Share Investor: picking stocks

It seems that me old mate Bruce Sheppard is heading off into the sunset and his burying his blog, Stirring the Po t.

I frequently read what he has to say on a number of topics and he is always entertaining in the extreme.

He is at his most entertaining and informative to me though when he is writing about investing and specifically writing about shares.and the stockmarket.

With this in mind you must read what he wrote back in August of this year about Picking a Share.

It is an excellent place to start before putting your hard earned moola at risk and will put beginners in the right place when in comes to investing in the stockmarket.

Please pay particular attention to the long term nature of his investment style.

Read on:

Picking a Share

Any investment is worth to you what it will return to you over its expected life. As you outlay cash to purchase such an investment, "return" to you means cash returns.

As most investments can expect to keep returning cash to you until they fail, and good ones don't fail, the income from such investments can eventually be regarded as an annuity.

Humans on the other hand expire, and thus every investment has a time horizon on it, not dictated by the investment, but dictated by the investor's own circumstances.

Thus every assessment of an investment's future cash back to you should include a notional sale at a point in the future that is tailored to your own investment horizon. For most this should not be less than five years or more than 10. This does not necessarily mean you sell the investment at any time during that period.

So in order to value an investment and determine if it is cheap, you have to assess the likely future cash flows of the business. So how do you do this?

Brokers and forecasts

If you are penny wise and using an online broker, consider changing to a full service broker. If you are a full service broker's client, you should receive the bi-annual research data that they produce which will include one, three and five year comprehensive forecasts for cash earnings and dividends for most of the large companies and some of the small ones too. In addition, if you are thinking of buying a share, if they have any research on it they will send it to you.

Now while the cash flows they produce are interesting, and I have had these for over 20 years now, beyond one year they are totally conjecture. There is no statistically significant correlation between forecasts of earnings and actual outcomes beyond at most two years. So the most you should look at is the one year forecast.

This forecast is generally prepared by the broker following a detailed review of the financials, and a discussion with management, and the board. The forecasts are thus in essence the management and board's forecasts, and the most you can expect from continuous disclosure is a poor shadow of this data.

Historical Data

Well at least this is fact rather than conjecture, or is it?

Profit or EPS is simply an opinion. Earnings are now so spun with Financial Reporting standards that it is difficult to rely on Earnings or Earnings per share either. This said the past is a better source of data than the conjecture about the future.

Even the cash flow statement can be gamed, interest received from borrowers for example, was it really received by the lending finance companies.

What you can believe however is two things only. The price you have to pay for the share - as that is the money you outlay, and the cash that has been paid back to shareholders as dividends over time. Dividends are real cash. Or are they? Sure some companies hoodwinked shareholders with dividends that they pay with borrowings, in which case such dividends are not sustainable into the future, but testing the sustainability of past returns is phase two after you have completed the first shift of opportunities to reduce the list.

The first pre-screen

With listed equities (private company investing requires a different approach) to determine what I want to look at in more detail, I have a simple ratio called the PEGY ratio. This is an extension of the James Slater PEG ratio which I found in his book the Zulu Principle.

The plus of this ratio is that it does not require you to do much work or for that matter to make any assumptions. It is simply a hard number assessment of the value of a particular share.

The ratio, and even me a mathophobe can do it:

PE/( G+Y).

PE = the published price earnings ratio.

G = Normalised EPS growth over 5 years turned into a percentage multiplied by 100.

Y = the current pre tax dividend per share divided by the current price multiplied by 100.

PE and Y you can get from your morning paper, G, requires you to do a bit of work, ie you have to go back over five years of financial statements and pick out five years of Normalised EPS and calculate the growth over five years and turn that into an effective compounding growth rate from year one to year five. So I only tend to do this for companies that actually do have a dividend yield, as the lower the dividend yield the higher the growth has to be to justify the investment and with NZ equities growth is hard to find.

The lower the result of this formula on the face of it the cheaper the investment is, and thus on the face of it, it might be a buying opportunity; the higher the ratio is, the less attractive an investment is.

For example - you can buy a company on a PE of 20 with a Yield of 5 percent and a growth rate of 5 percent, this has a score of two. Or you can buy a company on a PE of 12 with a yield of 10 percent and a growth rate of 5 percent, this is a score of .8. Which company would you prefer to buy?

Cautionary note

Now before you get carried away, the PE ratio and the Yield quoted in the paper is not always right. Sometimes you will see really low PE ratios and this is sometimes because they have used the reported profits, and not the normalised profits. So check it. Likewise sometimes they get confused about Imputation credits as well, and these are valuable.

Any score more than 1 is unlikely to be cheap and anything less than .5 may be a bargain.

This first skim is about the return side that you can expect from an investment, now the harder work begins, understand the risk.

In no particular order:

The risk of total failure.

The risk of adverse surprises to earnings or dividends.

The sustainability of dividends going forward.

The risk of fraud idleness or stupidity, i.e. the people.

So now to the second skim:

The first thing to look for is debt. In big companies debt is not like it is for us mortals, ie about security, it is about cash flow. So the key ratios for you to check around this are as follows:

Net interest bearing debt ( net of cash holdings)/ Earnings before interest tax and depreciation. ( EBITDA)

It will be a rare company that can sustain a score above 5 and a ratio of around 2.5 is, depending on income volatility likely to be safe enough. As soon as it goes over 3 you are taking a risk of total default at worst and income or return default at best.

Earnings before interest and tax/ Interest paid. ( interest cover)

$4 should be the minimum you would consider safe.

Debt/total tangible assets.

This is sometimes important, but if any of the other ratios look too risky is a good one to do as well. If the lending is less than 50 percent of tangible assets even if the income is currently crappy or if the margin is a bit thin to cope with an adverse event the tangible asset backing might hold off a total default.

The list should be smaller now.

The third skim is around the risk of dividend default.

Three key things.

The first is the dividend cover ratio which is the net profit after tax/ dividend ( net of ICA or other tax credits , but excluding Resident withholding tax).

A ratio of 2:1 is normally pretty safe, a ratio of $1.20 to $1 will normally indicate a high risk of dividend volatility especially if debt is also high.

The next is earnings volatility. This is the maximum adverse movement EPS in the last five years.

It is earnings that fund dividends, high volatility of earnings and low dividend cover would indicate that there is a high risk that dividends will be volatile and might drop before they revert to trend.

And the final one which should always be checked is the operating cash flow to dividend cover ratio. This is operating cash flow / Dividends net of ICA taxes etc.

It is cash that pays dividends , and if it looks a bit tight but everything else looks ok, you should be alright for at least one year.

Now in terms of your filtering you need to set your own filters, but mine go like this:

A PEGY ratio of more than .9 strike it off the list.

Debt, more than three times EBITDA, or exceeding 80 percent of NTA cross it out.

Earnings per share volatility greater than 30 percent, this is the biggest one year adverse fall in earnings in the last five years strike it off the list.

The sum of five years' operating cash flows should be greater than 70 percent of reported profits, and should be at least $1.50 for each dollar of dividends paid over the last five years, if not strike it off the list.

With these filters the list will be a short list, and now the real work begins.

Assuming you have nothing on your list and you are still keen to invest move the parameters by 10 percent. If more than one on your list, then rank them from the lowest PEGY ratio, as that is the most cheap stock relative to risk levels you are prepared to bear.

Now you are going to do some work on the company.

What do they do, how do they do it, why would a customer buy their product or service, how do they sell it what is the selling process, how do they reward the team to make money, who are the leading managers , who are the directors who are the major shareholders what are their track records?

To start with get the last three years annual reports, start with the oldest, read the Chairman's and CEO's reports. Write down the key predictions and outlooks, map it to outcomes. Check what they have said they will be doing , strategically, see if they did it. You are looking for people who take risks, who have at least some reliability of forecasting and say what they will do and do what they say. The most recent report has to have some element of optimism about it, and there should be no adverse continuous disclosure announcements.

Now before you buy you need to assess the likely return you will make on this investment, ignoring gearing. The factors are these dividend, earnings and growth of each over a timeline.

How much is enough of a return to justify the risks you have accepted is mute point and one that investors in finance junk ignored.

My base line is 8 percent for any equity, being double the tax paid risk free rate of return from cash, very roughly. I then increase this by the amount of volatility, so 25 percent volatility increases the hurdle rate to 10 percent. I then increase it if debt is high, again I calculate a base line figure. Let's assume the target has debt 15 percent higher than base case, or earnings are not correlated with cash, again if out of line, by how much as a percentage, or if the cash or profit cover of dividends is skinny again by how much. Then I add these percentages together, say the sum of these is 80 percent, then increase the base line yield by 80 percent. The required yield on this investment is 18 percent. If on a far wind the prospective yield is more than this, then the share is worth buying, if with the rubbish factor taken in for the first year, it is still above the base line equity yield it is still worth buying. Other wise pass for the moment and set yourself a target price. If you have to wait six months, learn patience, but before you put in the buy order make sure nothing has changed.

In the words of Buffett, the market rewards the patient at the expense of the impatient.

Related Share Investor Reading

Stockmarket Education: How do you buy shares?
Stockmarket Education: What is a Share?

Stockmarket Education

Stockmarket Dictionary
Stockbrokers: What you should know before choosing one
10 Basic questions to ask before investing
How the Stockmarket works
Understanding Risk
Watch Your Risk Tolerance
Stockmarket Education: What is a Share?
What Moves the Stockmarket?
7 Signs of Shareholder Friendly Management
Financial Media For Investors
Dividends in detail

Related Links

NZX - How to Invest

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