Knowing what we now know about emotions in investing, we can start to try and limit their negative impact on our investment decisions. In this series of articles we explore a few areas of checklists and how they might be helpful to investors when making their own systems and strategies.
We explore 6 areas which different types of investors will favour depending on their approach (growth vs value etc)
- The first hurdle – defining your universe
- Underlying Business Solvency – is the business going to survive the year
- Profitability and Strength – how good is the business today
- Valuation – is the price right
- Growth and forecasts – how good could the business be in the future
- Technicals – what is the price action telling us
The first hurdle
- Size –
How much capital do you have to allocate? If you have billions, investing in the AIM is not going to provide a useful playground! However, when you get to even an investment portfolio of £0.5m, you may want to rule out companies below a certain size. Are you comfortable filing TR-1 Forms? Do you want to hold 5% of a company? These may seem obvious, but things that need to be considered.
Much like size, when considering where to invest, we need to consider liquidity. A highly illiquid stock may not suit those who need easily available cash or like to have freedom to sell at around the bid and ask when things are not quite right. This can be driven by both size and free float. Free float is the % of the shares out of ‘insiders’ hands, and is usually the maximum % of shares that will trade, as often, insiders shares are likely to be held for very long periods – if not indefinitely. The bid and ask aren’t always real in small caps!
- Geography and market
We are UK only investors, and as a consequence we’ll focus on market, but the same principles apply. The AIM and the main market have quite different disclosure rules and regulations. How comfortable are you investing in a lower regulation environment? Do you understand your rights as a shareholder across the different markets?
Underlying Business Solvency
- Net Debt
What is the net debt of the business – do they have more cash than their debt liabilities? Having net debt is not an issue, many businesses are inefficient when they hold net cash, but judging net debt to the business’s ability to pay down that debt (via assets or cash flow) is important to understand how solvent or not the business is. We like net debt to EBITDA multiples to gauge overall solvency, but would generally go for businesses with low levels of net debt.
- Free cash flow
Does the business generate cash? But not just cash, cash after paying down debt, making capital purchases and paying interest. Businesses can go a short while (sometimes even a long while!) without generating free cash, but not forever. We think that ultimately free cash flow is what makes a business attractive, but investors can go a long time without seeing it flow to their hands if a business is growing!
This is can be difficult to assess, but if the business has large amounts of debt, understanding the debt covenants with the creditors is crucial – particularly if in a turnaround. How much headroom do they have? Are they likely to breach in the next 12 months? Can you track them easily from the outside – in? – this one is particularly important, because of window-dressing (the practice of hoarding cash at quarter end) and the opacity of some annual reports, it can be difficult to judge the true business position.
- Net assets
Does the business have more to its name that it owes? Owning a house in negative equity is unattractive, even if you rent it out for cash flow. We think the same about companies – does the business have net positive tangible assets? Does it have net assets including intangibles? Are those intangibles fair? (often they are not!). Its useful to think about the net assets of a business in terms of 1) what happens if this were liquidated now (eg is it a positive outcome for equity holders) 2) it tells the story to date, it speaks to all the profits and losses and equity raises accumulated over time.