In writing this weekend I’m coming off the back of a week of excellent performance from my portfolio, culminating in a takeover offer from Kindred Group for 32Red (TTR). The offer prices my holding at a gain of approximately 185% on the initial purchase price, and represents the first significant offer on one of my holdings. I am now left with the task of deciding where to place my funds, once they arrive. It’s hunting season in the stock market.
In the beginning…
I usually like to begin my search for an investment by using a quantitative approach, looking for companies that meet specific criteria:
- High ROE/ROIC
- Positive net income growth
- Low-to-no long term debt
- A high current ratio
- Reasonable valuation (P/E, P/B, P/S, etc)
There’s nothing radical in that approach, and certainly it will filter out many fast growing, highly valued companies (Boohoo.com, anyone?). But it will also filter out many badly performing, at-risk companies who are perhaps highly indebted or operationally inefficient. If you’ve seen my portfolio you’ll know there are a few non-UK stocks in there too. I am happy to take advantage of A J Bell’s ability to invest in overseas markets (13, last I checked) and perhaps look for value beyond these shores.
Quantitative investing obviously works for some people, but they tend to hold a large basket of stocks so as to mitigate any perceived risk to any one, or a number of, them failing. I cannot afford to do that, holding a portfolio of approximately 20 constituents, hence screening quantitatively is only the first in a number of steps towards finding an investment. It’s no good being cheap if it’s also likely to encounter obvious problems in the future.
Domestically, running a quick screen actually highlights a number of companies I already own (housebuilders Berkeley and Persimmon for example). I have no problem existing to current positions. Toiletries & fragrances manufacturer Creightons (CRL) for example, is up 127% in my portfolio but quantitatively could still be regarded as cheap:
- P/E 11.62
- P/B 1.3
- P/S 0.4
A Deeper Dive
Having run a screen, I usually end up with a few results worth looking into further. I say a few, because a LOT gets screened out. There are no results at all in France, Italy or Spain, for example. A quick trip over to Morningstar (if you use it, use .com instead of .uk) gives a nice ten year summary of the financial performance of a company, as well as five years of the income statement, balance sheet and cash flow statement. I’ve written before about my affinity for cash flows, therefore the first thing I look at is to see if there are any. If free cash flows are both positive, and ideally, growing, a further look is warranted.
Usually a glance at a ten year financial summary of a company will tell you a lot about it. Is net income and revenue growing? Are their margins consistent and reasonable for their industry? Do they have consistent ROE & ROIC? If they pay a dividend, is the payout ratio consistent, prudent and sustainable? Do they have a track record of diluting share ownership (or ideally, buying back shares)?
A lot of questions must be asked before making an investment. Ideally I want to be in for the long haul, therefore it’s worth putting the time in now to try to mitigate as much risk as possible.
It’s Cheap, but is it Cheap Enough?
If a company appears quantitatively cheap, and financially looks decent, it’s time to do a discounted cash flow analysis. I’ve written about this before (see here, for example) so won’t bore you further, suffice it to say a DCF analysis will help determine if a company is cheap enough to purchase. Is it materially trading at a discount to its intrinsic value? Does it present a margin of safety?
The more I make use of a DCF analysis, the more I am beginning to model a range of possible outcomes going forward. I have been remiss in the past in stating one fixed price that I believe represents the intrinsic value of a company. Professor Aswath Damodaran has written extensively on using a DCF to present a spectrum of possible valuations, so if this is something that is of interest to you, I suggest looking him up.
With all that in mind, I’d like to take a quick look at three potential investments:
1. Solid State (LSE: SOLI)
Current price: £5.15
Solid State PLC is engaged in manufacturing of electronic equipment and distribution of electronic components and materials. The Company is a manufacturer and specialist design-in distributor to the electronics industry.
- P/E 10.8
- P/B 2.6
- P/S 1.0
- Yield 2.33%
- Back of a fag-packet DCF £8.63
2. Sturm Ruger & Co. (NYSE: RGR)
Current Price: $49.85
Sturm, Ruger & Company, Inc. and subsidiary, is engaged in the design, manufacture and sale of firearms to domestic customers. The Company operates through two segments: firearms and castings. The firearms segment manufactures and sells rifles, pistols and revolvers to a range of federally licensed, independent wholesale distributors located in the United States.
- P/E 10.9
- P/B 3.5
- P/S 1.4
- Yield 3.5%
- Back of a fag-packet DCF $79.28
3. Safestyle UK (LSE: SFE)
Current Price £2.97
Safestyle UK plc is a United Kingdom-based company engaged in the sale, manufacture and installation of replacement un-plasticized poly vinyl chloride (PVCu) windows and doors for the United Kingdom homeowner market. The Company’s segment includes the sale, design, manufacture, installation and maintenance of domestic, double-glazed, replacement windows and doors.
- P/E 16.6
- P/B 7.1
- P/S 1.5
- Yield 3.55%
- Back of a fag-packet DCF £3.74
This has been an abridged version of my investment methodology but hopefully goes some way to establishing my methods. Talk this week (at the end of Feb 2017) has been of whether markets are expensive, or even in bubble territory. The UK currently sits on a CAPE ratio of 14.8, above its historic average but hardly expensive by CAPE standards. I am, however, finding it harder and harder to find companies that pass my screening criteria. Whether this is indicative of anything, I don’t know.
Disclosure: TTR, BKG, PSN & CRL are constituents of the portfolio.
If you’d like to discuss anything contained in this article, contact me on Twitter @britishinvestor.