3 Simple Stock-Picking Rules You Must Abide By

Leverage, cash flow and working capital are three elements that savvy investors must consider before choosing their value candidates, argues Alessandro Pasetti.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Here are three basic rules you should follow before deciding whether to invest in equities or not. 

Leverage

Leverage need not be a bad word, yet investors ought to be careful when it comes to choosing companies whose net leverage is too high — as a general rule, you should avoid companies whose net debt is higher than five times earnings before interest, taxes, depreciation and amortisation (Ebitda).

If properly applied, leverage boosts returns on equity, which is a key financial metric, particularly for such traditional lenders such as Barclays, HSBC, Royal Bank Of  Scotland and Standard Chartered, all of which are finding it more difficult to deliver rising returns to shareholders. Decreasing returns are likely to last for some time in the banking world, particularly if regulators keep asking for more stringent capital requirements — lower leverage, that is — as they have done since the credit crunch.

Consumer companies such as Reckitt, SABMiller and Unilever carry some leverage, but that helps them boost returns safely as long as cash flows are stable. Elsewhere, National Grid‘s debt pile is much higher, but this utility boasts a virtual monopoly in the UK and churns out almost £1bn of free cash flow —  leverage, in fact, could be more problematic for smaller players in the sector, such as Severn Trent

Operating Cash Flow

Cash flow from operations — not the cash held on the balance sheet! — is king. 

Look for companies whose core cash flows are rising and compare that knowledge with their debt maturity profile. 

Not all cash flows are the same: those of miners and oil companies, for instance, are much less predictable and are more cyclical than those produced by consumer companies or even by retailers, the vast majority of which, in normal times, do not need much debt to finance their operations as they profit from favorable terms with suppliers as well as prompt access to cash from their customers. 

The big four supermarket chains in the UK are a different story in this business cycle, but net leverage at Tesco, for instance, would become problematic only if Britain’s largest grocer had a much shorter debt duration. 

Working Capital

Always look at the balance sheet when you have to assess value, and remember that short-term liquidity and smart working capital management could make a big difference to any investment case.

When margins shrink, and core operating cash flow comes under pressure, companies that are good at managing their receivables, payables and inventories will find it easier to get out of their problems — or they’ll simply be a able to borrow to finance their short-term needs. 

Working capital management: that’s what Quindell, for instance, has never been particularly good at. Centrica is a another example of a company that should better manage its short-term liquidity. 

Strong companies whose shares are attractive — International Consolidated Airlines is a good example — could have negative working capital, which simply means that the value of their current liabilities exceeds the value of their current assets. That’s not ideal but it may become a problem only when the business cycle turns south, net leverage is too high and the average debt maturity profile is less than two or three years. 

Otherwise, negative working capital could be a very smart way to self-finance any business. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

The Motley Fool has recommended shares in HSBC and Centrica, and owns shares in Tesco and Unilever.

More on Investing Articles

Three signposts pointing in different directions, with 'Buy' 'Sell' and 'Hold' on
Investing Articles

Time to sell this FTSE 100 underperformer, says Goldman Sachs

Analysts at one investment bank have a ‘sell’ rating on FTSE 100 stock Diageo. But could a short-term weakness in…

Read more »

Arrow symbol glowing amid black arrow symbols on black background.
Investing Articles

Down 5%, Glencore’s share price looks a serious bargain to me now

Glencore’s share price looks undervalued to me, supported by strong earnings growth prospects and the potential resumption of extra shareholder…

Read more »

Young brown woman delighted with what she sees on her screen
Investing Articles

I’d invest £6,580 in this FTSE 250 REIT for £500 passive income

This FTSE 250 renewable energy enterprise is on track to become a Dividend Aristocrat! Here’s how I’d invest to earn…

Read more »

Investing Articles

Buying 1,000 of some dividend shares today unlocks £45 in weekly passive income!

These shares are among the biggest dividend payers in the FTSE 100. Should investors be buying them now to earn…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

If I’d put £5k in index funds 5 years ago, here’s what I’d have now

Investing in index funds is an excellent way to grow wealth with minimal effort. But how much money can investors…

Read more »

Investing Articles

10.2% yield! 1 of the top income stocks to buy in July?

A 10% yield's pretty rare, but this firm's been growing shareholder payouts for nine years! Does that make it one…

Read more »

Investing Articles

‘FTSE 100 to skyrocket to 10,000’! 1 cheap stock I’d buy before the surge

Analyst forecasts predict a massive surge for the FTSE 100 may be coming by April 2025! Should investors snap up…

Read more »

Investing Articles

My Taylor Wimpey share price prediction for the second half of 2024

Having underperformed the FTSE 100 from January to June, our writer reckons the Taylor Wimpey share price might enjoy a…

Read more »