In practice: Finding companies and analysing them

Part 4 of a series of 4 articles on beginning value investing, originally published in the gleaming new-look Interactive Investor mothership’s Trading and Investing Strategies pages. If you’re new to value investing, or a seasoned bargain hunter, I’d like to know whether you think I’ve done a good job explaining the basics.

Peter Lynch famously urged investors to "buy what you know", but he complained in the second edition of his bestselling book One Up on Wall Street, that people had misinterpreted him.

Readers had taken him literally and he subsequently wrote:

Liking a store, a product, or a restaurant is a good reason to get interested in a company and put it on your research list, but it’s not enough of a reason to own the stock! Never invest in any company before you’ve done the homework on the company’s earnings prospects, financial condition… and so forth.

Lynch even interrupted family holidays to visit nearby companies, never missing an opportunity to ‘kick the tyres’.

Warren Buffett says he always stays within his ‘circle of competence’, jargon that has joined ‘margin of safety’ in the value investors’ lexicon. But Buffett flicked through catalogues of companies getting to know them, and constantly reads the business press and company reports. Both men are intensely curious, and as they have invested, they have expanded their circles of competence.

Learning about different companies is one of the rewards of investing, and it’s essential if you are to diversify. To find them, you could start at ‘A’, and work right through the stock market investigating the companies. But there’s a more efficient way: using a computer to screen out companies that don’t meet basic value criteria. In other words, focus on those that, statistically speaking, look cheap and sound.

Let’s start with two fundamental statistics in investing, net profit and book value. You can find these figures in any set of company accounts.

Net profit is the money earned by the company for its owners in, say, a year. It’s recorded on the bottom line of the company’s income statement. Book value is the value of the company’s assets, what it owns, minus its liabilities, what it owes, at the end of the year according to its balance sheet. It’s also called shareholders’ equity, because it’s that part of the company funded by shareholders, as distinct from other forms of funding which are broadly speaking kinds of debt.

If we calculate net profit as a percentage of shareholders’ equity, we get return on equity, which is a measure of how profitable the company is.

If we calculate shareholders’ equity as a percentage of all the company’s assets (ie those funded by debt as well as equity) we are measuring leverage, or gearing. That is, we’re discovering how indebted the company is.

A high level of profitability suggests the company’s managers are doing something right and the company may be a growth engine. Although it may pay a dividend to its shareholders, it will also retain some of the profit to invest, and because the company is so profitable, those investments should earn shareholders a good return in future.

A high level of equity (as opposed to debt) suggests the company has the financial resources to fund itself into the future, even if profits should fall unexpectedly.

By instructing your computer to find companies with high levels of profitability and low levels of debt it’s likely you’ll find lots of good companies. But that’s only half the recipe for success. Good companies are not good investments, if you pay too much for them.

To guard against paying too much you can compare the book value to the market value. The higher the book value in relation to the market value, the cheaper the shares look.

So a simple, but effective strategy for a new value investor is to concentrate your search on companies that are:

• Profitable: the higher the return on equity, the better

• Mostly funded by equity: the lower the level of debt to equity or assets, the better

• Cheap: the lower the market price relative to book value the better.

Generally speaking, shares with combinations of characteristics like this perform better than the stockmarket over long periods of time, but individual companies will often disappoint because these measures are neither precise nor invariable

A company’s accounts are the result of a large number of often questionable judgments made by accountants, some companies’ assets are intangible, meaning literally you can’t touch them, and impossible to value with precision, and just because a company is profitable in one year, does not mean it will be profitable the next.

Some investors are content to get the basics right and play the averages using mechanical investing strategies. Others improve on and interpret the financial statistics.

When you get to that stage, you’re definitely no longer a beginner, but as Warren Buffett and Peter Lynch know, and Benjamin Graham knew, the learning never stops.

Taking the next step:

• Screen stocks at Interactive Investor

• Try a more advanced screener at Sharelockholmes.com

• Participate in my blog

Accounting texts for value investors:

• How to figure out Company Accounts by Michael Brett

• Guide to Analysing Companies by Bob Vause

• Interpreting Reports and Accounts by Geoffrey Holmes, Alan Sugden and Paul Gee

Advanced reading for value investors:

• Security Analysis by Benjamin Graham and David Dodd

• Behavioural Investing by James Montier

• Value Investing by James Montier

• Financial Statement Analysis and Security Valuation by Stephen Penman