For my debut SharePad article, I’ve been invited to introduce my stockpicking strategy. It’s a daunting prospect because strategy is everything. Without a strategy, luck or instinct will determine our returns and in the stock market neither can be relied on.
There are many reinforcing activities that make a good strategy, so please forgive the lack of detail. I’ll share more in forthcoming articles and commentary.
Soft, strong and very long
I look for investments that are soft, strong and very long. To be more precise, I prefer the share price to be soft, the businesses I’m depending on to be strong, and my holding period to be very long. Preferably forever. The strategy is not just restricted to suppliers of toilet paper.
The ‘Andrex’ strategy has many close relatives: buy and hold, growth at a reasonable price, good companies at reasonable valuations. I’m basically one of those investors.
What differentiates the various shades of buy and hold is how the investor defines ‘good company’, ‘reasonably priced’ and ‘long-term’.
Most would probably start with financial ratios that measure profitability, financial strength and value.
Listed companies are in business to make profit and since profit is the money attributable to shareholders after costs, it’s the source of our returns. Unfortunately the profit figure on its own is not much use.
To put profit into perspective we must compare it to the amount of money invested to earn that profit – in factories, offices, computers, warehouses, raw materials, stock, and delivery vans, for example. The ratio of profit (return) to money invested (capital) is profitability, and we measure it using a statistic known as return on capital employed.
Generally speaking, the more profitable a company is, the better the business.
Profitable companies are earning lots of money so they should be financially strong. Low levels of debt can therefore be a mark of quality. They can also improve a company’s prospects, when it goes through hard times.
Poorly financed businesses must cut investment and spending to save money and ensure they survive downturns. Companies with strong finances can keep investing when they’re earning less, and they’ll usually emerge from recessions stronger.
We can compare a company’s debt to its assets to gain an impression of the level of debt, a ratio known as financial gearing.
Generally speaking, the less geared a business is, the safer the investment.
The earnings yield is a measure of value. It’s how I check I’m not paying too much for shares. Since profit, which is synonymous with earnings, is the shareholders’ return we can compare it to the market value of the firm (i.e. how much we pay for our share of the profit). It’s like an interest rate for the investor. Generally, if a really good company is offering more than a 5% return at the current market price, I consider it good value.
Good businesses should grow and earn more profit in future, which will mean the return on an investment made today will likely grow over time as the company does. The earnings yield should be a conservative measure of future returns.
Why set a 5% baseline? It’s considerably more than you’d get in a savings account and while shares are more risky, if they are shares in ‘good’ companies, they shouldn’t be that risky (as long as we have the courage to hold them through thick and thin).
The statistical advantage
Systematic trading strategies using statistics like these have been studied extensively, famously by Joel Greenblatt, an investor and author of the best selling “Little Book That Beats the Market”. My partner in crime, Phil Oakley, has written about Greenblatt’s ‘Magic Formula’ (click here) and how it might be improved by tweaking the ratios. I often wonder if it might be improved, simply by holding the shares it recommends for longer than the prescribed year.
The theory supporting statistical strategies is they take the judgement out of investing. Behavioural finance experts tell us our instincts are usually wrong when it comes to the stock market, so there’s good reason to believe they ought to perform well.
I don’t know of any investors who don’t exercise judgement (but I’d love to hear from you if you’ve put all your faith in an algorithm). It’s human nature to believe we can do better. Whether we will, or not, of course depends on whether we can turn judgement to our advantage.
The advantage of judgement
I believe we can improve on the raw stats by examining a company’s past performance, its return on capital employed and its debt levels as its fortunes have fluctuated. It may be that this year’s profit, which feeds into the earnings yield calculation, is unusually high, or low, and is not representative of what we can expect in future, so some adjustment is necessary.
Generally the future will not be like the past though. Profitability invites competition and so typically it declines as rivals develop better products and services and share some of the spoils. Only the best companies can defend their profitability because of the unique ways they do business.
Teasing out these competitive advantages is difficult but rewarding work, both intellectually and financially. It’s difficult because it requires us to understand a company’s culture, its relationships with customers and suppliers, and its internal capabilities – often hidden from outsiders.
It’s rewarding because there’s hidden value in highly profitable companies.
How SharePad fits in
SharePad can do much of the donkey work, indeed if you stick to the stats it can do it all. I use SharePad to screen out all the wastrels, companies unlikely to fit my strategy. This makes life a lot easier, and it means I’m probably already fishing in waters stocked with good investments.
SharePad also helps with the long-term context, because the data goes back for decades if companies have been listed that long. Charting profitability and financial strength helps me visualise a firm’s performance at different times in the past, and how it might perform in the future.
Having excluded non-starters, I read the annual reports, talk to executives and sometimes visit the companies to determine which of these statistically good companies have sufficient intangible qualities to remain good prospects for years to come.
SharePad also reports the value of investments, which is very helpful when it comes to maintaining a balanced portfolio of shares and making financial plans.
Shares to hold ’til I die
No discussion of strategy is complete without defining an objective. Mine is to own a portfolio of shares and funds that are so good I don’t have to worry about them, investments I can hold ’til I die and perhaps even pass on with confidence.
There’s also a social reason I focus on good companies. Buying shares is a vote of confidence. I want to put my confidence in the best businesses: companies that will grow and provide jobs for future generations, taxes to fund future governments, and dividends to pay for the retirement of future pensioners.
These objectives are personal. Everyone has their own objectives, and everyone has their own strategies. I’m not suggesting you adopt mine, only that you know where you’re going and how you’ll get there.
This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.