13th August 2010
Investing is easy, right? Buy good companies, hold for the long-term and bingo, you're Warren Buffet. But it's the definition of a ‘good' company that is the biggest stumbling block for investors. MM asks the experts what they look for when investing in a company.
The starting point in any investment process is to narrow down the list of companies that are worth researching. Alec Letchfield, chief investment officer at HSBC and manager of their UK Focus fund says that they do this by screening for 3 criteria: "We look for companies that are generating high returns on equity, have an attractive valuation based on the cash they are generating, and experiencing positive momentum."
Once you have a short-list, there are a number of things to look at:
1. The management
Letchfield says that they like to meet the management to hear them explain their strategy for the company: "Over time we want to see them deliver on their objectives as this gives you confidence that they are in control of the business."
Stephen Peak, head of pan-European equities at Henderson Global Investors, agrees: "The question to ask yourself is would you trust this team to run a company you are personally invested in?"
2. How much cash is the business generating?
Fund mangers tend to focus on the cash rather than the profits as this is much harder to manipulate in the accounts. Peak makes the point that the cash flows should reflect profitability: "Don't be misled by subjective accounting practices; it is ultimately ongoing cash-generation that should decide the value of a business."
3. Balance sheet strength
Letchfield always looks at the balance sheet to get a feel for the strength of the business. Companies with good quality assets and manageable levels of debt are better able to survive a period of weakness in the business. "This is more important in a downturn than when the economy is growing strongly," he says.
4. Positioning in the market
Peak emphasises that it is also important to try to understand where the company is positioned within its industry. This means looking at things like the barriers to entry, their market share, and the strength of their suppliers and customers: "Companies do not operate in isolation so you need to understand the wider industry," he adds.
5. The profitability of the company
Another key area is to be clear on how the company makes a profit and its prospects going forward. Peak warns that this sounds simple, but will involve a large amount of fundamental research.
6. Earnings expectations
At Gartmore the philosophy of the Global Equity team is that those businesses that consistently beat earnings expectations will outperform. Hamish Chamberlayne, an investment analyst at the company, says that they are looking for change and not just the best franchises: "Sometimes the worst franchise can move to average, bringing strong returns for the stock."
The Gartmore Global Equity team search for companies where they feel the market has underestimated the prospects for earnings and aim to avoid those where future earnings are likely to disappoint: "I look for stocks where I can find a discrepancy between what the market is pricing in and what I think is likely to happen," explains Gartmore investment analyst Ed Wallace.
Ultimately the key point is the valuation of the business. Every company has a ‘fair price' and even the best company in the world would be a bad investment if its valuation is too high.
Peak says don't be afraid to hold a view that is different to the crowd.
"It is natural to assume that the majority is correct, but it is not always the case. Sometimes the most money can be made by taking a contrarian stance."