Warren Buffett, the sage of Omaha, once said that it was far better to buy a wonderful company at a fair price than to buy a fair company at a wonderful price.
It is difficult enough for bargain hunters to identify stocks which are particularly good buying – in other words, shares that are truly undervalued by the market. But it is probably even harder for them to recognise stocks which should be avoided entirely because they are overvalued and could therefore be regarded as lemons. But, of course, even such stocks can sometimes lead to good windfall profits if they happen to receive an attractive takeover offer.
With about 2200 companies listed on the stock exchange, nobody has the time to research the lot. Thus many investors compromise by confining their portfolios to the leading stocks and avoiding the penny dreadfuls.
But such a strategy has its problems in both directions. As all current investors know only too well, even good quality stocks can fall by 25 per cent or more from their high points. Small capital stocks are more numerous and pose bigger risks, but those that do come good can show much better capital appreciation per dollar invested than is ever available from the big leaders.
Furthermore, wise investors do not assess stocks on any single yardstick, such as the price earnings ratio, the dividend yield or the market value as a proportion of a share’s net tangible assets backing, important though such figures are.
Sophisticated investors also realise the limitations of some indicators published in the media – for example, the price earnings ratio, as a matter of simple arithmetic, is the market value of a particular share divided by its last published earnings per share figure. If this is low it then gives the illusory impression that the stock is good buying, whereas the ratio comes about because the true value of the share would be its current market value divided by its likely future earnings per share figure.
Therefore such investors prefer to look at the bigger picture.
A most important criterion for investors to consider is probably the quality of a listed company’s management team. To some extent this can be measured by the company’s actual performance in the recent past, but there are also some specific danger signals to look out for.
In no particular order these include: splits in the board of directors, frequent or unexplained changes of the chief executive officer, directors sitting on too many other boards, a declining market share for the company’s main products, falling profit margins, a declining earnings rate on the funds employed, a failure to revalue assets (thus disguising the company’s true performance), inadequate research and stgelopment expenditure, excessively generous management contracts, onerous trust deeds, imprudent overexpansion, prolonged or frequent industrial disputes, irrational hostility to mooted takeover bids, poor handling of questions at annual general meetings, leaks to the media designed to affect the market price of the company’s shares, becoming subject to prosecutions for breaches of the law, excessive related party transactions, the watering of the capital by placements below the market value or the asset backing, a failure to keep up with technological change and a failure to set up a good quality site on the World Wide Web.
Naturally, several of these danger signs in combination pose even greater risks than any one by itself. In addition, and most importantly, a high gearing ratio can also cause problems.
Other potential weaknesses include a lack of growth potential, overproduction, excess capacity, inadequate returns on the equipment used, excessive competition, overdependence on tariffs and subsidies and competitors from overseas setting up in Australia regardless of the cost in the short term of doing this.
Some of the necessary information to appraise the aspects discussed above will be contained in a company’s annual report. Some will be found in the formal reports to the Australian stock exchange under the continuous disclosure regime. Other information may be gleaned from stories in the media. In addition, interested shareholders can always ask pertinent questions at company annual general meetings.
A declining market share may be due technological advances, fashion changes, variations in the exchange rate, different attitudes to health or environmental issues, increasing competition from imports, and so on, or from a number of such factors in combination.
The extent of diversification instituted by a company’s board of directors is also of relevance. However, as with so many issues of this type, there is no single “right answer” as to the degree of diversification which is best for any particular enterprise.
There are clearly advantages in a company engaging in a spread of different activities, just as there are advantages in investors holding a spread of different stocks. If something goes wrong in any one line of business then this is not the same disaster as if something goes wrong in a company’s sole line of business – and the “going wrong” may be due to circumstances beyond the control of the company, such as natural disasters, tax changes or adverse legislation.