2 Ways To Find Winning Shares

As I’m sure you know, index trackers offer great returns by matching the market at a reasonable cost.

And for many investors they’re the perfect investing solution.

But if you have a passion for the stock market, it’s possible to do better than the market by building your own portfolio with individual shares.

There are many strategies for finding market-beating investments, but there are four that I prefer. I’m going to discuss two of them today and will follow up with the other two next month.

Like most investors at the Motley Fool, I believe investing for the long term is the most rewarding and practical.

So as I lay out my thinking on:

1) scooping up industry leaders in a panic and

2) identifying companies going through a transition,

…remember I’m looking out two-to-three years in the future at what I believe these companies will become.

Buy strength when there’s panic in the streets

Every few years, investors always seem to work themselves into a frenzy about a real or perceived danger that they believe will change everything for the worse.

Almost every year, at least one industry goes through such an upheaval, and this year it’s been anything connected to commodities. Whether you look at oil and gas producers, fertilizer companies or gold miners, you can easily find shares 30% or more off their highs.

This might surprise you, but more often than not, there is good reason to be broadly concerned during these sector upheavals. And there is usually good reason to be very concerned about businesses in troubled sectors that have weak balance sheets.

But in the long term, the stronger players generally win out during these upheavals.

The way to find successful investments in this situation, then, is to focus in on the companies with the strongest competitive positions.

These companies will generally enjoy the lowest cost of production, the strongest balance sheets and in some cases the highest returns on capital.

Their profits and related measures may very well be declining, but their competitors are likely to be in much worse shape. In time, the strong should survive, take market share and then flourish as competitors fall by the wayside.

Look for companies in transition

My second strategy is a little more complicated, but it is an all-weather approach.

There are always businesses making changes to their strategies, executives or operations.

Often, you can tell if a management change is a clear positive or negative right away. If not, they tend to be clear once the new man unveils his strategy.

I must admit, strategic and operational changes are a little more nuanced. Nonetheless, every time I come across a company going through some sort of change, I log its ticker in a spreadsheet and then wait to see what happens.

Sometimes the market will react positively to the changes, only to cool off later. Alternatively, the uncertainty that comes with change may cause investors to start selling right away. Either way, an opportunity often develops.

I’ve found that a couple of types of transitions tend to work out well

The first is when companies sell one or more subsidiaries that represent, say, a quarter or more of revenues or profits, but with margins lower than the rest of the group.

Often the division being sold has a weak competitive position, and if it requires substantial capital investments that’s even better for me.

True, the disposal will lead to a short-term dip in total group sales and profits, but what’s left is typically a higher-margin business with better earnings quality and often better growth potential.

US chemicals producer Rockwood Holdings is an example of a company shedding divisions and reducing its focus to where it sees its greatest strength.

So far the market loves Rockwood’s strategy, but the chemicals industry is still cyclical and investors can be fickle with such companies — I think this stock is one to keep an eye on.

It can turn a company with mid-single digit growth potential into a 10%-plus grower

The other type of transition I’ve found works well involves companies focused on small acquisitions that fill gaps in their product line-ups. This approach can give such companies access to new customers and/or new countries, to which their entire product lines can then be sold to.

In my experience, this type of transition can turn a company with mid-single digit growth potential into a 10%-plus grower.

In fact, the strategy has been employed well by Essentra during the past few years and, given the fragmented nature of the industries Essentra operates in, I think there’s room for this mid-cap to continue bolstering its growth via acquisition.

Buying and integrating businesses is still a risky strategy, however. So it’s important to make sure the acquiring company is keeping its debt load manageable, its return on invested capital stable and its cash flow growing. If these measures are consistently deteriorating, consider it a red flag.

And be careful with companies making large acquisitions — I generally recommend staying away from firms acquiring 30% or more of current turnover. And I steer well clear if the company is making a large acquisition in a completely different industry.

Substantial rewards for patient investors

Investors tend to focus on recent sales and earnings growth as indicators of winning investments, but trying to understand what is going to happen in the next two years is much more important than what has happened in the last two years.

Companies going through substantial changes, and industries in recession, are two areas where a willingness to look at less conventional ideas can lead to substantial rewards for patient investors.

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> The Motley Fool has recommended shares in Essentra.