Rule 1: Know your investment target

(Published in the South China Morning Post on 24 June 2007)

Watching recent footage on television of punters gathered around computer screens at Shanghai brokerage outlets, poring over charts of stocks in their portfolios, made me wonder whether they have any idea what they actually own?

I recall visiting one of these outlets in the early nineties and witnessing an impromptu lecture on Elliot wave theory on market cycles — so I was told — given by a gentleman who would have made a rickshaw driver look well dressed.

Not much, it seems, has changed.

As with all stock-market bubbles, irrationality reigns supreme, and investors lose sight of what they are actually acquiring.

Did a buyer on Friday of 9,400 Kweichow Moutai A shares at 121 yuan, for example, consider that he bought one hundred thousandth of the assets and liabilities of the company?

Does he know that if he drank the annual production capacity he effectively owns, he would need to guzzle 100kg, or 2,000 bottles, of Moutai — not to mention the company's other products?

And, perhaps most importantly, does he know he paid 173 yuan for one yuan of dividends, representing a paltry yield of 0.5 per cent?

I doubt it. If he is like so many other investors, yield is how much his shares are going to rise in the next month. As far as he is concerned, what he owns is that colourful line on the computer screen, and the rewards he expects are in the same ballpark as those won at a casino, the stock exchange's not-so-distant cousin.

You might think this column is about stock-market bubbles. It is not. The above example simply illustrates how easy it is to disregard what one actually owns when dabbling in shares, a luxury you may think you can afford while a bubble lasts.

But bubbles always go pop.

As billionaire investor Warren Buffett famously remarked, "Only when the tide goes out do you discover who's been swimming naked".

The point is that it is always a good idea to know what you're buying, even — or particularly— if others don't. Most companies are sufficiently capable of presenting their best side (take the case of Enron). It is therefore more a question of you working out who is wearing Speedos.

The best way to quickly work out what lies beneath the surface is to read a company's latest annual report, which should be available on its website. (If it isn't, that is a good reason to avoid the stock anyway— either they don't want you to see it or they're dumb, both negatives.)

You do not need a CFA or a holiday weekend to work it out either. Here is a 12-point guide to tearing apart an annual report in 10 minutes.

No doubt many will find this all a bit basic, but then rarely is sticking to the basics in any activity a bad idea.

Note that companies that do not pass the following test are not necessarily bad investments. There will be plenty of interesting situations that slip through the net.

What this checklist tries to do is identify companies that will make very steady, long-term investments, for sensible investors who have a reasonable amount of time to dedicate to the pursuit of stock picking.

As in astronomy, it is all about having an efficient way to decide where to point your telescope so that you give yourself the best chance of finding stars.

·               By looking at the annual report for one or two minutes are you able to understand what the company does? There are, no doubt, companies that are very difficult to understand but whose shares perform well. However, you may not be able to sleep comfortably at night not knowing how their success is being achieved.

·               Do you think that demand for the company's products will rise in a relatively steady fashion over the long term? This will discount cyclical stars such as commodity and semiconductor companies that may take you on a wild ride.

·               Does the company have a reasonably dominant position in its industry? On the whole, dominance is a good thing as all sorts of good things come with it, such as economies of scale and high barriers to entry.

·               Do you think that brand value matters to the company? Brand value can add several percentage points to a company's profit margin and is a significant competitive advantage. It is therefore something that companies treasure and, in the absence of incompetence, can last forever.

·               If the company has a mission statement or a set of core values at or near the front of the annual report, do you feel that a lot of thought and care went into their composition? Companies who stick inane, generic statements at the front of their annual reports are not making much effort to sell themselves to you, and likely in other ways as well.

·               Does the annual report contain a table summarising the company's five or 10-year financial track record, and does it show a relatively stable history? This point is partly related to the fact that companies that include clear, long-term historic data have made a conscious effort to provide useful information, and partly to check that the company has not had a volatile past.

·               In the notes to the accounts, does the list of subsidiaries cover more than two pages? The choice of two pages is fairly arbitrary, particularly since font size can vary and disclosure requirements can vary from country to country. The point is that, as with question one, it is more difficult to feel comfortable investing in complex corporate structures. At best they are difficult to understand. At worst, complex structures can be indicative of something more sinister.

·               Are there any worrying qualifications in the auditor's report? As a rule of thumb, any qualification is worrying.

·               Compared with other annual reports, do you get the impression that the company looks after its employees? Companies are nothing without their employees. A sign that a firm appreciates this fact is always heartening.

·               Does the company have a worth- while profit margin? Profit margins vary from industry to industry, so there is no specific target rate. I therefore tend to use return on equity as a better measure of profitability and look for companies whose returns have been above 15 per cent annually for the past five years.

·               Does the company have a strong balance sheet? As a general rule, stick to firms with net debt to equity ratios below 30 per cent. The legendary stock investor Philip Fisher said he never invested in highly geared companies, even if they were well run.

  

·               If the company's investment programme has required external finance, has this been sourced mostly with equity? Intensive fixed asset investment programmes can present exciting opportunities, particularly since they tend to depress profits in the short term, resulting in share price weakness. But financing them with debt is generally a bad idea. In the cash flow statement, add together investments in subsidiaries, fixed assets and other non-current assets, and subtract "cash flow from operations". A red flag should go up if this number is less than double the amount under "increase in debt" (one or more items in the "cash flow from financing activities" section of cash flow statement). Again, this yardstick is somewhat arbitrary and there will almost certainly be specific issues that complicate the picture, but carrying out this calculation should be instructive.

Even though an annual report is a backward-looking document, it is probably the most efficient way to identify companies that are well placed to do well in the future. To quote the "Oracle of Omaha" again, "If a business does well, the stock eventually follows".