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QUALIPORT
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The Qualiport buys great businesses at attractive valuations and holds for the long term. But how do you determine whether a company is actually a great business? One good place to start is the annual report and accounts. If your chosen firm squares up to the following financial characteristics, then you could be onto a long-term winner. (Note: FREE annual reports can be ordered here.) 1. Incremental Return On Equity "Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite -- that is, consistently employ ever-greater amounts of capital at very low rates of return." -- Warren Buffett. So what's employing 'large amounts of incremental capital at very high rates of return' all about? Although there are many ifs and buts involved in the calculation, it boils down to how much extra profit a company can generate for every £1 retained in the business. Any firm that can produce an additional 15p of post-tax profit for every £1 retained is certainly worth investigating. So, which companies will employ large amounts of incremental capital at very high rates of return in the future? No guarantees, but those that have done so in the past have as good a chance as any. Read more. 2. Operating Margins A company's operating margin is determined by dividing its operating profit by its turnover and expressing the result as a percentage. The average operating margin for companies in the FTSE 100 is about 14-15%. Margins getting on for 20% and beyond indicate a certain amount of business quality. High margins suggest the company has some pricing power over customers and perhaps weak competition as well. Having few industry rivals is one of the secrets of long-term business success. Read more. 3. Fixed assets Companies with relatively few tangible fixed assets tend to generate superior incremental returns on equity (see above). Rather than continually spend money replacing/refurbishing assets just to maintain profits, asset-light businesses can instead free up their cash to fund dividend payments or expansion programmes. Companies that can generate big profits from few tangible assets will obviously possess more in the way of intangible assets. Such inherently difficult-to-replicate assets generally create a more robust competitive advantage. In general, any firm whose operating profit is equal to the tangible assets employed is well worth inspecting. Read more. 4. Working capital Just like fixed assets, companies that have little cash tied up in stocks and debtors also tend to produce superior incremental returns on equity. Ideally, you want companies whose customers pay immediately and whose suppliers collect their money a few months after delivery. All in all, working capital movements underpin the cash nature of a company's accounting profits. In addition, working capital can hide a multitude of corporate sins; a substantial outflow of cash in this department often heralds trouble. Read more and more still. 5. Acquisitions The best companies should have no need to buy up somebody else's ideas and products. For that reason, firms that run on an acquisition treadmill should be treated with suspicion. As well as showing a lack of management creativity, corporate takeovers often create costly integration problems. What's more, the accounts of acquisition-free businesses are far easier to interpret, which reduces the chances of missing a deteriorating performance. There have been numerous occasions in the past when a major acquisition tried to rescue an under-performing predator, Rentokil (LSE: RTO) buying BET being one. Read more. 6. Debt The past few years have seen plenty of businesses succumb to that age-old investment danger: a mixture of falling profits and a debt mountain. While a company can defer dividends and capital expenditure, postponing interest payments is never well received at the bank. Dividing a company's operating profit by its debt interest charge produces a figure for interest cover. Anything below five and there's every chance a deterioration in trading will cause an unwelcome call from the lenders. Great companies should be drowning in their own cash, not borrowing somebody else's. Read more. 7. Exceptional Items Although the authorities have clamped down on their abuse, exceptional items remain an accounting art form. Past corporate misdemeanours (frequently acquisitions - see above) always catch up with the perpetrator and often result in chunky 'one off' charges. Knowing that investors sometimes ignore big write-offs to focus on the 'underlying' picture, opportunities arise for 'kitchen sinking' and the crafty disposal of other accounting problems. As a rule, the greater the exceptional charge and the greater their frequency, the less confidence should be placed in the company. The inherent nature of a quality business suggests exceptional charges will be a bookkeeping rarity. Read more.