Differentiating between the two ongoing fundamental investment situations, stalwarts and susceptible, shapes investors’ expectations
Differentiating between the two ongoing fundamental investment situations, stalwarts and susceptible, shapes investors’ expectations.
For investors in shares, there are two ongoing fundamental investment situations: stalwarts and susceptibles. Differentiating between the two shapes our expectations.
A change in terminology
Last week I explained why I categorise some business as 'speculative', and others as 'good companies' in the Share Sleuth portfolio. In the process, I realised the terms are not as clear as they could be, a criticism that might also have occurred to investment newsletter writer John Kingham, who left a great quote on the blog post to illustrate that all investments are speculative.
Its from John Maynard Keynes: 'We have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence.'
This is pessimistic but usually true, and in any case, I can use more precise nomenclature to describe what makes a good company less speculative, and what makes a speculative one more so.
Good companies are now stalwarts, a description I've nicked from Peter Lynch, and speculative companies are now susceptibles, a term I've plucked from the air.
Good is a vague word. It could mean just about anything positive; strongly growing profit in the past, a company that treats customers well, or pays a high dividend, held in high esteem, innovative, ethical...
I'm using 'stalwart' to describe something more specific. A business that has competitive advantages I can articulate that are evident in its financial statements and in particular the company's profitability and sound finances. Sound finances are indicative of a company's past health, high levels of profitability are indicative of its current health, and competitive advantages are indicative of its future health.
A stalwart is a strong company that should prosper.
Stalwarts have more control of their destinies than susceptibles. Their ugly sisters are susceptible to new competition, mismanagement, and economic cycles, for example.
All businesses are susceptible to a degree, the test of whether a company is not too susceptible to be a stalwart is a judgement: whether or not I'm confident it will remain comfortably profitable over an economic cycle, averaging, say, at least a 10 per cent return on capital.
Susceptible businesses are also worth owning sometimes, but they can be misleading, looking like stalwarts when conditions are good, but revealing what they are susceptible only when they are tested. Counter-intuitively, they are most attractive when the conditions they are susceptible to are at their worst because they can be bought very cheaply.
Circumstances must change for susceptible investments to prosper, so the past may not be a good guide to the future. They're risky, unless they join the portfolio at very low prices and there is good reason to believe things will change.
Stalwarts have more control, so the past is a better guide to the future. The confidence a strong company breeds in investors may be reflected in a high valuation. That can be risky too, but its less likely to be if the stalwart proves itself and delivers strong returns for decades.
Differentiation between the stalwarts and susceptibles is important, because it shapes our expectations of the investments, and the prices we will pay for them.
Anpario: Food for thought
Natural animal feed additive manufacturer Anpario is a growing company in a growing industry, but it doesn't belong on the Share Sleuth watchlist.
Agricultural, industrial and banking conglomerate Camellia published half-year results on 28 March. As usual, I'm bemused by the mass of reports on production levels and prices of various commodities. I'm also beguiled by the company, the only one I find impossible to slot into my framework of stalwarts and susceptibles. Its long-term vision and strong finances should make Camellia the ultimate stalwart, but the complicated accounting of biological and financial assets reinforces its susceptibility to commodity prices, and turns valuation into a minefield.
McBride warning shows it's tough in the aisles
A supermarket price war is a race to the bottom that could lead to many casualties. Portfolio member Finsbury Food could be affected.
Hyder talks a good recovery
A positive update from Hyder Consulting prompts an enthusiastic response from the market, but not me.
I've recategorised Nichols. Having relegated Nichols to the susceptible category because it's susceptible to pressure to reduce the sugar content in its drinks, I've decided to rehabilitate it. Although that pressure may well intensify as our understanding of the effect of sugar on health improves, it's a speculative threat. Currently, the company is a stalwart.
The following companies joined the research list
Two potential susceptibles
Avesco: Rents audio visual equipment and provides technical support to event organisers and broadcasters. The shares are trading at a fraction of the company's tangible book value and periodic losses suggest it is susceptible to something.
North Midland Construction: Does civil engineering and building. Also mechanical and electrical engineering. It's trading below tangible book value and susceptible to contract cancellations and delays.
And four potential stalwarts
ITE: Organises trade exhibitions and conferences, especially in Russia, Eastern Europe and Asia. The company is in most respects a stalwart, but susceptible to crises in some of its markets, currently Russia and the Ukraine.
Northbridge Industrial Services: Manufactures loadbanks for sale and rental and hires out other specialist equipment. Loadbanks are used to test electrical power sources like diesel generators, gas turbines, and uninterrupted power supplies.
Waterlogic: Manufactures water purification and dispensing systems for offices, schools and hospitals.
Universe: Develops payment software and supplies payment systems to petrol and convenience store retailers.
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