To take an independent view of a company's results investors must challenge the headlines. Half the battle is knowing the right questions to ask.
Specifically, investors challenge the figures in the published accounts by adjusting them, and calculating the ratios we think are important.
And we use our own figures and our own knowledge to challenge management's explanations of the businesses' performance and strategy. The way we do this is what makes us unique as investors, and determines whether we succeed or fail.
Once I have calculated my own set of figures for a share in the Share Sleuth spreadsheets, I begin to ask questions...
To add a share to Share Sleuth I must trust the numbers and the words in the company's annual report since it is from them that further analysis follows.
Next I require stability. If we are to draw conclusions from information from the past about the prospects of a company in future, then the past must resemble the future. Finally, I require value because returns from an investment depend in part on the price paid for it.
The more closely a company matches the three criteria, trust, stability, and value, the more likely it is to join the portfolio or replace a share in the portfolio that matches less closely.
The closest matches, and those that deviate from them in acceptable ways, are high confidence picks, stalwarts in which I'm prepared to allocate up to 10 per cent of the portfolio's value.
Over recent months I've been refining the questions into a more formal checklist to determine trust, stability and value.
Most of the questions answered yes, no, or maybe, with additional explanation and, perhaps, qualifications. The more yeses, and the less qualification, the better.
Two questions require more open answers. The first, 'what could stop the company achieving its strategy?' will result in a list of risks. The shorter it is and the less significant the risks, the better.
The second, 'at what market valuation would I add this company to Share Sleuth?', will usually have the same answer for a stalwart: an earnings yield of 8 per cent or more.
Here are the questions, with a brief indication of where I look for the answers. If I can't find them in published sources and I'm interested enough in the company, I may call the financial director.
- Is it clear how the business makes money? Strategic report in the annual report, company website.
- Is the accounting straightforward? Financial statements and notes to the accounts, in the annual report.
- Is the company as profitable in cash terms as it is in accounting terms? Share Sleuth spreadsheet, derived from accounts in the annual report.
- Is the annual report forthright about strategy, and setbacks? Executive statements and strategic report, in the annual report.
- Does management own substantial shareholdings? Directors' report, in the annual report.
- Is management responsible for past success? Directors' report, in the annual report.
- Do management incentives encourage long-term thinking? Remuneration report, in the annual report.
- Does the company have a stable history of profitability? Share Sleuth spreadsheet, derived from accounts in the annual report and occasionally commercial data sources, principally Sharescope.
- Is the company mainly self-financing? Share Sleuth spreadsheet, derived from accounts in the annual report.
- Does the company's strategy differentiate it from rivals? Strategic report, in the annual report.
- What could stop the company achieving its strategy? Strategic report and key risks sections, in the annual report.
- At what market valuation would I add this company to Share Sleuth? Typically, an earnings yield of 8 per cent or more for stalwarts.
- Is the valuation based on a conservative view of the company's prospects? This checklist, outlook statement in the annual report.
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