlying value. And they will do this when they can see only the brightest of prospects for the future and are generally feely cheery.

To help you identify top stocks, we’ve identified a small collection of top quality companies from around the globe. They’re large, well-known brands, whose products you may use as part of your daily life.

Rolls-Royce Holdings PLC

SAP AG

The Jean Coutu Group

Exxon Mobil Corporation

ASX-listed CSL, together with Canadian company Jean Coutu Group (PJC) and Hong Kong-listed Industrial and Commercial Bank of China (1398) have achieved an A1 Skaffold Score for the past three years. US giant Exxon Mobil was rated A2 in 2010 and 2011, before rising to A1 in 2012. Software and programming business SAP recently declined to A2 (it was rated A1 by Skaffold in 2010 and 2011), and in the past three years Rolls-Royce (RR) has risen from A3, to A2 and most recently A1. I’ve included below a snapshot of each company’s quality and performance scores as well as Skaffold’s estimated intrinsic value estimated and future intrinsic value growth to help you determine if the company is indeed a high quality business with bright prospects.

There is no substitute for understanding a business and the competitive landscape in which it operates. The approach advocated here and displayed in Skaffold fast tracks the reading of a decade’s worth of annual reports and allows you to focus on those companies that genuinely deserve your investigation and attention.

Roger Montgomery is a top performing mutual fund manager based in Sydney Australia and the founder of Skaffold.com a global value-investing search and analysis application for private and institutional investors and advisors. His bestselling guidebook Value.able - how to value the best stocks and buy them for less than they’re worth, is now available on Apple iTunes and also in Android and Kindle versions.