LONDON, 18 April 2005 — To start, quality stocks are synonymous with value stocks. They exhibit consistent sales growth, a good record of earnings and dividend growth, relatively low gearing, and disciplined capital investments in projects that deliver returns above the cost of funds.
“Value stocks are valued by value investors!” A wise approach would be to simply strike the right balance between risk and reward. Stocks, of course, offer the best chance to earn high returns over time. As the global economy grows, corporate profits rise. That drives share prices higher and allows companies to pay fatter dividends.
But stocks are also a dicey endeavor. Think about the huge losses suffered by technology-stock investors over the past years and by holders of Japanese shares during the 1990s. To avoid such disasters, an investor should diversify into quality/value stocks across a load of different companies, sectors and countries.
There is no magic into this: Investors need to pick a strategy and have the discipline to stick with it. Remember that a company that increases its earnings in a consistent and powerful way is a company whose stocks will rise, no matter what. This should, I believe, be the best way to think about investing in equities by considering yourself a “partner” in the business and not an owner of a stock.
From this rather simple idea flows the notion that the price of a company on a given day is not as important as most investors think. “Who cares if you pay $30 a share for a particular stock instead of $29, if you think its fair value is twice the current market price?” That could perhaps attribute to volatile short-term results. But, if you are a long-term value investor, who cares? You should otherwise be confident of a sizeable long-term outperforming results.
From my experience, there are certain rules, or tests, for successful investment in quality stocks with the main objective to improving results and building wealth:
• Reject “junk” stocks, like companies with a small market capitalization, companies trading on unregulated exchanges, and companies that regularly miss its filing deadlines with regulators. Stay away from initial public offerings (IPOs), since its prices are generally inflated.
• Check earnings from operations and operating cash flow to see if the company is consistently generating enough to finance its business largely from within. Companies with negative cash flow will eventually have to seek additional financing by selling shares, or bonds, which will dilute the value of your holding.
• Find the return on assets (ROA) ratio, a measure of how efficient a company is at converting assets into profits. Since companies are not required to break this out, you may have to do it yourself by dividing net income by total assets. Look for around 7 percent for non-financial companies. However, for financial companies, divide net income by shareholder’s equity to arrive at a return on equity (ROE) ratio. Look for around 15 percent or better.
• Look at earnings growth to see if the pattern is consistent or erratic. Consistent is of course better. The best way is to look at a 10-year table of the company’s results.
• Gauge the debt load. A quick way is to think about the stability of the business. A company that sells cereal can safely hold more debt than one that sells semiconductors because of the predictability of its sales cycles.
• See if the number of shares outstanding has increased, and why. Companies usually issue new shares for two reasons: to finance acquisitions or to grant stock options. Both should raise a red flag.
Why? Because most acquisitions fail and the issuance of a large number of options (e.g. 3 percent of equity or more), is dilutive.
Finally, a word about management: Evaluation of management is critical. My motto has always been: “invest in people, not stocks”.
To summarize, if a company passes these tests and you are satisfied with the results, only then should you start looking at the quality stock and drawing conclusions about whether or not the company is a real bargain for “value”.
(Habib F. Faris is vice president at Clariden Bank, London.)
