Using direct Australian equities instead of managed funds for a part of a client’s portfolio can offer a number of advantages. It can allow an adviser to tailor a portfolio to a client’s specific requirements, perhaps for income or perhaps due to a client’s social concerns, provide some tax efficiency and help lower costs.
However, using direct equities creates the need for good due diligence on those stocks.
With that in mind, here are my top five tips to selecting the best companies for your client’s equity portfolio:
1. Know the business of the company
What is the business of the company? Does the company operate in a sector exposed to future economic growth, or is the business model susceptible to fluctuating economic conditions?
2. Earnings and Dividends
Avoid companies whose earnings (and dividends) are stagnant or declining. You should also question if the company can afford to pay a dividend and how that dividend is funded. Investigate how companies fund dividends and avoid those incapable of generating organic growth.
3. Debt and profitability
In business, the use of debt directly impacts the bottom line – debt costs money and requires ongoing service. With this in mind, ask yourself if the company relies too heavily on debt to fund their business activities? How have their businesses and shares performed over the past few years?
It’s important to understand the profitability of the businesses you are recommending to a client. A simple way to calculate profitability is to use the ratio Return on Equity (ROE). ROE compares how many dollars of equity were required to produce the company’s profit. If a company has $100m of equity and produces a profit of $5m, the resulting return on equity is 5%. If another company produced a profit of $25m on $100m of equity capital, return on equity is substantially higher at 25%. Which business would you prefer to own?
Attractive businesses are able to increase profits each year without the need to raise additional capital or take on debt. These companies produce increasing profitable returns on their equity without increasing risk.
4. Cash flow
Every business operates to generate cash. The amount of cash generated in a given period is known as cash flow.
Think about it this way. At the start of the year your business had $50,000 in its bank account. At the end of its financial year, after receiving revenues from sales, paying staff, taxes and all other operating expenses, you have generated an additional $100,000 in cash. Great!
Now the bad news… in order to generate that cash you had to buy additional equipment for $200,000. Your shareholders also insisted on a dividend that equated to $50,000. So despite your operating cash flow of $100,000, your net cash flow for the year is a gap of $150,000. That gap will need to be funded, either by taking on debt or asking shareholders to contribute additional equity. If this situation continues it will soon lead to difficulties.
Have the companies in your portfolio been spending more money than they’ve earned? Have they raised capital, taken on debt or paid dividends they couldn’t afford?
Remember poor and worsening financials can result in falling share prices.
5. Buy, sell or hold?
Once you understand the business, its economics and future growth prospects, the final step is to estimate the intrinsic value to determine an appropriate price to pay for its shares.
Paying too much for a top-quality company can destroy wealth just as quickly as investing in one with excessive debt. Over time, share prices tend to converge with value.
Ideally you want to advise a client to buy shares when some of the existing shareholders are willing to sell for much less than they are worth. In turn, advise your client to sell shares when other members of the investing public are happy to pay much more than their underlying value.
Chris Batchelor CFA is Skaffold’s General Manager.
Chris is a specialist in equity markets and securities. He is a Chartered Financial Analyst and has 20 years experience in financial markets.
