Advisors sometimes ask us what rules of thumb or parameters we use when selecting companies for research coverage or inclusion in our model portfolios. The answer is none.
By following a fundamental investment approach (as opposed to rigid quant investing), we acknowledge that boundaries move constantly due to factors like shifting interest rates and ever-changing rules for financial statements. Static factors or limits simply don’t apply.
However, telling advisors that the best returns come from constantly rewriting the rules isn’t a handy take-away. So, we considered what advice holds up over time and through varying market conditions.
What follows are guidelines that have proven useful to us through the years. These suggestions aren’t for everyone, but they work for our approach: seeking growth in adjusted cash flows to support value, avoiding unnecessary risk and volatility, and focusing on the longer term.
Avoid unprofitable companies. You could make money today by trading the shares of an unprofitable psychedelics, fuel cell or telemedicine company. Or you could wait for one of the clear winners to emerge and invest for the long term.
Most investment returns usually come after a company turns profitable, and no remarkable foresight is required to benefit. Investing in Amazon for the five years before it became profitable would have netted a compound annual return of 30% — not bad. But you would have done better over the 18 years since, without needing to guess in 1997 that Amazon, which then sold only books, would become the world’s largest e-commerce retailer.
When faced with a deluge of potential names in an emerging industry, most advisors and investors have a poor track record of picking the ultimate winner years in advance. How many bought a cannabis company five years ago that today is one of the profitable few? Invest in profits now, and in emerging trends in the future.
Avoid bad smells. Sometimes, ignoring the herd is difficult even when something seems off. We avoid companies that have financial reporting or governance red flags or reek too much of financial engineering. An investment with a similar return profile that doesn’t share the same worrisome characteristics can always be found.
You need own only so many companies to provide clients with equity diversification. That means you’ll end up passing on hundreds of others, and there’s no need to own any with known faults, regardless of their positive traits.
Don’t swap horses. Advisors are always contending with new ideas and opportunities, and there’s a constant temptation to trade for a quick return — often in the form of chasing a potential takeover candidate. Whether based on rumours of a deal brewing or on merger trends in a certain sector, buying into a company solely with the thought that it’ll be bought out is never a good idea.
Sometimes sell-side research can’t help but dangle the prospect of a takeover. Analysts are keyed in to the thinking of investment bankers, who constantly troll for mergers and acquisitions work. That’s trading, not investing. Acquisition rumours can evaporate, and shares can deflate without warning. If takeover potential exists as a free call option on an already attractive stock, all the better. But if you’re going to buy a name, be ready to own it for the long haul.
Look for re-rating opportunities. Re-rating is when investors expect a company to trade higher due to an increase in valuation multiple. This process can be fairly transparent, and outperformance can be achieved simply with patience. Some Canadian companies will seek a U.S. stock listing to gain exposure to a market where peers trade at higher levels due to increased investor interest and knowledge. Other times, a shift in business revenues creates a clear path to improvement. Increases in recurring service revenues can frequently allow companies to realize higher margins and lock in repeated sales, both of which the market favours.
Another path to re-rating is for a company to fix a problematic segment or exit a lower-margin or volatile part of its business. Actions that increase reliability in financial forecasting attract more investors and propel valuation higher. Management often lays out the objective or process in advance, and investors can reap the returns over several years as the plan is executed.
Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP, and Mark Rosen is MBA, CFA, CFE.