บทความของ Mr.Yoyo แห่ง ThaiVI
In Search of Great Stocks, by Yoyo@ThaiVI
A good start when searching for great investments is to look for a good company and then buy its stock at the right price. Some investors use gut instinct, which often times just isn’t accurate enough. Some use check lists which might have too many details and can cause investors to miss some great opportunities because of small defects which don’t have a material effect on companies’ performance.
In this article, I will introduce you to my method of how to find a good stock using “big picture analysis.” Let’s start with 3 qualities a good stock should have.
• Large future growth
Many investors love this quality, especially Peter Lynch, because on average growth stocks can return very large capital gains. When speaking of growth, I mean future growth, not past performance. I look for at least 25% EPS growth annually over the next 3 years. Usually, growth comes from growth of the industry, expanding into a new market and/or gaining market share from competitors. A strong company that has a large market share and operates in a mature industry can’t be considered to have this quality because there is no room for growth. Many Chinese stocks exhibit great growth. (Cost cutting or price increasing which generates bottom-line results is another way to generate EPS growth, even though sales volume doesn’t increase.)
• Great cash flow
I look for companies that don’t need a lot of money to invest in accounts receivable, inventories, or expensive plants or equipment to grow their business or just sustain their competitive position. Sectors in which we can find this quality are, for example, retail businesses, online businesses and the insurance sector. These kinds of companies can have excess cash to pay dividends and to make share repurchases.
• Low competition
A company which operates in a highly competitive industry can have difficulty sustaining profit margins because when industry players have a high margin they attract many new competitors and/or cause old players to expand capacity. When there is more supply in the market, price will be decreased due to price wars. A good company needs to have a high barrier to entry, an established distribution network, differentiated products, a recognized brand and/or cost leadership to make it difficult for others to compete.
A company does not need to have all three qualities to be worth investing in. Just 2 out of 3 qualities are fine because finding a company that has all 3 qualities and has an attractive valuation is like looking for a needle in a haystack. From the three above-mentioned qualities, we can divide worthy-to-buy stocks into 4 groups as shown in the diagram below. I refer to it as my “Stock Selection Diagram” or “SSD” for short.
• G-CF stock (Large future growth with Great cash flow)
Usually, a high-growth company needs a lot of money to invest in new equipment, more accounts receivable, and more inventories. Where we can find G-CF stocks which do not need to invest a lot of money is in online businesses, retail businesses, the insurance sector and so on which do business in emerging markets such as China and other Asian countries, except Japan. Because this group of stocks does not need a lot of capital, new competitors can easily enter the industry and this can result in high competition. If investors can’t find any reasons to believe that a G-CF stock has special advantages over competitors which will enable it to become a great company in the future, we shouldn’t make a long-term investment in it. A good time frame for holding this kind of stock is not more than 3 years and the suitable strategy is hit-and-run. The last tip on dealing with this kind of stock is to keep an eye on many G-CF stocks because this is the group of stocks that has great potential to become great stocks if they become big enough to establish cost leadership, distribution power or brand recognition.
• G-LC stock (Large growth with Low competition)
A G-LC stock can grow significantly while sustaining a high margin but the downside is it needs lots of money to keep business running. In the growth stage, we shouldn’t expect any dividends from it, moreover, we should prepare for a lot of dilution along the way. Examples of this kind of stock are distributors, which need to invest a lot in working capital and establishment of their distribution network, and energy/utility companies, which need licenses from the government. When investing in a G-LC stock, investors should look closely at cash flow in the cash flow statement to determine whether it is enough for the company’s investment plan or not. Some G-LC stocks which become bigger and have stable revenue and income might have easier access to loans, which can decrease dilution risk.
• CF-LC stock (Great cash flow with Low competition)
A CF-LC stock doesn’t need much money for inventories, new equipment or R&D budget. Many famous and mature companies in America are in this group, for instance, Coca-Cola (KO) and Wal-Mart (WMT). A CF-LC stock usually has a high payout ratio or continuously buys back its shares, so the best strategy for investing in this group is to buy when a company has a temporary problem or when the stock market has a big decline and brings down the stock to a low P/E ratio. Most ex-great stocks, when the growth stage has passed, become CF-LC stocks which are still interesting for investors who love sustainable dividends.
• Great stock
This is a great company with all 3 qualities. It can grow continuously, sustain a high margin by getting bigger and creating durable competitive advantages through its distribution network, brand recognition and economies of scale while still being able to pay a dividend or buy-back a lot of its shares, which makes EPS growth even higher. When a great company sees a big opportunity in the market, it might not pay any dividend and use more cash to capture as much market share as possible to hinder new competitors and we might see huge growth in this situation, say more than 50% a year. Some great companies that have a lot of excess cash might eliminate potential competitors by taking them over and consolidating their position in the industry. A great company run by an exceptional management which always thinks about maximizing shareholder’s wealth will have a very high ROE. Investing in this kind of stock has proven to be the fastest way for investors to become successful, just like Warren Buffett.
Good investing isn’t only selecting a good stock but also buying it at a reasonable price. In my opinion, the 3 groups of good stocks (G-CF, G-LC and CF-LC) should be priced around a 10-20 P/E depending on their fundamentals. Great stocks are very hard to find, especially with low P/E ratios. We usually see them when they become very well known and have a very high P/E ratio. The best strategy to invest in a great stock is following many good stocks in order to have a chance to see one that gains some attributes which enable it to become a great stock and then buy a lot of it while it’s still cheap and is still not recognized by many investors. A great stock should be priced at least around a P/E of 30. Some might even be worth very high P/E’s, around 50-70, if their 3 qualities are very strong.
When analyzing stocks, my SSD might help you to do your work easier. I’ve used it myself and it is easy to remember.
“Large future growth,
Great cash flow,