Quality, Value and Prospects
The share market is notorious for generating noise which can cloud your investment decisions. Be it a “hot pick” you hear from a friend, or trying to decipher financial jargon, investing in equities can seem overwhelming. Yet it needn’t be. You are entirely capable of identifying companies that can outperform over the long term if you focus on three key factors.
Quality. What is the strength of a company’s financial position and performance? The most important rule when it comes to investing is never to lose money, so your portfolio should contain companies with proven track records. This means focusing on companies that have sustainable competitive advantages, which have allowed them to consistently generate earnings and cash flows.
Value. How much is the company worth? It is imperative to understand the distinction between price and value – price is what you pay, while value is what you receive. Many investors let the share price tell them whether the business is any good, without even considering the underlying earnings. Always aim to buy a company when its share price is trading below your estimate of its intrinsic value.
Prospects. Does the business have a positive outlook? A company is far more likely to outperform over the long term if it has favourable tailwinds, rather than headwinds, on a macro or micro level. Just consider the challenges facing mining servicers. Falling capital expenditure in the mining sector means that even the best contractors will struggle to grow at historical growth rates.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
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Tony C
:
Maybe you should write a book about it Andrew. I hope it sells as well as Rogers
paul white
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What has happened to the Reject Shop. I thought it was an OK business ??
Tom Newton
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I am a confessed Montgomery groupie. My portfolio has two commas. My average return for each of the last 5 years is 37% excluding dividends. My stock picking has 4 steps, 1) find a strong tailwind, 2) find the best company that will benefit, 3) wait till begins to run and 4) protect your downside with stop losses. Its not rocket science.
Allen Dodd
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It is inevitable that a rising stock will eventually reach its zenith and take a tumble. In times of volatility (such as Apr/May to Jul/Aug over the last four years) I tighten up my stop losses and let the share go if it falls. I rarely lose money on a trade, the last one being MMS, where it bypassed my stop loss. I was able mitigate the loss by putting in a Falling Buy instruction and was able to buy more at the bottom of the market. Before that I recall TRS doing the same thing (but no falling buy that time).
I have traded my SMSF since 1996. I accept the logic of your approach and that intrinsic value will usually be achieved, it’s just that (in my experience) it takes longer for the market to react than I am happy with.
Enjoyed your book, where did Sally McDonald end up after ORL?
Allen Dodd
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I made 39% returns in 2013, including reinvested dividends.
I look at:
The company’s historical chart, has it been able to resist the (downward) fluctuations in the XAO, and has the price been consistently above its 50 week moving average for 2-3 years?
Does it have a record of delivering increased EPS (and reasonable dividends) over at least the last 4 years.
Is the company delivering a good RoE, say 15% or better?
Is the company forecasting reasonable growth, 15%+ pa, over the next 2-3 years?
Is the debt:equity below 20% or close.
Does it have enough CASH assets (Cash and Receivables, not Inventory or Other) to meet its current expenses.
Does it have a significant number of shares held by Institutions and Directors.
Have directors been buying on market recently?
And is liquidity OK? More buyers than sellers?
And I set a stop loss at 5% below the 50 week moving average, moving it up with (hopefully) an increasing share price. I buy more when the stop loss exceeds my original buy price.
There is no guarantee that this will make you successful but its not a bad start point to produce a shortlist, and it works for me.
Interestingly hardly any of my current portfolio has an intrinsic value much above the current price. My experience is that in the 6- 12 month investing period within which I tend to work, the market doesn’t seem to take much notice of it.
But smarter investors than I, including you Roger, would probably disagree I am sure.
Roger Montgomery
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Will be interesting to see how the most expensive holdings perform if the market turns. How many decades have you run this approach?
Elliot Power
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In the bi-monthly reports of the Montgomery Fund can you please explain what order the “Top Completed Holdings” are in? They seem to change order from month to month. I assume the one on the top of the list is the biggest holding? If so, ANZ is the largest holding. If so, why have you purchased ANZ in the past two months given it’s historically high share price and P/E.
Andrew Legget
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ANother important thing is to know what quality does not look like and stay as far away from that as possible.
I have recently seen an ASX business who has goodwill making up 93.5% of there total assets, has less than a $1000 in the bank it appears, generating quite large losses (employee expense alone are 4x reported revenue elt alone finance expenses etc), reported revenue is 5x the actual cash received by customers so it is even worse than what the income statement says, negative interest cover, negative equity as well as having what appears to be a remuneration policy that does not have a single cent related to actual performance.
A task that i routinley try and do when i learn something new is to test what both a quality company will look like as well as a poor company. Staying away from the bad is just as important as finding the good.
zoran arnautovic
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Thanks Ben,
Something so simple, yet so hard to do.
cheers
Andrew Legget
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My definitions:
Quality- A company whose business exhibits some form of sustainable advantage which allows it to do things better and more profitably then their competitors which is backed up by a reasonably strong brand and has superior economics and finances.
Value- What it is you atre getting when you buy a share at $x.xx. You want to receive more value then you are paying out.
Prospects- Once again similar to yours and for me fits into quality as a sustainable competitive advantage will allow for superior performance over peers. One thing to consider though is whether the business is in a price taking/commodity position or whether it is able to set the price (especially if that price setting also sees little to no change in the demand for the product or service). A commodity business is one where over the long term there will be very little or no economic profit. Is forced to accept the “market” rate whether this is good or bad and has few weapons in its arsenal to provide outstanding value to shareholders over the long term.