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High-quality, undervalued stocks... and how to spot them

High-quality, undervalued stocks... and how to spot them

By Tony Featherstone 08.05.2017


Picture this: a stockbroker calls their client with a “hot tip” on a mining stock. The unknown explorer is about to hit the big time as drilling results unfold. The broker suggests going “hard and early” to buy the stock before the rest of the market catches on.

The client invests $20,000 in the junior miner on the broker’s recommendation, having little understanding of the company or its prospects. The broker’s tips have worked well previously and the timing is circa 2010 near the mining-boom peak.

Within weeks, the mining stock halves, costing the client $10,000 on paper. There is talk the company could go under. Fortuitously, the stock rallies and the client sells, taking a small loss. Two months later, the company is worthless. 

That client, of course, was me, back in the days when I traded stocks (or in that case wildly speculated). This experience encapsulated so many investment mistakes in a single trade – and reinforced how easy it to destroy wealth on the sharemarket. 

I covered five such mistakes in last week’s column for The Bull: listening to market noise, overtrading, anchoring (basing decision on past information), poor risk management and too much focus on buying. Tick each of those boxes with my failed mining stock.

Those great investing emotions – fear and greed – can wreak havoc on your wealth. But overcoming them is only half the battle. The next step is spotting exceptional companies and buying them when they trade below their intrinsic (true) value.
 
The failed mining company I owned was the opposite of exceptional. In retrospect, it explored low-grade deposits, was a long way from infrastructure and poorly managed. It had no revenue or profit, yet was worth $60 million at one point, such was the hype.

Long-term sharemarket success is built on investing in exceptional companies. The best of the best, preferably before the market realises. There’s nothing wrong with trading micro-caps, provided you adopt a trader’s mindset and strategy, and recognise this is speculation rather than investment. 
Here are five tips to spot exceptional companies at bargain prices:

1. Start with the industry

I have long believed that good industries beat bad companies and vice versa. Consider media. Years ago, I recommended to The Bull readers to buy internet-advertising stocks, such as REA Group, Seek and Carsales.com during market corrections or pullbacks. Fund managers who said these stocks were overpriced underestimated their favourable industry dynamics.

It was a no-brainer that more advertising dollars would migrate from traditional print and TV media to online platforms. Acting on that view by buying Seek and selling Fairfax Media a decade ago would have made a massive difference to portfolio returns.

Look for industries that can sustainably grow faster than the economy, have positive competitive/regulatory settings and offer better profit margins. Think healthcare, tourism, agribusiness, online media and personal services. 

2. Companies with competitive advantages

Choose companies that have a clear “economic moat” or sustainable advantage that allows them to earn higher returns for longer. I like the “moat” analogy because it suggests the company has something that stops it being invaded by competitors.

When choosing a company, ask: “How hard would be it be for a competitor to replicate the business?”. The employment site, Seek, for example, is almost impossible to replicate in Australia because Seek’s high user-base attracts job ads, which in turns attracts users.

Companies that are hard to replicate have latent pricing power. REA Group is raising its prices again. Why? Because it can, such is the dominance of its property advertising platform. Agents will grumble, as they did when REA last lifted prices, but inevitably will accept the higher prices. 

The best indicator of sustainable competitive advantage is a rising return on equity (ROE). Companies that deliver a high ROE (above 15 per cent as a rule) over a long period, and keep increasing it, are maintaining and exploiting their competitive advantage. Think CSL, whose competitive advantage is built on intellectual property.

3. Balance sheet

Exceptional companies typically generate surplus cash and reinvest it to grow the business. Their ability to fund growth internally means they do not have to raise debt, which adds risks, or issue equity, which dilutes shareholders.

Amazon is a great example. It has incredible revenue and surprisingly low profit for a giant multinational. The business keeps reinvesting surplus cash to expand, build its dominance and capitalise on its first-mover advantage in global online retailing.

Favour companies with low or preferably no debt and growing operating cash flows. These traits minimise risk, create firepower to acquire other companies and fund growth internally. 

Better still, companies that reinvest surplus cash flow have an ability to turn off the tap when market conditions slow. That is, they have the option to reinvest less in the business for future growth if they need to prop up earnings or dividends. 

Surplus cash flow and internal expansion funding are often traits of companies with capital-light business models or high margins (the exceptional ones I referred to earlier). Think Carsales.com or other online media companies with lower fixed costs. 

4. Management 

Some fund managers get too hung up on management and try to second-guess their motives. I know a few who even study CEO body language during presentations. Apparently, some US investment firms train their analysts on how to read CEO body language, and algorithms have been written that track the positive and negative of CEO comments.

Don’t get me wrong: management is critical. But stick to the facts when assessing management rather than focus on personalities. Most CEOs are persuasive in one way or another. The ROE and balance sheet tells you more about management than their CV or prepared speeches.

Better still, assess management’s “skin in the game”. How much “hurt money” do they have in the business? Do they own many shares and what do they stand to gain/lose if the company succeeds/fails? Is management’s interest strongly aligned with that of shareholders?

If you still want to focus on people, look at the board members. Their main job is to choose, incentivise and monitor the right CEO. And get rid of them if they fail. Is the board sufficiently diverse, 
experienced and independent from management? Excessive CEO pay and poor acquisitions can be signs that management has “captured” the board – that is, directors agree with everything management says and do not act as shareholder agents.

5. Valuation 

Here’s the rub: the market usually knows which companies are exceptional and prices them accordingly. Often, it prices exceptional companies to perfection, leaving no margin for disappointment and setting the stock up for a huge fall at the slightest disappointment.

Consider using valuation data, rather than doing the valuation itself yourself. I use several share valuation services for background research. For example, the Skaffold, StockDoctor, Stocks in Value and Morningstar (for research). 

Consensus analyst forecasts are another insight. This data provides a snapshot of the market’s view of the stock; how many firms have buy or sell recommendations, their target share price and how their earnings forecasts have changed in the past few months.

Sometimes, the best way to spot exceptional companies trading below their intrinsic value is through sheer patience and having a decent chunk of cash in portfolios. That is, waiting for market corrections or share price pullbacks that are more about overall market sentiment and irrational selling than company-specific factors.



Tony Featherstone is a former managing editor of BRW and Shares magazines. The information in this article should not be considered personal advice. The article has been prepared without considering your objectives, financial situation or needs. Before acting on the information in this article you should consider its appropriateness, regarding your objectives, financial situation and needs. Do further research of your own or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at May 4, 2017.



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