After speaking to a number of readers, there seems to be widespread fear among investors. The extreme instability of global equity markets resulting from economic and political turmoil has fuelled these fears. However, for the disciplined value investor, these times can be one of opportunity, allowing you to choose the best stocks. Many high quality companies have become available at desirable prices.
In light of this instability, now is a good time to review the principles that underlie the investment process. This applies not only to times when the market is volatile, but also during times of stability and growth.
Capital Preservation and Returns
Always keep in mind what you are trying to achieve when making your investment. As long term investors, we are return focused and strive for an annual return of 10% plus. We work towards our goal by pursuing value, proper diversification and practical risk-management.
We aim to achieve a minimum of 100% return over 7 years by maintaining steady performance and through compounding returns.
An essential ingredient in the investment process is capital preservation. The power of cash has been demonstrated by the recent correction. We were in a position to seize the new opportunities that arose when markets sold off.
It is our belief that the prospect of achieving our goals through different economic cycles is greatly increased by maintaining a diversified portfolio of high quality businesses that are purchased at discounts to value.
With well over ten thousand companies listed globally, only a miniscule 1-2% or about 100-200 actually pass through our simple screening process and only half of that then pass through further in depth research processes. This shows how choosing the best stocks does take time and patience.
The essential factor in discovering companies that will offer high value over the long term is quality. We seek high quality companies that are trading at a discount to intrinsic value. By intrinsic value, we mean an assessment of the sustainable profitability, as measured by return on equity, return on assets, earnings growth rates as well as a number of qualitative and quantitative factors listed below;
- Governance and Management
Good governance and management is essential for the success of any company and its shareholders. A good management team is one that makes certain that the company’s interests are in line with the shareholders’ interests.
- Capital Management
The value (if any) that is returned to shareholders is very much dependent upon what senior management and the board of a company does with available capital. The nature and extent of the company’s growth and profitability is very much dependent on them as well.
- Business Model
The manner in which a business makes its profits dictates the quality and course of its earnings. We look for companies that have proven and sustainable competitive advantages with high barriers to entry.
- Cash flow
Cash flow is what moulds a company’s balance sheet, organic growth initiatives, capital management activities and the strength of a business’s cash flow is what ultimately determines the return value to shareholders. We place a premium on cash flow. Cash flow after all is the life blood of any business.
Just as cash flow moulds a business’s balance sheet and flexibility in capital management, so does debt. We analyse a business’s debt to equity ratio, cash flows and available cash. Those with higher leverage are generally more sensitive to market movements and tend to have greater risk profiles.
In general, higher profitability relative to peers is a good indication that there is a competitive or operational advantage. We look at each company’s medium term sustainable level of profitability and compare it to the sector, industry and market averages.
- Profit Growth
We assess the course of each business’s earnings growth and the quality of its future potential. We take the maturity of the business, its ability to enter new markets and its ability to make value-adding acquisitions into account.
By ensuring that every, and I mean every new stock you add to your own portfolio passes through the above seven fundamental criteria’s, you will create a world class financial freedom portfolio over time by only choosing the best stocks.
So there you have it! 7 criteria on How to Choose the Best Stocks.