My Equity Investing Philosophy

Posted on 14/01/2011

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The following five factors (in no particular order), are the key criteria on which I consider potential investments for my equity portfolio:

1. High and stable cash flow generation. I want to invest in companies that are free cash flow positive (calculated as cash from operations less normalised capital expenditures), usually where the free cash flow yield is greater than 5% and ideally where it is nearer to 10%.  Following the advice of Benjamin Graham, I view the purchase of stock in companies that generate no cash flow as speculation rather than investing.  Companies which generate no cash flows today may never generate any cash for investors, and consequently the shareholders in such companies are dependent upon an appreciation in capital values, and often an improvement in market sentiment, in order to drive their returns.  While such speculation may turn out to be successful, I would argue that an investment case built upon the potential for the revaluation of the asset by the market is a weak investment case, as sentiment can quickly change to the detriment of the speculator.  On the contrary, when investing in a business which generates regular cash flows, investors have the opportunity to profit from: earning the cash flows (like a bond yield); the growth in cash flows over time as the market expands with the economy; by expanding the business by reinvesting the cash flows in new opportunities; leveraging balance sheet (borrowing against future cash flows) to pay dividends or make acquisitions; or selling the business to someone who values the stream of cash flows more highly.  One other positive factor about investing in cash flow positive companies is that the downside tends to be limited, as the free cash flow yield tends to provide a floor to the share price.  Finally, companies that are cash flow positive are able to pay dividends and make share buybacks.  Some might argue that by focusing on cash generative companies the resulting investment universe will be full of mature or declining businesses, leaving me with no opportunity to invest in younger business with potential for significant growth.  I would argue that this is not the case and that there are a large number of attractive, growing, cash-generative businesses available for investment at attractive prices.

2. Understandable financial statements. This may appear obvious to some, but in my view the probability of me making a mistake with an investment rises exponentially with the increase in the complexity of the financial statements of the company in question.  I’m a professional securities analyst, but I’m not ashamed to admit that the greater the number of the following items that appear in an annual report, the less likely it is that I’ll be able to gain a sufficient understanding of the business in order to feel comfortable making an investment:

  • A proliferation of derivatives transactions;
  • Multi-layer capital structures;
  • Secured borrowing agreements;
  • Multiple subsidiaries which are not >50%-owned;
  • Regular acquisitions/disposals (with corresponding write-downs/adjustments);
  • Recurring extraordinary and exceptional items;
  • A regularly changing management incentive programme;
  • The use of off-balance sheet financing arrangements;
  • A change of year end;
  • Unusual revenue recognition practices;
  • Overseas investments that lack disclosure of currency-adjusted results.

Complicated financial statements are also, in my opinion, an aid to fraud and a mask of incompetence, the complexity providing cover to management to either steal from shareholders or to stumble along while achieving little, but providing the pretence of activity.  Because of this, I have a preference for investing in companies with straightforward financial statements.

3. Revenues flat, or preferably growing. As Warren Buffett said in his letter to Berkshire Hathaway Inc shareholders in 1977, “One of the lessons your management has learned – and, unfortunately, sometimes re-learned – is the importance of being in businesses where tailwinds prevail rather than headwinds.” My view is that investors are often willing to overpay for the shares of companies that operate in growth industries, sometimes bidding-up their price to unsustainable levels.  Consequently, I do not necessarily seek out companies which operate in markets with rapid revenue growth – unless I’ve spotted something the market has missed – as companies can also generate value for shareholders by improving margins, reducing working capital, expanding into new markets, launching new products, divesting assets, optimising the balance sheet, etc.  However, I will certainly avoid those which are exposed to a declining market or increasing low-cost competition, as conditions such as these often leads to pressures in other areas – on margins, working capital, asset prices, etc, which can significantly impact shareholder returns.

4. Low indebtedness. While it is clearly most efficient for a company to have a certain amount of debt on its balance sheet (which will vary depending on the industry, size of the firm, current credit market conditions and the jurisdiction in which the company operates), the returns from this efficiency accrue mainly those investors who hold shares at the time the balance sheet is levered-up, as in an efficient market, the share price should quickly move up to reflect the present value of the tax shield provided by the debt and the lower cost of debt interest vs the cost of equity.  Therefore, I prefer to own companies with low levels of indebtedness, as such companies are able to gear the balance sheet at a later date, either to make an acquisition or to return cash to shareholders.  I see this as an in-the-money option, where the premium is the ongoing cost of capital (in excess of that which the company would pay if it had an efficient capital structure), the exercise is an acquisition/dividend and there is no expiry date.  In the case of companies that already have an efficient or over-levered balance sheet, the benefits of such actions accrued mainly to previous shareholders, and as a consequence the company now has fewer options for the future.  I will consider investing in indebted companies where certain criteria are met, these being: (1) there is clear visibility over the company’s financials; (2) the company has sufficient debt service cover; (3) refinancing of principal should be comfortable in current credit market conditions; (4) there is clear headroom on all financial covenants; and (5) the industry background should be characterised by improving conditions.  Clearly, these criteria are highly subjective, but they are intended to be so given the significant additional complexities that arise once a company begins to finance itself in the leveraged finance market.

5. Sustainable Competitive Advantage. In a previous post I have already written at length about Michael Porter’s Five Forces analytical framework, which I view as the optimum manner in which to consider the strategic positioning of a company.  By selecting only companies that score highly on this (subjective) measure, I believe that investors can have a high degree of confidence in the company’s ability to generate growing cash-flows over the medium-to-long-term future.  Warren Buffett describes such companies as economic “castles”, surrounded by “moats”, commenting on Coca-Cola and Gillette in the 1993 Berkshire Hathaway letter to shareholders:

The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles. The average company, in contrast, does battle daily without any such means of protection.

Companies that score badly on this framework, in my opinion, are more likely (compared to those that score highly) to experience a decline in profitability as suppliers, customers, competitors and potential new entrants take advantage of the opportunities afforded to them by the circumstances.

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Posted in: My Thoughts