Do you think like a clever investor?

No doubt many financial advisors are now being asked by clients whether it’s time they joined the crowd and if “yes”, what stock or stocks? Obviously, an adviser’s answer should be linked to how it dovetails into a client’s portfolio.

But assuming the client is well positioned to increase their equities weighting, typically what type of advice do you give clients looking to buy shares?

Nobel Prize-winning economist William Sharpe believes the golden rule of sensible investing is to understand the business, its performance and future growth prospects. On this basis it’s a little unrealistic for ‘mum and dad’ investors (and even their advisers) to have the time to independently acquire the knowledge necessary to intelligently differentiate between good and bad businesses.

However, there are some key criteria to help investors quickly evaluate listed companies and to gauge their underlying value. They are:

1. What business is this company in?

Smart investors will avoid companies operating in sectors offering limited future economic growth or where the business model is unduly exposed to fluctuating economic conditions.

2. Have earnings been rising and are they expected to continue going up?

Smart investors will avoid companies that have stagnant or declining earnings, and limited ability to generate organic growth or fund future dividends without using debt.

3. Are the companies in your portfolio over-exposed to debt to fund core business activities?

Smart investors understand the disastrous impact that mismanaged debt can have on a company’s bottom-line earnings. You can’t lay claim to thinking like an informed investor unless you understand the relative performance of the business and its intrinsic value over recent years.

4. How well have the companies in your portfolio used their equity and how profitable are they?

You also need to be aware of key indicators (or performance ratios) to correctly interpret whether the company has delivered satisfactory returns. One of the key ratios favoured by Skaffold is Return on Equity (ROE). As an indicator of business profitability, ROE compares how many dollars of equity were required to produce the company’s profit. A smart investor would prefer to own shares in a company that produces a profit of $25 million from $100 million worth of equity than one delivering $5 million profit on the same amount of equity. The former has a return on equity of 25 per cent while the latter’s return on equity is only 5 per cent.

5. Are the companies in your portfolio adequately covering operating expenses with sufficient cash flow?

Companies with a notable gap between cash flow and debt required to generate it will seriously deteriorate their balance sheet. A net-negative cash flow position is unsustainable, especially where debt is involved and if not corrected will result in falling share prices as investor confidence diminishes.

Finally, a quick word about when it’s time to buy or sell.

Once you understand the business, its economics and future growth prospects, it’s equally important to recognise whether the company represents value for the current share price.

Paying too much for a top-quality company can destroy wealth as fast as investing in those with excessive debt. Sooner or later, the share price will start to converge with the company’s intrinsic value ( the sum total of the company’s worth based on earnings, dividends, equity and debt).

Smart investors, therefore, avoid buying companies for $20 when the underlying value is only half that.
Ideally you want to buy good companies when there’s a discount between the share price and its underlying value, and sell when the share price exceeds its intrinsic value.

About Chris Batchelor

Chris Batchelor CFA is general manager of Skaffold Pty Ltd and a specialist in equtiy markets and securities. He is a Chartered Financial Analyst and has 20 years experience in financial markets.

In 2010 Chris and three colleagues founded Skaffold, an innovative stock research tool which makes the task of analysing and selecting stocks simple and fun.

Previously Chris has been in education roles with Kaplan (and predecessors Finsia and SIA) where he developed content for the Masters of Applied Finance in the areas of investment analysis, valuation and investment management.