5 Key Characteristics of a Great Investment | Ron Shamgar

5 Key Characteristics of a Great Investment | Ron Shamgar

12 Jun, 2019 | Stock Insight

This week we take a look at what makes a business an attractive investment opportunity and examine what we look for in our search for the next opportunity.
Here are some key points to look out for:
1 – The ultimate revenue model

There is nothing like waking up in the morning and knowing exactly what you are going to earn in the next twelve months. The same applies for businesses. We do like to see companies that have the bulk of their revenue contracted or recurring in nature. We look for these types of businesses as they have great visibility on their revenue going forward and typically offer a product or a service that is essential for their customers and difficult to replace.

Sticky revenue and sticky customers are a great start when it comes to evaluating a company. These types of companies tend to have less volatility in their earnings and so investors are willing to place high multiples on them compared to other listed stocks. Software and technology platforms and payment solutions companies come to mind when thinking about companies with this kind of revenue model, even “must have” professional services firms like accounting firms. Stocks we like and own here are EML Payments (EML.ASX, 90% recurring revenue), Altium (ALU.ASX, 60% recurring) and Infomedia (IFM.ASX, 95% recurring) and CountPlus (CUP.ASX, accounting services).

2 – Cash is king

There is a saying that ‘a company’s cash flows, are its profits on a truth serum.’ We think that this sums up one of the things we try and look for in any business. There are a seemingly endless number of accounting tricks that manifest as “profit” for a company but, at the end of the day, the cash flow statement never lies. You either have cash coming in or you don’t. Ideally, what we are looking for is a company that is able to convert at least 70% of their earnings into operating cash flow.

We also look at below the operating cash flow line, and see what capital investment is required to keep the business going and, more importantly, growing. The difference between these gives us the free cash generation of a company and that should, in most cases, equate to their net profits after tax. You would be surprised to know how many well-known market darlings don’t meet this simple yet important criteria. Retailer Noni B (NBL.ASX) and recruitment firm People Infrastructure (PPE.ASX) are some examples of companies we like in this respect.

3 – Build it once and sell it many times

Great businesses have developed a product or a service that, once complete, can be sold to many customers with little to no additional investment or expenditure required. We love these types of businesses because, as they scale up and grow, the majority of sales above the break-even point tend to fall straight to the bottom line. They tend to generate strong cash flows and have high margins. Again, technology platforms, software companies and payment solution providers form the majority of this category and it is not uncommon to see these types of companies generate Gross Margins in excess of 80% and earnings margins above 30%.

4 – ​Avoid value traps

There are A LOT of investors out there looking for value. Typically, true value investors are searching for deeply undervalued stocks that tend to trade on very low multiples, offer high dividend yields and are sometimes trading below asset backing. Similarly, growth-oriented investors are also looking for value but in a slightly different way. Their search involves stocks that tend to have low price/earnings-to-growth (PEG) ratios and trade on multiples that are, relatively, not as high as their peer group. In both cases it is important to distinguish perceived value from a potential value trap.

Many value investors get caught out in what initially seems to be a deeply undervalued company only to later realise the business is actually in structural decline. Growth investors sometimes get caught up in what seems to be a high growth company only to find out that the growth was not of a sustainable nature or that the comparable peer group has been de-rated dramatically. In both cases, analysing the historical trends of sales and margins can give some indication as to which basket a company may belong in. Some historical examples of value traps include traditional media and printing businesses while future value traps may emerge from the disruption to the banking and financial services industry and the shift to online sales when it comes to property or retail.

5 – The art of valuations, don’t be precisely wrong…

There are many ways to value a business. Most analysts and investors tend to use a discounted cash flow model (DCF) where by forecasting future cash flows and discounting back to today at a certain discount rate yields a company’s valuation. Others like to use price earnings (PE) and enterprise value (EV) multiples by comparing to an average multiple from a peer group of companies. We personally prefer a somewhat blended method incorporating all three as, unfortunately, each method has its flaws.

DCFs are easily manipulated by the chosen discount rates and trying to predict cash flows out into perpetuity is an almost impossible task. Comparing a company to a group of its peers is also risky. You may find the entire group of peers, or a few outliers, to be overvalued in nature thus distorting the average you are comparing it against. Additionally, these peers may have different fundamentals in play than the company you’re looking in to. Either way, it is important that investors do not get fixated on any one valuation method and learn to adapt and apply each to each company based on its own merits. We have always been advocates of the saying ‘We’d rather be approximately right, than precisely wrong!’

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