State of Play: Having found five potential companies to invest in, I have started analysing the financials of one of them, Nomad Building Solutions. Last post looked at the income statement; this post looks at the balance sheet with guidance from “The Motley Fool Investment Guide” (‘MFIG’ / “the book”) by David and Tom Gardner (aka “the Fools”).
The pointers from the book are as follows:
1. Cash is “very, very, likable” and “we like to see lots of it.”
The Motley Fool boys like cash because it:
- indicates company is generating cash, which is a fairly important part of being a company (alternatively, they’ve done a share raising)
- gives an indication of the absolute floor price of the shares (although I tend to believe that cash is too easy to spend and just because a company had cash in the bank at 30 June doesn’t mean it was still there by close of business on 1 July)
- provides the ability to pay off debt
- provides the ability to acquire other businesses including competitors
They don’t actually define what “lots” is. At 30 June 2008, Nomad had $22m in cash, which was 19% of their net assets. This seems like lots to me. At 31 December 2008, they had $21m in cash, still 19% of net assets. So still lots although reducing.
Cash per share at 31 December 2008 was 15 cents, which, interestingly, was the low the share price reached on 27 January 2009. The $21m in cash was 1.6x the current borrowings, so if they couldn’t refinance they could just pay the bank back, which is a good position to be in.
I think we can conclude that the cash position is OK.
2. Avoid too much debt.
Again, no definition of “too much” provided. Lets look at whether they can pay their interest bill each year, as banks tend to get annoyed when businesses don’t pay their interest and start doing nasty things to them.
The interest cover ratio, aka, ICR (net profit before interest, tax, depreciation and amortisation or “EBITDA” divided by finance costs) for FY2008 was 16.0 times. That is, they can pay their interest or “finance costs” 16 times over from the cash they generated over the year. So, it seems to me that they do not have “too much” debt.
For the half year to 31 Dec 2008, the ICR had fallen to 6.1 (ignoring the impairment of goodwill), which still seems a quite healthy figure by itself, although the significant drop is a bad sign. I’ve ignored the impairment of goodwill because, like depreciation and amortisation, it is a non-cash item and does not affect their ability to fork out cash to the bank.
3. Make sure growth in accounts receivable and inventory approximates sales growth.
The Fools see accounts receivable and inventory as being more like liabilities than assets because they represent a (temporary) failure to generate cash. For the half-year to 31 December 2008, revenue had increased 62% compared to the same period in the year before, whereas, accounts receivable and inventories had gone down 14% over the six months. So Nomad are getting better at generating cash. On the surface seems good.
4. Do whatever ratios catch your fancy.
Examples provided in the book include:
Current Ratio: current assets divided by current liabilities. It is a test of short term liquidity, in other words, can they pay their bills and can they protect themselves from unforeseen circumstances? The Fools like this ratio to be above 2. For small caps, they like it higher still.
For Nomad, we get the following results:
FY2008 1.18
HY2009 1.05
Doesn’t quite pass muster, particularly as it is falling. Looking at the balance sheet, we see that current liabilities stayed virtually the same over the 6 months at $87.8m. Current assets however fell from $103.4m to $93.4m. So they have met criteria 3 above, but it has all gone towards meeting the cost blow-out, so perhaps was driven by necessity. If the cost issue continues, they could be in real trouble.
Quick Ratio: current assets minus inventory divided by current liabilities. It is a harsher test of liquidity because its looking only at cash and receivables to meet short term liabilities.
For Nomad, we get the following results:
FY2007 1.19
FY2008 0.88
HY2009 0.82
So, the movement over FY2008 was not good and the six months to Dec 2008 made things worse. This is basically saying that Nomad are dependent on selling inventory to be able to pay their bills. Note 1 of the financial statements says that inventory includes (i) Raw materials and stores, work in progress and finished goods and (ii) Construction work in progress less progress billings. It represents about 20% of the net assets. I don’t really understand why a building company has such a high inventory. It appears they are building buildings and then looking for buyers later, rather than finding the buyers and building later. This strikes me as a risky way of doing things.
Debt-to-Equity Ratio: The book calculates this as long term debt divided by shareholder’s equity, but I am going to include both long and short term debt, because it is trouble in getting maturing debt refinanced that brings companies undone (think Centro, a company now virtually owned by its banks). A low ratio is good because debt payments have to be met and, as stated above, banks get nasty when businesses miss payments. A low ratio also indicates that a company will be able to raise debt easily if they need it.
For Nomad, we get the following results:
FY2008 32%
HY2009 42%
Its hard to assess what constitutes a “low” debt-to-equity ratio without comparing companies across an industry, but a jump from 32% up to 42% cannot be good. Looking at the details we see that debt increased from $38m to $47m and equity decreased from $119m to $113m over the six months to 31 Dec 2009. So the cost blow out hit both sides of the ratio.
Return on Equity: net income divided by equity, ie the amount of money generated relative to the amount of money put into the company.
Here are the results for Nomad:
FY2007 28%
FY2008 20%
HY2009 before impairment of goodwill 15%
HY2009 after impairment of goodwill 2%
So with all their trumpeting about increasing revenue and net profit at 30 June 2008, they kept very quiet about the fact that their return on equity dropped a whole 8%. Meanwhile, the events of the last half of calendar year 2008 just made everything worse.
Having done all this I’m not feeling much confidence in the management of Nomad. They bought to companies that worsened their results and they have issues within their Nomad Modular Building subsidiary which they don’t appear to fully explain anywhere, not in the financial statements and not in ASX announcements. I don’t like the lack of transparency on this issue.
Nomad’s full year results should be released to the ASX this week (all companies have until the end of August to report), so I’ll be interested to see whether they have managed to turn things around, but they are not gearing up as a buy in my book.
Sunday, August 23, 2009
Saturday, August 15, 2009
What a difference a P&L makes
Nomad shares were trading at 17.5 cents when I first checked their price on 30 January 2009. They closed at 75 cents on Friday 14 August 2009. An increase of 429%. That’s equivalent to around 800% per annum. Phenomenal, so what do the financials tell us?
As per the blog I wrote way back on 26 January 2008, Chapter 14 of the MFIG looks at how to analyse a company’s income statements (otherwise known to oldies like me as the Profit and Loss Statement, or just the P&L).
D&T’s first piece of advice is to “make sure margins remain at consistent levels if they are not actually rising”. Nomad’s net profit margin for the financial years ending 30 June 2007 and 2008 are:
FY2007 7.8%
FY2008 7.1%
Oh dear. They have failed the first test.
Net profit margin is net profit after tax divided by revenue. The book explains that shares trade off expectations and those expectations are based on trends. This trend is going the wrong way. We want the net profit margin either to stay the same or go up.
We also need to look at what is going on to get this result, so first to revenue:
FY2007 $208.7m
FY2008 $335.7m
Yes, you’re reading right. Nomad lifted their revenue by $127m or 61% in only one year.
An extraordinary result.
How did they do it?
They did it by buying two businesses. So actually, we have no idea whether it is extraordinary or not. They don’t tell us how much revenue was derived from the parts of the business that was in place at 30 June 2009 and how much came from the new businesses. We don’t now how much revenue the two new businesses made last year, so we have no way of judging whether this is good or bad. Damn, that is annoying.
Moving on, lets look at the net profit after tax (‘NPAT’ or “the bottom line”) in both years:
FY2007 $16.3m
FY2008 $24.0m
An increase of 47%, which by itself again you would think is impressive, but we just have no way of judging. We also see why net profit margin has fallen. If revenue has increased by 61% but profit has increased by only 47%, then the increase in costs must have eaten up the difference.
So what can we conclude from this? Either, the two businesses bought are not as profitable as Nomad in its original form or Nomad in its original form has not performed as well over FY2008 or both.
I don’t like it.
The market did not seem too fussed about it, however. The 30 June 2008 results were released on 24 September 2008. On that day, 2.8m Nomad shares changed hands, over ten times the daily average for the year prior. In spite of this, the price only changed by 2c per share on the day, closing at $1.65, compared to $1.67 the day before.
D&T’s second piece of advice is “make sure research and development expenditures aren’t getting shortchanged”. Unfortunately, we can’t check this because Australian companies don’t itemise research and development expenditures on the P&L. So we just have to move on.
D&T’s third piece of advice is “make sure the company is paying full income taxes. They say to do this by dividing the tax paid by the earnings before tax.
For Nomad, these rates work out at:
FY2007 31%
FY2008 32%
Which is a tad odd given the Australian company tax rate is 30%. Fortunately, they have a note in the financials which reconciles the tax paid back to a straight 30%. The issue is there are some expenses which are not deductible for the purposes of calculating taxable income. These include “Share based payments”, “entertainment” and “other”. These total less than 0.2% of all costs, so I’m not going to worry about them.
The book explains that the point of this is that if a company has carry-forward losses which are diminishing their tax rate, then these need to be taken into account when examining margins. This does not apply here.
D&T’s last piece of advice is “keep an eye on growth in shares”. This is because its not so much the net profit after tax that counts, it the net profit after tax divided by the number of shares, because that’s what its worth to you as a shareholder.
There’s a whole note in the financial statements about this and it looks more complicated that I would like, but lets wade through it.
At 30 June 2007, the balance of the number of shares issued was 116,466,124. So, with a NPAT of $16.3m, the earnings per share (‘EPS’) were 14 cents.
This seems a fairly straightforward calculation to me, so why do Nomad report the EPS as 18.9 cents per share?
At 30 June 2008, the balance of the number of shares issued was 135,273,708. So the profit is being shared between 16% more shares and the EPS on my calculation was 17.7 cents per share.
So why do Nomad report the ‘basic’ EPS as 19.7 cents per share and the ‘diluted’ EPS as 19.5 cents per share (the ‘diluted’ figure takes into account options).
Nomad’s calculation is based on using the weighted average number of shares over the year, rather than the number outstanding at the end of the year. I’m sure this has been the topic of countless papers and committees on accounting practice and numerous very learned people have determined this is the best method, but I don’t see how this helps me. If I was holding 100 shares at 30 June 2009, unless the company gave me more shares for free over the year, I will still hold 100 shares at 30 June 2010 and if the company had made the exact same profit, my profit would be down almost 14% on the year before.
So lets look at what the changes are over FY2008 and see what happened.
- 6 Sep 07: Issued 673,401 shares in part payment for one of the businesses they bought
- 26 Oct 07: Issued 457,042 shares under the dividend reinvestment plan, ie some shareholders elected to give back the cash they received as a dividend in return for more shares.
- 4 Mar 08: Issued 5.6m shares in part payment for one of the businesses they bought and on the same day, issued 105,076 shares under a share purchase plan
- 24 Apr 08: issued 706,992 shares under the dividend reinvestment plan.
So no-one got free shares (which is a good thing), and the EPS have increased 3.7 cents over the year for a person who held x shares at the start of the year and the same number at the end. This seems a good result to me, and quite a bit better than the 0.8 cents increase calculated under the weighted average method.
So the lesson here is, do your own EPS calculation.
What can we say at the end of it all. The company is generating slightly less revenue for the amount of money it is spending (return on cost has fallen), but in buying the new businesses, it took account of this in the price, so the net result to shareholders is positive? But how will this affect things going forward? Will Nomad bring the new companies up to speed or will they drag things down? Hard to say at this point.
Chapter 14 goes on to talk about P/E ratios. With an EPS of 17.7 cps (my calculation, lets call this the ‘spot EPS’) the P/E ratio at the sound of the closing bell on 24 Sep 2008 would have been 9.3. The book makes the point that the P/E ratio really doesn’t tell us much, but there is a rule of thumb that the P/E ratio should equal the percentage of the company’s earnings per share growth rate. So you can use this rule of thumb to determine whether a share is under- or over-valued. Unfortunately, you need to have a view on the growth rate. I don’t have a view, at least not yet. I also don’t have access (yet) to any analyst views, so I will just stick this in the back of my mind for now.
It all needs to be considered with a grain of salt, in any case. Going back to a year earlier, the 2007 results were released on 26 Sep 2007. With a closing price of $2.81, the P/E ratio based on earnings of 14 cps was 20. The actual growth in spot EPS was 26%. So using the rule of thumb, the shares were undervalued then at $2.81 and interestingly the shares reached a high of $3.40 on 31 October 2008, which gives a P/E ratio of 24. Unfortunately, it then started a steady decline, reaching a low of 15 cents on 27 January 2009, co-incidentally, just a couple of days before I checked the price. So, I don’t think this rule of thumb is going to be of great use to me.
Lets jump ahead and look at the 31 December 2008 results, where we find things have all gone horribly wrong. Firstly, there is a new expense item on the P&L called “Impairment of Goodwill”. Not being an accountant, just these words send shivers down my spine – what the hell is “impairment of goodwill”? Then it gets worse, the figure against it is $6.852 million. This is a big whack, leaving a bottom line of only $1.3m compared to $10.3m for the same period last year.
Looking through the note on this, it has to do with the valuation of goodwill, which they reassess every six months and as a result have come up with this figure of $6.852m. This says to me that they paid too much for the businesses they bought. But the share market was falling steadily during this same six months, so I'm not sure how much I can blame them for this.
Reading further we find out the even before the impairment of goodwill, profit is down 21%. The Net Profit Margin before the impairment of goodwill is 4.8%, quite a fall from 7.2% for the same period last year. Now this really is a big issue.
The fall in profit is attributed to “problems in the Nomad Modular Building division in WA” and the CEO of this division has “tendered his resignation”. Nomad Modular is not one of the new businesses they bought during the year, this is part of the original business, so it should be running like clockwork. The departure of the CEO just raises more questions than it answers. Is this just scapegoating for an event that was beyond anyone’s control? Are they letting required knowledge and experience walk out the door? They don’t provide enough detail to make an assessment.
So, in summary:
* the headline presentation of Nomad’s 2008 annual results, ie "we’ve made a 48% increase in profit", was misleading, it should have mentioned that the acquisition of two businesses contributed to this rather than leave it for the fine print, and
* based on the admittedly small window of performance I have assessed, I have no evidence that they can manage their business successfully. They made acquisitions that lead to write-offs and their costs have blown out cutting one third off their net profit margin.
These issues no doubt contributed to the fall in their share price from a high of $3.40 on 31 October 2007 to the low of 15 cents on 27 January 2009. But given the growth in the share price since then, something must now being going right for them. I will delve into this in a future post, however, in the next post I will go through their balance sheet.
Deciding on an online broker
State of Play: I'm kicking myself for not investing in the five companies I identified back in January and I can't do anything about it right now anyway, because I don't have a broker. So this post is about deciding on who to go with.
Some time back in the not to distant past I bought a copy of the Fin Review's Smart Investor magazine and it contained an Online Trading Supplement. As I am Virgo, I filed it in my filing cabinet, where it has been waiting for this day to arrive.
The supplement says there are 18 online brokers to choose from and suggests you consider how often you intend to trade (I'll be using a buy and hold strategy, so not often), whether you want to borrow money to invest (not yet), what securities you want to trade (just Aussie shares), whether you want research (yes, particularly broker/analyst, reports because I don't know where else you can get them from) and whether you want to pick up the phone or just go through the internet (the latter unless there is an emergency / breakdown of some sort).
My main consideration is price. The cheapest broker is Interactive Brokers (http://www.interactivebrokers.com.au/), but they are a USA based company who offers access to the Australian market. This makes me uncomfortable. They also don't provide analyst reports.
Bell Direct the second cheapest broker, at least at the levels I will be trading (ie around $1,000 per parcel, I know, pathetic but we all have to start somewhere), offer trades at $15 each and they provide analyst reports. However, you need to open an account with them and when you want to buy have enough money in the account to cover the trade when you place it (note, however, there is usually a delay between placing an order and the order being filled and a further delay before the order needs to be settled). As I'll be redrawing my investing funds from my home loan (I only have two accounts, an everyday transaction account and a home loan), this will mean I end up paying more interest on my home loan because of the days wasted transferring money from my home loan, to my everyday account to the trading account and then waiting for the trade to settle. The extra interest will cost me more than what I will save by using Bell Direct, so they are out.
It seems most of the "cheaper" brokers have catches, either you need an account with them or you actually pay a monthly fee and then a trade fee on top.
Commsec let you use any account and charge $29.95 or $19.95 if you have a CBA account (which I don't). NAB charge $29.95 but you have to use a NAB account. They have just sent me a brochure offering a rebate on up to $750 worth of brokerage if I open an account with them before 16 November 2009. So I could use a NAB everyday account linked to my home loan (which overcomes the extra interest issue) and save the brokerage in setting up my initial portfolio. The rebate period is limited to 60 days. Worth considering but I will wait till I'm ready to trade and if it is before 16 November will set up an account with them. Otherwise, will just stick to Commsec, the most used online broker, which appears to be because they are the only broker who realises need to make it easy for people to use.
Ok, decision made. Next post will look at Nomad's income statement.
Some time back in the not to distant past I bought a copy of the Fin Review's Smart Investor magazine and it contained an Online Trading Supplement. As I am Virgo, I filed it in my filing cabinet, where it has been waiting for this day to arrive.
The supplement says there are 18 online brokers to choose from and suggests you consider how often you intend to trade (I'll be using a buy and hold strategy, so not often), whether you want to borrow money to invest (not yet), what securities you want to trade (just Aussie shares), whether you want research (yes, particularly broker/analyst, reports because I don't know where else you can get them from) and whether you want to pick up the phone or just go through the internet (the latter unless there is an emergency / breakdown of some sort).
My main consideration is price. The cheapest broker is Interactive Brokers (http://www.interactivebrokers.com.au/), but they are a USA based company who offers access to the Australian market. This makes me uncomfortable. They also don't provide analyst reports.
Bell Direct the second cheapest broker, at least at the levels I will be trading (ie around $1,000 per parcel, I know, pathetic but we all have to start somewhere), offer trades at $15 each and they provide analyst reports. However, you need to open an account with them and when you want to buy have enough money in the account to cover the trade when you place it (note, however, there is usually a delay between placing an order and the order being filled and a further delay before the order needs to be settled). As I'll be redrawing my investing funds from my home loan (I only have two accounts, an everyday transaction account and a home loan), this will mean I end up paying more interest on my home loan because of the days wasted transferring money from my home loan, to my everyday account to the trading account and then waiting for the trade to settle. The extra interest will cost me more than what I will save by using Bell Direct, so they are out.
It seems most of the "cheaper" brokers have catches, either you need an account with them or you actually pay a monthly fee and then a trade fee on top.
Commsec let you use any account and charge $29.95 or $19.95 if you have a CBA account (which I don't). NAB charge $29.95 but you have to use a NAB account. They have just sent me a brochure offering a rebate on up to $750 worth of brokerage if I open an account with them before 16 November 2009. So I could use a NAB everyday account linked to my home loan (which overcomes the extra interest issue) and save the brokerage in setting up my initial portfolio. The rebate period is limited to 60 days. Worth considering but I will wait till I'm ready to trade and if it is before 16 November will set up an account with them. Otherwise, will just stick to Commsec, the most used online broker, which appears to be because they are the only broker who realises need to make it easy for people to use.
Ok, decision made. Next post will look at Nomad's income statement.
Monday, August 10, 2009
So what's been happening since January?
State of Play: Started the blog over Christmas 2008, created a set of selection criteria to find companies worthy of full analysis, applied the criteria and came up with a list of 5 companies. Then everything came to a grinding halt.
So what's happened - bugger all! Actually, back in January I looked at the list of the five companies, being:
• Macquarie Office Trust (MOF)
• Mount Gibson Iron (MGX)
• Nomad Building Solutions (NOD)
• Macquarie Country Wide (MCW) and
• Charter Hall Group (CHC)
and thought, mining and property - you've got to be joking, as if they are going to go anywhere! To motivate myself I tried to view it all as a learning exercise, but at the end of the day, I lost interest because I was thinking its all a waste of time.
A couple of days after coming up with the list, however, I did note down the prices of each share:
MOF - 19.5 cents per share ('cps')
MGX - 38 cps
NOD - 17.5 cps
MCW - 23.5 cps
CHC - 23.5 cps
That was during the day on the 30 January 2009.
Lets compare these prices with the closing prices on 7 August 2009:
MOF - 23.5 cps, an increase of 4 cps or 21%
MGX - $1.16 ps, an increase of 78 cps or 205% !!!
NOD - 64 cps, an increase of 46.5 cps or 266% !!!!
MCW - 50 cps, an increase of 26.5 cps or 113%
CHC - 47 cps, an increase of 23.5 cps or 100%
If I had spent an equal amount of each share back on 30 January 2008, the portfolio value would have gone up 241%. Even taking brokerage into account only reduces that gain to 231%. Meanwhile, the All Ordinaries Index has increased 27%. Needless to say, I am kicking myself hard and fast and am now caught in the dilemma of deciding whether to just jump in or whether to do the proper analysis before jumping in.
Meanwhile, I don't really have a broker. I have an account with Commsec which I haven't used since about 2004, so I'm not even sure its still valid and given there are now stacks of online brokers, I'm not sure that they are worth going through anymore. So I think that will be my next post - online brokers.
So what's happened - bugger all! Actually, back in January I looked at the list of the five companies, being:
• Macquarie Office Trust (MOF)
• Mount Gibson Iron (MGX)
• Nomad Building Solutions (NOD)
• Macquarie Country Wide (MCW) and
• Charter Hall Group (CHC)
and thought, mining and property - you've got to be joking, as if they are going to go anywhere! To motivate myself I tried to view it all as a learning exercise, but at the end of the day, I lost interest because I was thinking its all a waste of time.
A couple of days after coming up with the list, however, I did note down the prices of each share:
MOF - 19.5 cents per share ('cps')
MGX - 38 cps
NOD - 17.5 cps
MCW - 23.5 cps
CHC - 23.5 cps
That was during the day on the 30 January 2009.
Lets compare these prices with the closing prices on 7 August 2009:
MOF - 23.5 cps, an increase of 4 cps or 21%
MGX - $1.16 ps, an increase of 78 cps or 205% !!!
NOD - 64 cps, an increase of 46.5 cps or 266% !!!!
MCW - 50 cps, an increase of 26.5 cps or 113%
CHC - 47 cps, an increase of 23.5 cps or 100%
If I had spent an equal amount of each share back on 30 January 2008, the portfolio value would have gone up 241%. Even taking brokerage into account only reduces that gain to 231%. Meanwhile, the All Ordinaries Index has increased 27%. Needless to say, I am kicking myself hard and fast and am now caught in the dilemma of deciding whether to just jump in or whether to do the proper analysis before jumping in.
Meanwhile, I don't really have a broker. I have an account with Commsec which I haven't used since about 2004, so I'm not even sure its still valid and given there are now stacks of online brokers, I'm not sure that they are worth going through anymore. So I think that will be my next post - online brokers.
Monday, January 26, 2009
Selecting Stocks – Take Two
State of Play: under Motley Fool basic rules there are no companies worth investing in listed on the ASX, so I’ve dug out another book, Tim Hewat’s The Intelligent Investor’s Guide to Share Buying to see what I can glean from it.
In Chapter 8, Solid Signposts for Success, Mr Hewat sets out six guidelines for selecting shares:
1. Diversify by investing in 12 shares. Interestingly the same figure I settled on – clearly great minds think alike.
2. Tend towards Big Caps first and then, if there is no value there, second-line shares. Unfortunately, the book doesn’t define what a second line share is, so I’m not sure how low to go with market capitalization.
3. Give top priority to PE ratios of 10 or below. Mr Hewat has a whole chapter on the Price-Earnings Ratio (current share price divided by earnings per share). He describes a study done by David Dreman (an investment manager) and Professor Michael Berry of the University of Virginia. They made a list of the top 60% of shares by market value listed on the New York Stock Exchange, ranked them by PE ratio and split them into quintiles (ie, shares with the top 20% of PE ratios in one group, next 20% in the next group, etc). They revised the groups each year for 25 years using the same methodology. (I’m guessing this means that at the end of each year they “sold” shares no longer in one group and then “bought” the shares that where now ranked within the group). Over the 25 years, the shares in the lowest quintile returned 17.3% pa, whereas the average for the whole group was 12.3% pa. (There is no comment on whether they took into account taxes and transaction costs).
Another fellow called Qualls did a similar thing with 100 randomly selected industrial companies listed on the (then) Sydney Stock Exchange and also found the lowest group outperformed the rest.
The chapter gives a few more examples, all with the same results. Mr Hewat settled on an absolute benchmark of 10 (note, his book was published in 1994 in the midst of a market boom). This approach saves the time taken to rank all the shares, however, a look over the tables from the weekend edition of the Australian Finance Review shows a fair proportion of them have PE ratios below 10. Also, given we now have the internet and MS Excel, the process of ranking shares by PE ratio and splitting them into quintiles should take all of five minutes, so I think I’ll use that method.
4. Price to Assets Ratio (PAR) should be 1.0 or lower. This is explained along the line of, for example, if the PAR is 0.9, it means you can buy $1 worth of the company or 90c. From this I’m assuming that the ratio is calculated by dividing the market capitalization of the company by the net assets reported on the balance sheet. My concern here is that it assumes the assets in the balance sheet are valued correctly. If I was looking at these figures today (26 January 2009) for a property company, and they were based on 30 June 2008 annual reports, I’d want to discount the properties by, say 10%. But I suppose, as with all of these things, the devil’s in the detail.
5. Satisfy yourself that Dividend Yield meets the demand for an adequate return. I have serious issues with this guideline. Aside from the fact that Mr Hewat provides no real way of determining what an “adequate return” is, the last thing I need is for companies to give me back money in the form of dividends, so I have to pay tax on it and then have to find a place to reinvest it and (unless they have a dividend reinvestment program) pay a fee to a broker to do so. Unfortunately, I think its quite fashionable for Australian companies to pay dividends. I use to the term fashionable quite deliberately, because there is no real reason to pay dividends except that investors in Australia seem to like them so you are an Australian company you are unlikely to attract investors if you don’t pay dividends. We will see when the time comes whether I can find any non-dividend paying shares for profit making companies.
6. Dividends paid without interruption for at least five years. This I see as a lazy way of checking whether the underlying performance of the company has been OK. I would prefer to look at whether the company has actually made a profit for the past five years, because, if a company is making a loss and funding dividend payments through increased borrowings, then it’s a company from which you should run a mile.
Having reviewed all that, I’m going to set a new set of criteria based on a mixture of the Motley Fool rules and the above. So, my new criteria are:
1. Daily Dollar Volume: From $100,000 to $25m;
2. PE Ratio within the lowest 20% of PE ratios for all shares;
3. Price-Assets Ratio of less than or equal to 1.0;
4. Net Profit a positive number and greater than last year;
5. Revenue of $500m or less and greater than last year;
6. Cashflow from operations: a positive number; and
7. Preferably all earnings reinvested (no dividends paid).
So lets see how we go.
1. Daily Dollar Volume: From $100,000 to $25m and
2. Price-Assets Ratio of less than or equal to 1.0
I ran these two tests together, starting with the full list of all securities on the ASX having deleted all the options and other non-share securities. First I ranked the shares by PE ratio and deleted all the shares with a PE ratio of zero or less (ie all companies that had made a loss). I then calculated the daily dollar volume for each share (closing price multiplied by volume traded) and deleted those shares with a DDV below $100,000 and above $25m. There were 201 shares remaining, which I ranked them by PE ratio and kept the bottom 40.
3. Price-Assets Ratio of less than or equal to 1.0
The AFR tables have the Net Tangible Assets (NTA) for each share, which is “the total assets of a company less total liabilities and not including intangible items such as goodwill.” (Refer http://afr.com/home/tables_1.aspx#indus_lnk).
There were nine shares with negative or no NTA so I deleted all of those. Of the 31 shares remaining a further nine had a PA ratio (last sale price divided by NTA) greater than 1.0, so I’m left with 22 potential shares to comprise my portfolio.
4. Net Profit a positive number and greater than last year
I already knocked out the unprofitable companies in the first test, so its just a matter of checking whether the 22 remaining made a greater profit this year than last year. Eight had negative earnings growth, so we are down to fourteen shares.
5. Revenue of $500m or less and greater than last year
Four companies had negative sales growth, so ten remain. Of those, only five had annual revenue less than $500m:
• Macquarie Office Trust
• Mount Gibson Iron
• Nomad Building Solutions
• Macquarie Country Wide and
• Charter Hall Group (one of the final contenders under the Motley Fool criteria)
6. Cashflow from operations: a positive number
The five companies all have positive cashflow from operations.
7. Preferably all earnings reinvested (no dividends paid)
I knew this would be a bridge too far. Only Mount Gibson Iron does not pay dividends, so I will keep the five.
Does this mean I get onto CommSec tomorrow and start splashing my cash around? No. It means I have to start reading annual reports, so I’m going back to “The Motley Fool Investment Guide” to read Chapter 14 “Making Sense of Income Statements” (next post, that is).
In Chapter 8, Solid Signposts for Success, Mr Hewat sets out six guidelines for selecting shares:
1. Diversify by investing in 12 shares. Interestingly the same figure I settled on – clearly great minds think alike.
2. Tend towards Big Caps first and then, if there is no value there, second-line shares. Unfortunately, the book doesn’t define what a second line share is, so I’m not sure how low to go with market capitalization.
3. Give top priority to PE ratios of 10 or below. Mr Hewat has a whole chapter on the Price-Earnings Ratio (current share price divided by earnings per share). He describes a study done by David Dreman (an investment manager) and Professor Michael Berry of the University of Virginia. They made a list of the top 60% of shares by market value listed on the New York Stock Exchange, ranked them by PE ratio and split them into quintiles (ie, shares with the top 20% of PE ratios in one group, next 20% in the next group, etc). They revised the groups each year for 25 years using the same methodology. (I’m guessing this means that at the end of each year they “sold” shares no longer in one group and then “bought” the shares that where now ranked within the group). Over the 25 years, the shares in the lowest quintile returned 17.3% pa, whereas the average for the whole group was 12.3% pa. (There is no comment on whether they took into account taxes and transaction costs).
Another fellow called Qualls did a similar thing with 100 randomly selected industrial companies listed on the (then) Sydney Stock Exchange and also found the lowest group outperformed the rest.
The chapter gives a few more examples, all with the same results. Mr Hewat settled on an absolute benchmark of 10 (note, his book was published in 1994 in the midst of a market boom). This approach saves the time taken to rank all the shares, however, a look over the tables from the weekend edition of the Australian Finance Review shows a fair proportion of them have PE ratios below 10. Also, given we now have the internet and MS Excel, the process of ranking shares by PE ratio and splitting them into quintiles should take all of five minutes, so I think I’ll use that method.
4. Price to Assets Ratio (PAR) should be 1.0 or lower. This is explained along the line of, for example, if the PAR is 0.9, it means you can buy $1 worth of the company or 90c. From this I’m assuming that the ratio is calculated by dividing the market capitalization of the company by the net assets reported on the balance sheet. My concern here is that it assumes the assets in the balance sheet are valued correctly. If I was looking at these figures today (26 January 2009) for a property company, and they were based on 30 June 2008 annual reports, I’d want to discount the properties by, say 10%. But I suppose, as with all of these things, the devil’s in the detail.
5. Satisfy yourself that Dividend Yield meets the demand for an adequate return. I have serious issues with this guideline. Aside from the fact that Mr Hewat provides no real way of determining what an “adequate return” is, the last thing I need is for companies to give me back money in the form of dividends, so I have to pay tax on it and then have to find a place to reinvest it and (unless they have a dividend reinvestment program) pay a fee to a broker to do so. Unfortunately, I think its quite fashionable for Australian companies to pay dividends. I use to the term fashionable quite deliberately, because there is no real reason to pay dividends except that investors in Australia seem to like them so you are an Australian company you are unlikely to attract investors if you don’t pay dividends. We will see when the time comes whether I can find any non-dividend paying shares for profit making companies.
6. Dividends paid without interruption for at least five years. This I see as a lazy way of checking whether the underlying performance of the company has been OK. I would prefer to look at whether the company has actually made a profit for the past five years, because, if a company is making a loss and funding dividend payments through increased borrowings, then it’s a company from which you should run a mile.
Having reviewed all that, I’m going to set a new set of criteria based on a mixture of the Motley Fool rules and the above. So, my new criteria are:
1. Daily Dollar Volume: From $100,000 to $25m;
2. PE Ratio within the lowest 20% of PE ratios for all shares;
3. Price-Assets Ratio of less than or equal to 1.0;
4. Net Profit a positive number and greater than last year;
5. Revenue of $500m or less and greater than last year;
6. Cashflow from operations: a positive number; and
7. Preferably all earnings reinvested (no dividends paid).
So lets see how we go.
1. Daily Dollar Volume: From $100,000 to $25m and
2. Price-Assets Ratio of less than or equal to 1.0
I ran these two tests together, starting with the full list of all securities on the ASX having deleted all the options and other non-share securities. First I ranked the shares by PE ratio and deleted all the shares with a PE ratio of zero or less (ie all companies that had made a loss). I then calculated the daily dollar volume for each share (closing price multiplied by volume traded) and deleted those shares with a DDV below $100,000 and above $25m. There were 201 shares remaining, which I ranked them by PE ratio and kept the bottom 40.
3. Price-Assets Ratio of less than or equal to 1.0
The AFR tables have the Net Tangible Assets (NTA) for each share, which is “the total assets of a company less total liabilities and not including intangible items such as goodwill.” (Refer http://afr.com/home/tables_1.aspx#indus_lnk).
There were nine shares with negative or no NTA so I deleted all of those. Of the 31 shares remaining a further nine had a PA ratio (last sale price divided by NTA) greater than 1.0, so I’m left with 22 potential shares to comprise my portfolio.
4. Net Profit a positive number and greater than last year
I already knocked out the unprofitable companies in the first test, so its just a matter of checking whether the 22 remaining made a greater profit this year than last year. Eight had negative earnings growth, so we are down to fourteen shares.
5. Revenue of $500m or less and greater than last year
Four companies had negative sales growth, so ten remain. Of those, only five had annual revenue less than $500m:
• Macquarie Office Trust
• Mount Gibson Iron
• Nomad Building Solutions
• Macquarie Country Wide and
• Charter Hall Group (one of the final contenders under the Motley Fool criteria)
6. Cashflow from operations: a positive number
The five companies all have positive cashflow from operations.
7. Preferably all earnings reinvested (no dividends paid)
I knew this would be a bridge too far. Only Mount Gibson Iron does not pay dividends, so I will keep the five.
Does this mean I get onto CommSec tomorrow and start splashing my cash around? No. It means I have to start reading annual reports, so I’m going back to “The Motley Fool Investment Guide” to read Chapter 14 “Making Sense of Income Statements” (next post, that is).
Thursday, January 15, 2009
The Criteria in Action
State of Play: I have a long list of 583 shares listed on the Australian Stock Exchange (refer first post) from which I want to pick 12. I have a list of seven criteria (refer previous post) to bring down my long list to a short list. Here goes.
Criterion 1 - Daily Dollar Volume: From $100,000 to $25m.
I downloaded the Industrial Market daily report and the Mining and Oil Market daily report for 9 Jan 2009 from the AFR website (http://afr.com/home/tables.aspx). For the 583 shares I found the volume and closing price (using the sumif() function in Excel, not by hand) and multiplied them together to get the Daily Dollar Volume (DDV) for each share. I then sorted the list by the DDV and deleted all the shares will a DDV below $100,000 and above $25 million.
Have a guess how many shares were left. Go on. Remember I started with 583 shares.
62.
Yep 62. Only 62 shares were left. That’s 12% of the original list. I thought, there must be some mistake, so I went to the full market list and did the same thing. Of the full list of 2,310 securities that you can invest in on the ASX, fully 49% did not trade at all on 9 Jan 2009. That 1,138 securities that if I owned I could not have sold on 9 Jan 2009. (I use the word securities because the list includes options and other types of instruments, not just shares.)
A further 817 had a DDV below $100,000. Only 18 shares had a DDV of greater than $25m (I told you that figure would be high for the Australian market). So, from the full list of available securities only 294 (13% of the market) meet this criterion. This matches my results on the long list and as the aim of the game here is to get down to a short list, I’ll move on with the 68.
Criterion 2. My Relative Strength Proxy: 90 or Higher
As discussed in my last post. I don’t know where to find the relative strength of shares so I’m going to rank them by last sale price divided by the 52-week low (both as at 9 Jan 2009).
So starting with the full list of securities from the Industrial Market daily report and the Mining and Oil Market daily report, I deleted all the options and other strange securities. That left 1908 shares. I then sorted by the “return” (closing price divided by the 52-week low). The results are worth a look at.
The highest return was 6900% for a company called Q Ltd. Their 52-week low was 0.5 cents and their closing price was 35 cents. I figured this was worth a further look, even though they did not trade on 9 Jan 2008 so they won’t be on my shortlist. Looking the company up on the ASX website (www.asx.com.au) revealed a serious downward trend in their shareprice from June 2008, when they were trading at above $2.00. This highlights just how flawed my little proxy is, but we shall press on.
188 shares or 10% of the market had a 0% “return”. This means they are at their 52-week low. It might be interesting to track this figure to see if it gives any clues about when the market is turning.
I then checked whether any of the 68 made it into the top 10% of “returns”. No. Top 20%? One – Australian Education Trust. Right. I now pronounce this whole criterion a waste of time so I’m sticking with the 68 shares from Criterion 1 and moving onto Criterion 3.
Criterion 3. Earnings and Sales Growth: 25% or Greater
For those of you paying attention, you would have noticed that I listed this last time as Criterion 5. However, you can pull these figures off Yahoo’s finance website (au.finance.yahoo.com) under Key Statistics, so I’m going with this one next.
I didn’t believe any stocks would meet this test and I was eye-ing my bookshelf to see what book I should move onto as I searched the yahoo site. However, a whole eight shares from my list of 68 had both earnings and sales growth above 25%, they are:
NAME Sales Growth Earnings Growth
AWB LIMITED 48.20% 262.90%
WOTIF.COM HOLDINGS LIMITED 41.80% 29.40%
JB HI-FI LIMITED 41.10% 59.40%
ABB GRAIN LIMITED 41.00% 532.00%
FLIGHT CENTRE LIMITED 40.20% 51.70%
INVOCARE LIMITED 36.80% 24.30%
CHARTER HALL GROUP 27.20% 35.20%
THE REJECT SHOP LIMITED 25.30% 35.10%
[Sorry about the formating, I'm afraid my blogging skills don't extend to tables.]
AWB immediately rings alarm bells. They are the crowd involved in the Iraqi oil-for-food scandal (check out Wikipedia for the full story) and litigation is on-going, they have lost the right to be the sole controller of Australian wheat exports, there is uncertainty over its share structure, its under threat of class actions and its having to pay (remaining) staff extra because they all want to leave (wouldn’t you!).
Criterion 4. Cashflow from operations: a positive number
Again, I’m not sticking to my original order, but again this is something you can look up on the Yahoo Finance website. All the shares get through on this one except AWB.
NAME Cashflow from operations
WOTIF.COM HOLDINGS LIMITED 46.28
JB HI-FI LIMITED 42.44
ABB GRAIN LIMITED 4.3
FLIGHT CENTRE LIMITED 391.93
INVOCARE LIMITED 38.6
CHARTER HALL GROUP 45.28
THE REJECT SHOP LIMITED 19.02
Criterion 5. Net Profit Margin: At Least 7%.
Strangely, this isn’t in the key statistics listed on the yahoo site, so I downloaded the latest annual reports for each company of their websites.
NAME Net Profit Margin
WOTIF.COM HOLDINGS LIMITED 3.6%
JB HI-FI LIMITED 3.6%
ABB GRAIN LIMITED 2.1%
FLIGHT CENTRE LIMITED 10.2%
INVOCARE LIMITED 12.1%
CHARTER HALL GROUP 70.0%
THE REJECT SHOP LIMITED 4.7%
As the table shows, only three companies meet the test and yes, the net profit margin for Charter Hall really is 70%. I think this has to do with it basically being a fund manager, but we can look into this further if it makes it all the way through.
Criterion 6. The company’s sales are $500m or less.
NAME Sales
FLIGHT CENTRE LIMITED $1,407m
INVOCARE LIMITED $228m
CHARTER HALL GROUP $91m
Who knew Flight Centre was such a big company? People who bother to look at these thing I suppose. However, they are too big according to the Motley Fools, so we are down to just two.
Criterion 7. Insider Holdings: 10% or more
I’m glad I was only down to two companies for this one, because it took a lot of flicking through pages on the annual report to work this one out (and even then I’m not entirely sure its correct.
For Invocare (funeral directors, by the way, odd what you find on the ASX) it appears that the directors of the company own a grand total of 1.5% of the shares. So Invocare doesn’t make the cut.
Charter Hall contained a nice list of its top twenty share holders, which consisted of 18 institutions (superannuation funds and such) and two people. The two people were directors holding 1.54% and 1.49% of the shares respectively. Its possible that if the information was there for all the directors it would amount to 10%, but I don’t think it would, besides, one share does not a portfolio make. So Charter Hall is out as well.
So what have we achieved from all this? Well we could throw in the towel and conclude that there are no companies worth investing in on the ASX or, as I said earlier, we could find another book. Coming to an end (perhaps) of one of the worst downturns on the market in history, I can’t believe that there are no companies worth investing in, so its time to turn to “The Intelligent Investor’s Guide to Share Buying” by Tim Hewat and see what he has to say about things.
Criterion 1 - Daily Dollar Volume: From $100,000 to $25m.
I downloaded the Industrial Market daily report and the Mining and Oil Market daily report for 9 Jan 2009 from the AFR website (http://afr.com/home/tables.aspx). For the 583 shares I found the volume and closing price (using the sumif() function in Excel, not by hand) and multiplied them together to get the Daily Dollar Volume (DDV) for each share. I then sorted the list by the DDV and deleted all the shares will a DDV below $100,000 and above $25 million.
Have a guess how many shares were left. Go on. Remember I started with 583 shares.
62.
Yep 62. Only 62 shares were left. That’s 12% of the original list. I thought, there must be some mistake, so I went to the full market list and did the same thing. Of the full list of 2,310 securities that you can invest in on the ASX, fully 49% did not trade at all on 9 Jan 2009. That 1,138 securities that if I owned I could not have sold on 9 Jan 2009. (I use the word securities because the list includes options and other types of instruments, not just shares.)
A further 817 had a DDV below $100,000. Only 18 shares had a DDV of greater than $25m (I told you that figure would be high for the Australian market). So, from the full list of available securities only 294 (13% of the market) meet this criterion. This matches my results on the long list and as the aim of the game here is to get down to a short list, I’ll move on with the 68.
Criterion 2. My Relative Strength Proxy: 90 or Higher
As discussed in my last post. I don’t know where to find the relative strength of shares so I’m going to rank them by last sale price divided by the 52-week low (both as at 9 Jan 2009).
So starting with the full list of securities from the Industrial Market daily report and the Mining and Oil Market daily report, I deleted all the options and other strange securities. That left 1908 shares. I then sorted by the “return” (closing price divided by the 52-week low). The results are worth a look at.
The highest return was 6900% for a company called Q Ltd. Their 52-week low was 0.5 cents and their closing price was 35 cents. I figured this was worth a further look, even though they did not trade on 9 Jan 2008 so they won’t be on my shortlist. Looking the company up on the ASX website (www.asx.com.au) revealed a serious downward trend in their shareprice from June 2008, when they were trading at above $2.00. This highlights just how flawed my little proxy is, but we shall press on.
188 shares or 10% of the market had a 0% “return”. This means they are at their 52-week low. It might be interesting to track this figure to see if it gives any clues about when the market is turning.
I then checked whether any of the 68 made it into the top 10% of “returns”. No. Top 20%? One – Australian Education Trust. Right. I now pronounce this whole criterion a waste of time so I’m sticking with the 68 shares from Criterion 1 and moving onto Criterion 3.
Criterion 3. Earnings and Sales Growth: 25% or Greater
For those of you paying attention, you would have noticed that I listed this last time as Criterion 5. However, you can pull these figures off Yahoo’s finance website (au.finance.yahoo.com) under Key Statistics, so I’m going with this one next.
I didn’t believe any stocks would meet this test and I was eye-ing my bookshelf to see what book I should move onto as I searched the yahoo site. However, a whole eight shares from my list of 68 had both earnings and sales growth above 25%, they are:
NAME Sales Growth Earnings Growth
AWB LIMITED 48.20% 262.90%
WOTIF.COM HOLDINGS LIMITED 41.80% 29.40%
JB HI-FI LIMITED 41.10% 59.40%
ABB GRAIN LIMITED 41.00% 532.00%
FLIGHT CENTRE LIMITED 40.20% 51.70%
INVOCARE LIMITED 36.80% 24.30%
CHARTER HALL GROUP 27.20% 35.20%
THE REJECT SHOP LIMITED 25.30% 35.10%
[Sorry about the formating, I'm afraid my blogging skills don't extend to tables.]
AWB immediately rings alarm bells. They are the crowd involved in the Iraqi oil-for-food scandal (check out Wikipedia for the full story) and litigation is on-going, they have lost the right to be the sole controller of Australian wheat exports, there is uncertainty over its share structure, its under threat of class actions and its having to pay (remaining) staff extra because they all want to leave (wouldn’t you!).
Criterion 4. Cashflow from operations: a positive number
Again, I’m not sticking to my original order, but again this is something you can look up on the Yahoo Finance website. All the shares get through on this one except AWB.
NAME Cashflow from operations
WOTIF.COM HOLDINGS LIMITED 46.28
JB HI-FI LIMITED 42.44
ABB GRAIN LIMITED 4.3
FLIGHT CENTRE LIMITED 391.93
INVOCARE LIMITED 38.6
CHARTER HALL GROUP 45.28
THE REJECT SHOP LIMITED 19.02
Criterion 5. Net Profit Margin: At Least 7%.
Strangely, this isn’t in the key statistics listed on the yahoo site, so I downloaded the latest annual reports for each company of their websites.
NAME Net Profit Margin
WOTIF.COM HOLDINGS LIMITED 3.6%
JB HI-FI LIMITED 3.6%
ABB GRAIN LIMITED 2.1%
FLIGHT CENTRE LIMITED 10.2%
INVOCARE LIMITED 12.1%
CHARTER HALL GROUP 70.0%
THE REJECT SHOP LIMITED 4.7%
As the table shows, only three companies meet the test and yes, the net profit margin for Charter Hall really is 70%. I think this has to do with it basically being a fund manager, but we can look into this further if it makes it all the way through.
Criterion 6. The company’s sales are $500m or less.
NAME Sales
FLIGHT CENTRE LIMITED $1,407m
INVOCARE LIMITED $228m
CHARTER HALL GROUP $91m
Who knew Flight Centre was such a big company? People who bother to look at these thing I suppose. However, they are too big according to the Motley Fools, so we are down to just two.
Criterion 7. Insider Holdings: 10% or more
I’m glad I was only down to two companies for this one, because it took a lot of flicking through pages on the annual report to work this one out (and even then I’m not entirely sure its correct.
For Invocare (funeral directors, by the way, odd what you find on the ASX) it appears that the directors of the company own a grand total of 1.5% of the shares. So Invocare doesn’t make the cut.
Charter Hall contained a nice list of its top twenty share holders, which consisted of 18 institutions (superannuation funds and such) and two people. The two people were directors holding 1.54% and 1.49% of the shares respectively. Its possible that if the information was there for all the directors it would amount to 10%, but I don’t think it would, besides, one share does not a portfolio make. So Charter Hall is out as well.
So what have we achieved from all this? Well we could throw in the towel and conclude that there are no companies worth investing in on the ASX or, as I said earlier, we could find another book. Coming to an end (perhaps) of one of the worst downturns on the market in history, I can’t believe that there are no companies worth investing in, so its time to turn to “The Intelligent Investor’s Guide to Share Buying” by Tim Hewat and see what he has to say about things.
Saturday, January 10, 2009
Selection Criteria
So, the state of play is: I have a list of 583 shares from which I want to pick 12. I’m hoping Chapter 13 of “The Motley Fool Investment Guide” will get me down to a short list from which I can pick the 12 . The chapter presents a list of eight criteria that are geared towards finding growing small-cap companies. The criteria are:
1. The company’s sales are $500m or less.
In the US this is considered a small company. The rational for investing in small companies is that there are more likely to grow than large companies. I’m pretty sure that would not be a small company in Australia, but I don’t know what threshold to use, so I will leave if at $500m for now.
2. Daily Dollar Volume: From $1m to $25m.
This is the value of trades done each day. Volume is usually quoted in number of shares, so I will estimate this by multiplying the number of shares by the closing price. Again, I don’t know whether this range is too high for Australian markets.
This criterion is about liquidity, ie how easily you can buy and sell a share. Given its Christmas at the moment, an extraordinary number of companies are not trading at all. I don’t want to be left holding something I can’t sell if I need to, but given I don’t have much to invest I will set a lower threshold of $100,000 (still many times more than any trade I would be doing).
3. Minimum Share Price of $7.
In the US, the share price for one share can be thousands of dollars. In Australia, the average share price is $1.66 (I calculated this by excluding options etc from the “Weekly Round Up – Sector by Sector” table for 9 January 2008. This table is available on the AFR website http://afr.com/home/tables.aspx). The Motley Fools cut out at $7 because shares priced this low in the US are generally illiquid. I’m inclined to think this is double counting. The Daily Dollar Volume is an accurate measure of liquidity and this is some strange proxy, so I’m not going to try and set a minimum share price for Australian shares.
4. Net Profit Margin: At Least 7%.
This is a measure of quality. It is the bottom line of the profit and loss statement (ie “Net Profit”) divided by the top line (ie “Sales” or “Revenue”). The Fools reckon 7% is a high number which indicates that the company is “soundly beating its competition or (Fool’s Choice) has no competition at all”. I have no idea whether this is a good figure for Australian companies, so in the absence of any available evidence, I’m just going to take the 7% at face value.
5. Relative Strength: 90 or Higher.
Relative strength is a rating of how a share has performed relative to all the other shares. The range goes from 1 to 99. A relative strength of 90 indicates that the share has outperformed (is that a real word?) 90% of all the other shares. The idea here is that shares will have a high relative strength because they “(1) are doing something right and (2) have the market taking notice.”
Relative Strength is not a figure you often see quoted in Australia. The only place I have seen it is at the end of news articles on www.businessspectator.com.au. This is not at all helpful if I’m looking up a share that hasn’t had any articles written about it.
Annoyingly, the book does not explain how to calculate Relative Strenghth, but as a proxy, I’m going to do my own calculation using the “Weekly Round Up – Sector by Sector” table. I’m going to rank the shares by closing price on 9 Jan 2008 and divide by the 52-week low. Anything that is not in the top 10% will get the heave-ho.
This is not perfect because it will mean that every share's return is calculated on a different time period. A company that has taken 12 months to achieve a return of 10% will be rated the same as a company that has taken 1 day to achieve a return of 10%, but we will just have to bear this in mind for now.
6. Earnings and Sales Growth: 25% or Greater.
So again we are looking at the top line and the bottom line of the profit and loss statement. This time to see whether the change in both is an increase of 25% from the year before. 25% sounds a lot to me, particularly with the way the economy is going, but I’ll stick with it for now.
7. Insider Holdings: 10% or more.
The idea here is that if the people managing the company also own the company, they will be very interested in making sure it does well. Sounds reasonable to me, but 10%? Again, I don't know if this is reasonable or not, so I'll just take it on face value.
8. Cashflow from operations: a positive number.
This figures appears on a company’s cashflow statement. Having it positive means that the company is being paid more from its customers then it is paying its suppliers and staff. This sounds like profit, doesn’t it? However, I’m reminded of a quip I heard about Centro “its business was great, but its debt was greater”. So, while its not a guarantee of a solid company, I still think it’s a good criterion.
So, to sum up, here are the criteria I’m going to use to get my long list down to a short list:
1. Daily Dollar Volume: From $100,000 to $25m.
2. My Relative Strength Proxy: 90 or Higher
3. Net Profit Margin: At Least 7%.
4. Cashflow from operations: a positive number
5. Earnings and Sales Growth: 25% or Greater
6. Insider Holdings: 10% or more
7. The company’s sales are $500m or less.
I’ve rearranged the order a bit, as the first two will cut out the most shares. The remainder requires downloading annual reports and I've put those I'm more sure about first.
Next post, I’ll put all this all into action.
1. The company’s sales are $500m or less.
In the US this is considered a small company. The rational for investing in small companies is that there are more likely to grow than large companies. I’m pretty sure that would not be a small company in Australia, but I don’t know what threshold to use, so I will leave if at $500m for now.
2. Daily Dollar Volume: From $1m to $25m.
This is the value of trades done each day. Volume is usually quoted in number of shares, so I will estimate this by multiplying the number of shares by the closing price. Again, I don’t know whether this range is too high for Australian markets.
This criterion is about liquidity, ie how easily you can buy and sell a share. Given its Christmas at the moment, an extraordinary number of companies are not trading at all. I don’t want to be left holding something I can’t sell if I need to, but given I don’t have much to invest I will set a lower threshold of $100,000 (still many times more than any trade I would be doing).
3. Minimum Share Price of $7.
In the US, the share price for one share can be thousands of dollars. In Australia, the average share price is $1.66 (I calculated this by excluding options etc from the “Weekly Round Up – Sector by Sector” table for 9 January 2008. This table is available on the AFR website http://afr.com/home/tables.aspx). The Motley Fools cut out at $7 because shares priced this low in the US are generally illiquid. I’m inclined to think this is double counting. The Daily Dollar Volume is an accurate measure of liquidity and this is some strange proxy, so I’m not going to try and set a minimum share price for Australian shares.
4. Net Profit Margin: At Least 7%.
This is a measure of quality. It is the bottom line of the profit and loss statement (ie “Net Profit”) divided by the top line (ie “Sales” or “Revenue”). The Fools reckon 7% is a high number which indicates that the company is “soundly beating its competition or (Fool’s Choice) has no competition at all”. I have no idea whether this is a good figure for Australian companies, so in the absence of any available evidence, I’m just going to take the 7% at face value.
5. Relative Strength: 90 or Higher.
Relative strength is a rating of how a share has performed relative to all the other shares. The range goes from 1 to 99. A relative strength of 90 indicates that the share has outperformed (is that a real word?) 90% of all the other shares. The idea here is that shares will have a high relative strength because they “(1) are doing something right and (2) have the market taking notice.”
Relative Strength is not a figure you often see quoted in Australia. The only place I have seen it is at the end of news articles on www.businessspectator.com.au. This is not at all helpful if I’m looking up a share that hasn’t had any articles written about it.
Annoyingly, the book does not explain how to calculate Relative Strenghth, but as a proxy, I’m going to do my own calculation using the “Weekly Round Up – Sector by Sector” table. I’m going to rank the shares by closing price on 9 Jan 2008 and divide by the 52-week low. Anything that is not in the top 10% will get the heave-ho.
This is not perfect because it will mean that every share's return is calculated on a different time period. A company that has taken 12 months to achieve a return of 10% will be rated the same as a company that has taken 1 day to achieve a return of 10%, but we will just have to bear this in mind for now.
6. Earnings and Sales Growth: 25% or Greater.
So again we are looking at the top line and the bottom line of the profit and loss statement. This time to see whether the change in both is an increase of 25% from the year before. 25% sounds a lot to me, particularly with the way the economy is going, but I’ll stick with it for now.
7. Insider Holdings: 10% or more.
The idea here is that if the people managing the company also own the company, they will be very interested in making sure it does well. Sounds reasonable to me, but 10%? Again, I don't know if this is reasonable or not, so I'll just take it on face value.
8. Cashflow from operations: a positive number.
This figures appears on a company’s cashflow statement. Having it positive means that the company is being paid more from its customers then it is paying its suppliers and staff. This sounds like profit, doesn’t it? However, I’m reminded of a quip I heard about Centro “its business was great, but its debt was greater”. So, while its not a guarantee of a solid company, I still think it’s a good criterion.
So, to sum up, here are the criteria I’m going to use to get my long list down to a short list:
1. Daily Dollar Volume: From $100,000 to $25m.
2. My Relative Strength Proxy: 90 or Higher
3. Net Profit Margin: At Least 7%.
4. Cashflow from operations: a positive number
5. Earnings and Sales Growth: 25% or Greater
6. Insider Holdings: 10% or more
7. The company’s sales are $500m or less.
I’ve rearranged the order a bit, as the first two will cut out the most shares. The remainder requires downloading annual reports and I've put those I'm more sure about first.
Next post, I’ll put all this all into action.
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