There’s a saying that you should “begin with the end in mind”, and it can also very appropriately be applied to investments. When you invest, your first step is to identify your expectations, or more specifically, your ultimate investment goal, whether it’s a short-term goal that should be reached in only a few months, such as saving for a holiday, or something more long term, such as saving for a comfortable retirement. You need to know what you expect at the end of your investment term, so you can plan accordingly. I find that this saying applies particularly well to equity investments. Surely, everyone that invested in shares at some point would eventually like to know that they actually made a quality investment? But how do we go about doing this exactly? Well, by simply making your starting point quality.
There are so many different themes surrounding investment strategies for compiling share portfolios and I’m sure most of you have heard of the three main themes: momentum shares, value shares and quality shares. When investors look for strong momentum-driven shares, they are looking for shares that have experienced strong price increases and support over different periods. Value investors look for shares that appear to be strongly undervalued according to various valuation methods. Finally, quality shares, which will be our focus this week, are shares that stand out as companies that have managed to generate better quality earnings over a particular period.
Before I continue, however, I want to point out that I am not favouring this strategy in any way whatsoever. On the contrary, I feel that each of the abovementioned strategies are equally important when conducting a proper analysis. In fact, you’ll find it extremely difficult (if at all possible) to identify a company/share that meets 100% of all three of the abovementioned criteria, and there are more than enough research reports to support this theory. So, what do we do?
This brings me back to the saying about beginning with the end in mind. If I want to keep quality shares in my portfolio, I have to start by identifying quality earnings. I do this by using companies’ last 12 months of data, and then by analysing those companies (I only use the top 75%) that showed the best quality earnings for that period. Obviously, this is only the first step in conducting my analysis, and it will be followed by the next steps which will of course include value analysis and momentum analysis.
There are three basic factors that will show me how strong (or how high the quality) a particular company’s earnings were:
Here we focus on the effect any changes in assets and liabilities might have had on the company’s cash flow. A decrease in accounts receivable might indicate an increase in cash sales, which would have a positive effect on the company’s cash flow. In the same way, a decrease in stock levels and other current assets might indicate an increase in sales, therefore, the lower these ratios, the better. A decrease in property, plant and equipment expenses can also contribute towards better cash flow.
On the other hand, a decrease in accounts payable, other current liabilities and other non-current liabilities may mean that more cash was used to cover these costs, which could have a negative effect on the company’s cash flow, so the higher these ratios, the better.
Here we focus mainly on cash flow from operations and capital expenditure. Both ratios are compared to the company’s industry median. If cash flow from operations is higher than the industry median, the company would obtain a higher score, while capital expenditure should ideally be lower than the industry median.
In this section, we focus mainly on two factors: the company’s operating profit margin and any changes in the company’s net operating asset turnover. Again, both factors are compared to the company’s industry median and would lead to a higher score if they are above the industry median.
Source: PSG Wealth Old Oak
After applying this first step in my investment process, I have identified the following 10 shares as shares that currently seem to stand out as good quality shares:
- Astral Foods Ltd
- Anglo American Platinum Ltd
- Adcock Ingram Holdings Ltd
- South32 Ltd
- Tiger Brands Ltd
- Vodacom Group Ltd
- Kumba Iron Ore Ltd
- Wilson Bayly Holmes – Ovcon Ltd
- BHP Billiton PLC
- AECI Ltd
I want to reiterate the fact that this is only the first ingredient in my full recipe, which means that quite a bit of homework still needs to be done. Also remember that a diversified portfolio should, include more shares than those I have listed above. However, by identifying quality shares as a first step, you can ultimately help to turn your entire portfolio into a portfolio of higher quality.
The opinions expressed in this blog are the opinions of the writer and not necessarily those of PSG. These opinions do not constitute advice. This is intended as general information and does not form part of any financial, tax, legal or investment related advice. Although the utmost care has been taken in the research and preparation of this blog, no responsibility can be taken for actions taken based on the information contained in this blog. Since individual needs and risk profiles differ, it is always advisable to consult a qualified financial adviser before taking action.