Guess what! Studies reveal that companies operating high-quality businesses tend to outperform those operating low-quality businesses.
Who’d have thought it? Actually, it seems intuitive doesn’t it? But still many investors chase after speculative firms with unproven operations, low or zero earnings, and high hopes – often with disastrous investment outcomes.
I find it reassuring to know that companies with profitable operations, high margins, sustainable cash inflow and high rates of return against capital tend to do well for their shareholders.
And it can happen in several ways. For example, share prices can drift up as they track expanding operations, dividends can grow a little each year, and when the firm’s excellent characteristics become widely known, valuations can rise. This can really turbocharge a share price.
And it’s also a source of comfort for me to know that speculative, cash-gobbling, money-raising, serially disappointing companies tend to do poorly for their shareholders. Simple – I’ll avoid those. But how can you pin down and identify the good-quality stocks? Here’s what to look for.
Is the business good?
If a firm operates in a robust trading niche, you’ll probably find decent profit margins, strong cash flow, good returns on capital and a consistent trading and financial record stretching back years.
You can pin things down by looking at factors such as the long-term average return on capital employed, and the higher it is, the better. I’d also look for decent and stable profit margins backed by solid and consistent cash flow. Finally, everything flows from the top line, so I’d look for stable growth in sales as measured over years, rather than months or weeks.
Operational momentum
I reckon the most successful investments arise when a company not only has a good business, but when it also has an improving business. So, I’d examine the record on revenue, cash flow, profits and that big ‘tell’, the dividend. The best investments show consistency and steady growth in all those indicators.
Is the company safe?
The way to figure out whether a company is well-financed is to examine the balance sheet. But you can get a quick feel for things by comparing the enterprise value (EV) to the market capitalisation. If the EV is bigger than the market capitalisation, you’ll find net debt on the balance sheet, so if it’s a lot bigger, the firm will have high debts.
If the market capitalisation is bigger than the EV, there will be net cash on the balance sheet, suggesting a well-financed company. Debt isn’t always a bad thing if used in moderation. However, I reckon it pays to drill into the financial statements to look for the possibility of ‘hidden’ debt such as pension obligations, lease commitments, tax obligations and excessive, unpaid creditors.
Once you’ve identified a good company with improving prospects, the next thing is to buy the shares as cheaply as possible, which is where valuation comes in. But that’s a topic for another day!
