Last updated: 15 January 2019
By Maynard Paton
I’ve developed my investing approach after years of learning about the stock market and experiencing what actually works for me.
Important influences on my style include the strategies of Warren Buffett, Peter Lynch, Jim Slater and Nick Train.
Simply put, I look to invest in respectable companies trading at modest valuations and to hold them for the long term. I am happy if I can find two or three good ideas a year.
Though I do tweak my philosophy from time to time, my stock-picking approach has five core foundations.
Admittedly some points are more clear-cut than others, so occasionally a lot of subjectivity, experience and instinct can come into play. Nevertheless, I believe keeping to a checklist can help me deliver reasonable returns and become a more informed investor.
Somebody once said accounting is the language of business and it’s the numbers — not the chairman’s statement — that often tells me whether a business is really good or bad. This is what I look for in the figures:
a. Clarity: Complex accounts equal a complex business and much more likely to harbour nasty surprises in my view. Textbook no-go areas for me include banks and those funny Lloyds insurers, and basically I’d avoid anything where the bookkeeping is not clear.
b. Low/no borrowings: I do not want companies that are dependent on their bank manager. I always ensure my investments have manageable borrowings, or ideally, no debt whatsoever.
c. Low/no pension issues: I view final-salary schemes as potential timebombs. Nobody really knows the exact level of future contributions they require and I prefer to back companies without any ’employee benefit liabilities’ whatsoever. (How To Evaluate Pension Deficits has further details).
d. Solid cash flow: Businesses must generate cash to survive and the very best ones generally drown in the stuff. I want to see my investments report profits backed up by cash flow, with manageable amounts diverted into working capital and capital expenditure.
e. Respectable margins: I’m attracted to businesses with decent margins, say 15% or more, as it suggests they have some sort of competitive advantage that encourages customers to pay that little bit extra. Companies with enduring competitive advantages can often produce more predictable earnings, which can mean more predictable returns.
This is an area I believe most investors do not pay enough attention to.
In my view, those great accounts are in fact the by-product of somebody in charge putting the firm’s people and products to good use. However, every great boss has to retire at some point and, when he does, the company’s culture, direction — and those attractive accounts — can be adversely affected by the new leader. As such, I can be wary of investing in any business that has just seen a significant boardroom change.
This is what I look for in the boardroom:
a. Proven experience: I want my investments to be led by loyal and capable bosses that have served in the top job for several years. I want to see improvements to profits and the dividend throughout their leadership. Better still is the founder/entrepreneur boss, who set up the firm in the first place, has led it ever since and has therefore shown even more commitment to building the business.
b. Shareholder-orientation: I feel executive remuneration — especially the more generous packages — can tell you more about the board’s priorities than any chairman’s statement. I’m keen to avoid ‘fat cats’ and ‘salarymen’, and instead prefer to track down bosses that have more investor-friendly pay arrangements. In particular, I like to see the chief exec’s wages grow no faster than the dividend. I also like to see him collect a meaningful dividend income, own modest option grants and receive appropriate bonuses.
(How To Evaluate Company Management has further details)
I always try to get hold of as many old annual reports as possible before investing. I want to know how the company progressed over time and what has caused any past upsets.
If the business has lifted profits every year for decades, then I’m much more likely to invest. Alternatively, I’m less likely to invest if the last downturn caused huge losses and required a major rescue. That said, I am prepared to overlook haphazard track records if other factors on my checklist are extremely appealing.
I feel investment success can be hard in sectors that have unfavourable (or somewhat uncertain) long-term prospects. I’m keen to avoid ‘value traps’ — lowly-rated shares whose underlying business is destined to go the way of textiles and typewriters.
I am, however, happy to back mature companies whose growth prospects may be pedestrian, as well as firms whose immediate prospects are dimmed only by wider economic problems. I do not demand my shares operate in ‘growth’ sectors. While it would be nice to have an industry tailwind to support an investment, it can be difficult to pinpoint future winners in a new, dynamic industry.
I only want to buy undervalued businesses for my portfolio and I am happy to base my sums on simple measures such as the price to earnings (P/E) ratio, the dividend yield and price to book. In my experience, the more complicated the valuation measure, the more likely the maths contains errors and the undervaluation does not exist.
I don’t want to pay too much for current-year earnings because I feel it leaves greater scope for a share-price re-rating if future profits can grow at a respectable rate, and helps limit the downside if future profits go into reverse.
I’d like a good dividend income as well, ideally something in excess of the market’s own yield, to bolster our total returns. For some investments, a share price backed mostly by entries on the balance sheet — especially cash, investments and freehold property — will suffice if earnings and dividends appear temporarily depressed.