Dear Reader,
Attached is our latest list of stocks passing value screens (low EV/EBITDA, low P/E, etc.), which don’t meet our investment criteria - and our reasoning.
This may help you avoid some ‘value traps’, and stocks that aren’t sufficiently attractive compared to opportunities available today.
For reports of stocks that pass our quantitative and qualitative standards:
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Terry Smith: Latest
Terry Smith, owner-operator of Fundsmith, is one of the UK's best performing money managers (15%/year vs. 11% for the index since inception) - though recent performance has lagged the index.
He's a clear thinker and stands out for his focus on quality over price. This interview is packed with insight, so we recommend a full listen - some notes below:
7:30 Profits vs. Cashflows
In the early 90s, large UK companies went bust after reporting record profits, which is understandably befuddling to an observant non-practitioner. It's because cashflows determine solvency.
Companies can report high profits while not recognizing uncollectable receivables or inflated inventories quickly enough, incurring significant capital expenditures that don't pay off, etc. If borrowings aren't repaid on time, bankruptcy looms.
This doesn't mean accounting profits don't matter - it's a generally good estimate of a company's economic progress - but it doesn't mean much if it isn't backed by cash generation over time.
We evaluate all available financial parameters in judging investment merit.
15:45 Return on capital employed
Return on capital employed (ROCE) is the most important measure of business performance. Companies with high returns on invested capital create value every day that you own them - and vice versa.
Smith says that a high ROCE is "no good" without avenues for reinvestment and growth.
While our focus is on companies that lack near-term growth prospects (and priced accordingly), we think that ROCE is generally a good proxy for competitive edge (that sustains earning power), and management fidelity (not hoarding unproductive assets).
Moreover, equities are the only assets that automatically reinvest your earnings. Since companies generally reinvest most of their earnings, ROCE is crucial to long-term investment success.
19:00 Moats
Smith identifies several types of moats (competitive advantages):
a) Brands
b) Control over distribution
c) Installed base of equipment (elevators, software, etc.)
d) Patents (not as valuable as the others due to limited life)
You should be able to answer why a business earns a high ROCE before you invest.
21:00 Intangibles
Smith makes an interesting point that intangible assets are not easily replicable because they can't be borrowed against. In certain cases, they may be far more valuable than tangible assets.
Price/tangible book value shouldn't be a limiting factor in investing - though it's certainly useful in limiting losses.
22:45 Time and patience
The problem with 'quality' companies is that the market generally recognizes these attributes and they tend to be overvalued. But Smith argues that time and patience can turn a seemingly unattractive price into a good investment.
Furthermore, value has to include an appraisal of quality before concluding on undervaluation.
We incorporate factors of business quality in on our appraisal process.
25:00 Subcontracting capital
When you invest, you're subcontracting your savings to management. This thought from Smith is an important reminder - especially when you seek bargain stocks.
29:15 Companies' core competence
Beware of companies that stray significantly from their core competence - it's usually a warning sign to get out.
35:00 Nobody wants to read the footnotes
It's ironic that when financial statement disclosures have improved significantly, very few read the footnotes. This involves work - and we focus on reading them.
45:30 98% underperform
It's rare to outperform the market - and invaluable.
53:00 Don't keep looking at price movements
There's no point looking at portfolio price movements frequently though it's tempting. But it is important to take a hard look at business developments from time to time.
In our experience, it isn't profitable to simply sell on bad news - but it is essential to watch out for materially adverse developments such as: a) potential de-listings, b) substantial increase in borrowings, and c) material changes in the nature of the business.
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