SHARE INVESTING, BUSINESS QUALITY AND KING KONG THEORY

In last month’s blog “Greece and Share Strategy” we had a look at how what is happening in markets at any given time no matter how noisy is simply a short term side show compared to what really is important to you as a long term share investor. It is the long term performance of the companies in which you are invested that matters. You will do just fine if a reasonable number of the stocks that you own perform well as businesses i.e. over time they increase their profits, dividends and value. And if we get that over time we should also get appreciation in the share price leading to capital gains as well as a growing dividend stream. And you don’t even have to have every share that you own being successful as an investment. As long as the companies in which you invest have the realistic potential to grow profits, dividends and value over time you will find that the returns from successful companies that you own will more than offset any shares that do not work out.

So how do we identify those companies that have this potential? We want to invest in stocks that are high quality, have identifiable favourable prospects and can be bought at a rational price (not overvalued). Stocks that have these three characteristics have as a group (not every single stock) historically been successful long term share investments. There is always uncertainty when it comes to the future which means there is always the risk of getting an outcome that wasn’t expected. Which is why a portfolio should be diversified. It also means that longer term share investment is a probabilities exercise. By restricting investment to shares that have these characteristics we should get more successful share investments than unsuccessful investments over time. And the beauty of it is that you don’t need to take a view (guess) as to what markets will do in the shorter term. Some of the time they will be moving and grooving and other times they will be misbehaving. Markets are not always efficient and not all investors are rational. Nevertheless sooner or later the share price for a stock will reflect whether the business is or is not increasing profits and dividends and growing in value.

Let us have a look at the quality of a business. Below are four stocks and the table sets out the quality of the business, profits per share, dividends per share, estimated value (Return on Equity or profitability valuation basis) and share price performance over a ten year period (as always some of the time markets were rising and other times falling).

Which of these stocks would you have liked to have had in your portfolio and which ones would you like to have avoided? While owning what appears to be a quality business is no guarantee of investment success for that particular business (things can always change) if you consistently include low quality businesses in your portfolio you are investing with the probabilities against you and sooner or later you are likely to experience disappointment.

All of these stocks are or were regarded as blue chip. Arrium was previously known as OneSteel. Fairfax shows what happens when a business gradually deteriorates in quality over a number of years. There are many stocks that range between these extremes nevertheless there is on average a distinct correlation between quality of business and profits, dividends, value and share price performance. If you only invest in CSL and Seek type businesses when it comes to quality then, while there will still be the occasional disappointment, having just one or two CSLs or Seeks in your portfolio will more than offset any stocks that don’t perform. You will be investing with the probabilities in your favour.

Ok let’s look at some boring theoretical stuff for one paragraph. How do we decide whether a business is high quality or not? Consistent rational and quantitative quality ratings can be determined from the financial data taken from a company’s accounts. From the balance sheet companies can be categorised into those that are financially weak, those that have marginal to average financial strength and those that are financially strong. Financially strong businesses are much less likely to have dilutive capital raisings, cut dividends or worse struggle to survive in hard times. Businesses that have strong cash flow (as opposed to accounting profits which can be manipulated) are able to pay increasing dividends to shareholders without having to take the money back through capital raisings. We don’t want companies that spend more than they earn regardless of the reported accounting profit. Companies that have high profitability (high return on equity) often have the ability to grow their business without having to borrow or issue more capital. The less debt servicing or capital raisings the more there is to fund increased dividends, buybacks or invest in further growth for the business from which there is potentially even more dividends etc. etc. a sort of virtuous loop.For those of you who are masochistically inclined I have an eight page paper that goes into more detail on quality and value. Let me know if you would like a copy.

And then businesses need to be reviewed on a regular basis usually when they report their half yearly or full year profits or if there is a significant change in affairs for the company like a big acquisition for example. As can be seen above companies that are high or average quality can become lower quality over time and vice versa.

So the concept of only investing in high quality businesses is simple if not always easy in practice. Still its child’s play compared with trying to set up a share account these days with all the ID and other requirements under the Anti-Money Laundering and Counter-Terrorism legislation. Here we find that King Kong Theory is most certainly alive and well. This theory is derived from the old not particularly funny joke that goes how many bananas do you give King Kong? The answer is that if you are within his reach as many as he wants. It’s the same principle when dealing with mind numbing bureaucracy. You can’t beat them so you not only give them as many bananas as they want but also how they want their bananas structured.
If you would like further information send me an email or give me a call or go to www.lifestylefstas.com.au

Regards

Curtis