One important lesson that many have learnt from the ongoing Euro Zone turmoil is the importance of owning high quality stocks in their portfolio at all time. Macroeconomics condition is ever-changing and no one has the ability to predict the future accurately. However, a good stock is one that will continue to prosper through the ebb and flow of the business cycle. This is not exactly what we called defensive stock, but these are companies that are able to survive a hit or two and yet able to grow fast during period of growth. The following are the characteristics that I always look for in my target:
Recurring and Predictable Income
Favourable Long-term Business Economics
Sustainable Competitive Advantage
High ROA and ROE
Clean and Strong Balance Sheet
High FCF/Net Profit Yield
Recurring and Predictable Income - Recurring income exists in many forms, with some being more explicit than others. Things like licensing fee, rental income, regulation and toll road are pretty straightforward. For other less obvious form, this involves your bread which you eat for breakfast everyday, the printer cartridge you need or the cable TV subscription. It is always good that the business has some form of recurring income as this is the portion that will keep the business afloat during a recession or unforeseeable Black Swan. So long as the business does not make a net loss, shareholder's equity will continue to grow.
Favourable Long-term Business Environment - As with all stocks that we buy, we are expecting that the business and net profit will grow. Having favourable environment allows a company to grow its business much easier as compared to one that is going against it. For e.g. ageing population and healthcare tourism are inevitable trends that will benefit those in the healthcare sector. Growing population will favour those in the FMCG and transport sector(if they have sufficient capacity). Demographics is just one of the more obvious and inevitable trend out there in the world. Kodak, print media and non-smartphone are the few that are destined to collapse in the long term (definitely not immediate as they will just die a slow death).
Sustainable Competitive Advantage - This is a term that has been repeated throughout the book Buffettology and has been seen as a key criteria of Warren Buffett. Why is sustainable competitive advantage so important? A business with this characteristic is like a castle with a wide and deep moat to fend off competition. Any good business that can deliver high returns will always be assaulted from all direction as a result of capitalism. As in the classic bubble tea case, new competitors seeking lower return will just lower the return of the existing business. A moat is one that allows the company its high return over a long period of time, be it through market share, mind share, monopoly, or monopsony. Example of moats include network effect, government regulation, strong brand name, patent, high switching cost and lowest cost structure.
High ROA and ROE - I have always viewed Return on Asset and Equity as one of the most important financial ratio. ROE is basically dividing net profit by total shareholder equity, while ROA is changing the denominator with total asset. High ROE and ROA is highly favourable as a company with the higher ratio will be able to grow its equity faster assuming the same dividend payout ratio. To illustrate, company A has a ROE of 20% while company B has a ROE of 10%. Assuming they are not listed company, every $100 pump into company A will yield a return of $20 annually as compared to $10 for company B. As such, it is very logical why this is important.
One reason why ROA is also being used here is that ROE= ROA x equity multiplier ((Total Equity+ Total Liabilities)/ Total Equity ). Therefore, a company can easily boost its ROE by taking on extra debt. To illustrate once again, we have company A and B earning $100 in Net Profit with Total Asset of $1000. However, company A has equity of $1000 with $0 liability while company B has equity of $100 with $900 of debt. Both companies will have ROA of 10% but company B will have a ROE of 100% as compared to 10% for company A. Company B will be an obvious choice if we were to choose solely based on ROE. However, does not it make sense that company A should be worth more than company B given that the only difference they have is that company B has extra $900 in debt? Though there is an exception to this which is when the liabilities are interest-free non-debt that are offered to the company.
Clean and Strong Balance Sheet - A balance sheet of this kind is one where there is very little debt, especially those bank loans. Debt can be a useful leverage for company seeking to expand their business beyond the ability of their equity. However, the problem comes where too much debt is undertaken beyond the company's ability to service them in the worst case scenario, typically a recession. A company with strong cash buffer and no debt can easily remain a going concern even if it were to face perhaps 5 consecutive years of losses.
High FCF/Net Profit Yield - Free cash flow is basically the amount of cash a company get after deducting all working capital needs as well as capital expenditure. It is a important factor to look out for as cash and not profit is what that keeps a company going. FCF represents the amount of cash a company has to invest, payout as dividend, pay debt or to add on to its cash holding after it has used up whatever is necessary to keep the business ongoing. FCF/Net Profit represents the amount of FCF that a company can generate from its net profit. These are often idle cash that can be used to grow the company or the shareholder's wealth. A company with very low FCF/Net Profit will find it hard to invest or to payout dividend
Dividend Yield - this is basically the amount of cash that the company returns to shareholder annually as a percentage of the price the stock is purchased. While I am not always looking for very high dividend yield of more than 6%, I find it more comfortable to purchase stocks that offer a decent dividend yield of around 4-5%. I viewed dividend as a form of margin of safety should the business not grow in the way that I have thought it will be. Dividend also provides important cash flow for your personal finance especially since undervalued stocks can usually stay undervalued for long. One reason why I am not preferring a company with dividend yield of more than 6% is that such company will not be able to grow their business much as equity injection is lower. However, there's company that recognises that they will not be able to grow their business much and choose a close to 100% dividend payout. These will be the kind of stocks that you should be going for if the main goal of your portfolio is to earn steady dividend.
One last part to add, many of these factors are in fact inter-linked together. A company with sustainable competitive advantage will in most cases has high ROE figures. High ROE can be sustained easier by a company with a high dividend payout ratio. FCF/Net Profit Yield will determine the dividend payout ratio that shareholders get. A company with strong business model can afford to take on a more debt-fuelled balance sheet, though in most cases the company will have a clean balance sheet as its high ROE is sufficient to grow the business. With a recurring and predictable revenue base, a company will also be more willing to pay higher dividend to its shareholders. Therefore, when you find a company that shows a few of these symptoms, it is good to dig out more about it as you will be likely in for pleasant surprise.