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t is not enough simply to buy every company that has a NCAV under current price. We need to be more selective than that. To start with I whittle down the short-list of potential NCAV using a ‘throwing-out’ checklist:
Foreign and opaque
For a start, I’m hesitant about investing in companies run from abroad. I don’t have a clue about corporate governance procedures, disclosure requirements, political interference, etc., for companies run out of, say, Russia or China.
I’m even reluctant to plump for US companies because I like to be able to judge the sustainability of the business and the quality of the management. How can I do that when I’m thousands of miles away, ignorant of the market environment and unable to meet the managers. At least with Smiths News (LSE:SNWS) I can see what they are doing on their delivery rounds, etc.
Cash shells
I’ve also rejected companies for further consideration because they seem nothing more than cash shells with thin management and even thinner business legs.
Natural resources
Then there are the mining (and oil) companies. Mark Twain said that mine is a hole in the ground owned by a liar. I would not go so far as to say that they are run by liars, but just ask what are those holes worth? Such imprecision makes me nervous.
Managers/controllers looking after number one
On examining accounts and reading between the lines I suspect some managers are syphoning value from the company. I spotted one team who set up a separate company with 50% of its shares owned by them. This unquoted company was then given control over various assets of the quoted company.
Then there are those which seem to have a history of playing games with the accounts. You cannot make a good deal with a bad person.
One family-dominated company I examined issued options allowing the family to buy shares amounting to more than the market capitalisation. You need to dig deep to find these little facts.
I would rather invest in a traditional manufacturing or service business, with long-standing experienced executives, than one run by sharp City-types who dart in and out of companies playing financial manipulation games.
Avoid those that appear to be the playthings of the main shareholders who show little awareness of their responsibility to minority shareholders
Hidden liabilities
Watch out for the hidden liabilities that wipe out NCAV, e.g. large pension deficit.
Having listed what I’m looking to avoid I will now outline the key elements I’m looking for in terms of prospects for the business.
Prospects for the business
I’m looking for ‘a good business’. And I expect to find it, even for companies on low prices relative to the Net Current Asset Value. This requires investigation and understanding of some vital qualitative elements:
Earnings power
One indicator of good prospects is a satisfactory level of current earnings and dividends, and/or a high average earnings power in the past. No projections of great things to come, other than those relying on ‘facts’ proven in the data.
And don’t rely on past data alone: it may mislead. Take Tesco, for example, the past ‘facts’ look very strong. But as we all know, the competitive environment can change on the ground. We must scan beyond the data for signs of vulnerability.
Earnings power is not the current earnings, but is derived from a combination of actual earnings over a period of years (5-10 years) and estimated future earnings over say five years in the future taking into account the competitive strengths of the business vis-à-vis rivals, suppliers, customers as well as the potential for new rivals to enter the industry and for substitute products/services damaging the firm (e.g. the internet provides a substitute for travel agents, recorded music distribution and book selling).
More on competitive position
Some industries are structured so that they provide the players within them a high return on capital employed. These firms can sell their products at a high margin over the cost of production. Other industries are notorious for the perpetually poor return on the shareholders’ cash that they use. It seems that they are locked into poor bargain positions with customers and/or suppliers, they have several rivals all clamouring for market share launching into calamitous price wars.
Quality of management
There are two aspects:
- Competence. Examine and compare their words and performance over a long period
- Shareholder orientation. If you have competent and energetic managers you still will not get very far unless they also possess the quality of integrity, particularly with regard to serving shareholder interests.
Financial stability
You do not want to be in a company with high levels of borrowing or highly variable income flows – steady as she goes is much more relaxing. Industries that are not subject to much change are likely to be stable; so bio-tech and computer game software is out, industries such as selling boring widgets is in (probably).
Professor Glen Arnold now offers a Managed Portfolio Service at Henry Spain Investment Services under which clients’ portfolios contain the same shares as his (write to Jackie.Tran@henryspain.co.uk)
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