How to pick good quality shares at a cheap price

Richard Beddard reveals how he picks companies to buy and hold, preferably forever.

Probably the most influential book I have ever read about investing was One Up on Wall Street, first published in 1988. The author was Peter Lynch, who achieved fame and fortune managing the Fidelity Magellan fund in the 1980s. Lynch worked for one of America’s pre-eminent fund management companies. He was a pro through and through, but he was also an enthusiast, a stockpicker who loved nothing more than to figure out companies.

Ask somebody who doesn’t invest what they think about the stock market and they’ll probably compare it to gambling: traders buy shares they think will go up in price (or maybe because they already have), and sell shares they think will go down. It’s a pretty good description of stock market trading, but it’s destructive if you fancy yourself as a long-term investor.

Understand the business

Lynch said the share price was the least useful piece of information an investor could track. It was no substitute for doing your homework on a company: establishing its prospects, its financial condition, its competitive position and its plans for the future. In order to buy and hold shares for many years so they have the opportunity to appreciate many times in value, rule number one in investing is to understand the business.

Ultimately, Lynch said, it’s not the stock market or the companies that determine an investor’s fate, it’s investors themselves. A shareholder who lacks conviction will likely become a victim of the market – selling at the worst moment, for a loss. Lynch’s message empowered me when I first read the book, nearly 20 years ago. He, a celebrated fund manager thought I, a rank amateur, could do my homework as well as a professional, maybe better. He said: ‘I can’t imagine anything that’s useful to know that the amateur investor can’t find out. All the pertinent facts are just waiting to be picked up.’

The facts could be picked up in company prospectuses (the documents required to list on the stock market), annual reports, and industry and trade association publications. They could be augmented by calling the company, visiting it, talking to customers, and trying out products and services. Lynch called this grass-roots research ‘kicking the tyres’.

‘Professional investment’, he said, is an oxymoron, like ‘jumbo shrimp’ or ‘military intelligence’. He didn’t believe his peers were stupid, just hamstrung. Because fund managers stand to lose their jobs if they make a big mistake, many are scared to stand out from the crowd – so they buy the same fashionable shares as their peers. But you can’t beat the market by doing what everyone else is doing.

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Lynch literally told us to think for ourselves. His book wasn’t just a rallying cry, it was also an instruction manual. He explained how to analyse a share, getting into the nitty gritty of price/earnings ratios and bank debt, and organising all that he’d learned in a ‘two-minute monologue’. He liked to keep things simple and the two-minute monologue had just three components: the reason he was interested in the share, what the company had to do to succeed, and the pitfalls that stood in its path. ‘Once you’re able to tell the story of a stock to your family, your friends, or the dog... and so that even a child could understand it, then you have a proper grasp of the situation,’ he said.

The world has moved on since Lynch wrote the book in 1988. The internet brings us real-time access to share prices and other data, and many new ways to kick a company’s tyres. But I believe the way Lynch thought about investing stands the test of time. When you read a Share Watch or Share Sleuth column, you are reading my two-minute monologues, constructed from what I’ve learned by kicking the tyres.

Today's sources

The annual report is the most comprehensive source of information on a company’s performance and financial condition, so it’s the mainstay of my research. The first thing I do is to calculate the most important financial ratios from the accounts.

Most companies include a description of their business model (how they make money, their strategy), how they plan to make more money, and the principal risks (what could go wrong), in a section of the annual report called the strategic report. Since this information is the meat of a Lynch-style monologue, I go there next. Companies such as XP Power and Howden Joinery explain their respective businesses very well, but if a company’s strategic report is incoherent or jargon-ridden, it’s not a good sign.

Then I skim the annual report from back to front, starting with the notes to the accounts. The segmental report is often informative and it can be worth tracing revenue and profit back over many years to understand how different parts of the firm have performed. The notes are rich with detail that allow you to form your own opinion on a business before the board gives you its perspective at the front of the report.

Once I have developed a monologue, I test it by kicking the tyres again. Smaller companies are usually happy to field queries from well-informed shareholders and potential shareholders, while larger companies have dedicated investor relations departments. Soon after the annual report is published, companies hold annual general meetings where shareholders have a right to ask questions and get answers. I’ve never regretted going to one.

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The annual reports of competitors and suppliers are also rich sources of information. My confidence in Jet2holidays, an insurgent package tour operator owned by Dart, was bolstered by reading the annual reports of Thomas Cook. While established tour operators are struggling with store closures, Dart sells most of its holidays direct. Trade journals have moved online and reviews on sites such as Amazon tell you what customers think of products. On the Glassdoor website, meanwhile, you can find out what employees think of their employers: Treatt gets very good reviews, but Sports Direct’s are less impressive.

Churchill China says its plates ‘frame the food’. You can see for yourself on Instagram, where the company posts pictures and promotes the chefs who use its tableware. Warhammer hobbyists post videos on YouTube, sometimes containing strong views on Games Workshop, the company that makes the miniatures they paint. Fortunately for shareholders, gamers and modellers are more positive about Games Workshop than they used to be. Many companies, meanwhile, have Twitter and Facebook accounts, which serve as marketing and customer relations channels.

When a firm takes over a private company, you can see what it’s bought by checking the accounts online at the Companies House website; and when the Competition and Markets Authority launches an inquiry into a takeover or merger, it sets up a web page of documentation for the case. These documents can contain a trove of information on markets.

Times have changed, but older methods of kicking the tyres are still available to us. My wife and I celebrated our anniversary at a restaurant recently. As usual, I checked the underside of my plate and discovered it was made by Churchill China. The natural handcrafted look, I thought, would offset my steak nicely, so I asked my wife what she thought of the plate. ‘I can tell it’s mass-produced,’ she said. It wasn’t the answer I wanted, but I’ve filed this anecdote with all the other observations I’ve made over the years.

Two key ratios from the annual report

The ­first ratio I calculate is return on capital, as it tells us whether the business is viable. Just as the interest is the annual return on savings in a bank, the return on capital is the annual return (pro­fit) on the money invested by the company in the factories, stock and other assets of the business.

It’s probably worth being in business if the  rm earns 10 per cent on capital invested, but not if it returns 2 per cent – the money would be safer in the bank.

Pro­fits vary over time, so it’s a good idea to look back at how a company performs in good times and bad times. The higher and more stable the return on capital is, the more con­fident you can be in the business, especially if by kicking the tyres you can explain why it’s so pro­fitable. I favour businesses that can consistently return at least 10 per cent on capital.

A company’s pro­fit belongs to its shareholders. You can get a feel for the return an investor might get if they buy shares, by calculating pro­fit as a percentage of the company’s market capitalisation (the value of all the shares).

This too is an interest rate, but it’s the investor’s interest rate, called the earnings yield. In the current low interest rate environment, shares with earnings yieldsas low as 4 or 5 per cent might be considered attractive for a highly pro­fitable business with good prospects, especially if it reinvests some of the profit .

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