Because investing in the stock market carries a larger degree of volatility than some other forms of investments there is more of a need to protect our capital from poor decision making and I will shout from the rooftops until the cows come home that buying shares in good quality companies is a great way to building layers of protection from bad decision making. In this blog, six signs of a quality company, I’ll go through six signs that highlight the difference between good companies and bad ones.
Profitability
Investing is about following FACT not FICTION. Numbers don’t lie. The first of the six signs of a quality company is looking at the profit figures. The WHOLE point of a company is to make profit. Take a look at this excerpt from stockopedia for Plug Power.
It amazes me that anyone would consider investing in this company a good idea. There’s no Net Profit; in fact there’s an increasing net loss even though total revenue is going up. This is not investing, it is speculating that this company will make profit in the future.
In contrast, take a look at this excerpt from Fonix mobile. Increasing revenue and increasing Net Profit. No speculation required. It is clear that this company is in good shape and growing nicely.
Plug power is an american hydrogen producing company and whilst clean energy is the future there is every possibility that it will go bust as it continues to refinance to keep the creditors at bay. Fonix mobile is in the mobile payments industry which is now in full flow. I have recently added a wallet to my phone and added all my debit and credit card details. All I do now is wave my phone at a device and it’s all paid for. Brilliant.
Plug power may well be the next BP or Shell of the hydrogen industry in years to come but investing right now is far too risky so it’s best to put it on your watchlist and wait to see what happens. As Fonix seems to be running very well, it may well be a takeover target for a much larger organisation and if so there would be a 30% markup on the share price if that were to happen.
Efficiency – ROCE (Return on Capital Employed)
The second of the six signs of a quality company is to look at the ROCE. You’ve got two companies both operating in the same market doing the same thing. They’ve both invested capital into the business to buy machinery, transport etc to get them operational. Both are now making sales and profit but which one is getting more out of their equipment than the other. Let’s take a look at an example:
Company 1 has invested £4000 and is generating £1000 profit from sales of £5000. Dividing the profit by the capital employed, Company 1 is producing a ROCE of 25%
Company 2 has invested £6000 and is generating £1200 profit from £5000 of sales. Again dividing the profit by the capital employed Company 2 is producing a ROCE of only 20%.
Therefore, company 1 is more efficient it is getting a better return from it’s investment than Company 2
On it’s own ROCE doesn’t really mean a lot but it comes into it’s own when you compare ROCE between competing companies in the same sector. And the good news is that stockopedia calculates it for us. Stockopedia also provides a comparison between the company, the industry and the whole market.
Cashflow – The lifeblood of a company
The third of the six signs of a quality company is to look at the cashflow. We’ve all heard the phrase ‘CASH IS KING’ and it is never truer than in the business world. What’s surprising however is that companies go bust because they are focussing so much on sales they forget to collect the cash. I know right, how is that possible? Intelligent individuals come together, build a business and then forget to collect the cash. It happens and businesses go bust as a result. You can declare increasing sales and profits in the year end accounts but if you don’t physically chase clients for the money, you can’t pay your debts.
The good news is that you don’t need to be an accountant and understand complex accounts documents to find out what’s happening to cashflow, Stockopedia does it for you. Let’s take a look at the cashflow figures for Fonix and Plug Power.
It doesn’t take the brains of Britain to see that Fonix’s ( Free cashflow ps (per share) is rising nicely and Plug Power doesn’t have any Free cashflow per share. It’s only a matter of time before the creditors keeping Plug Power afloat are going to lose patience and pull the plug (no pun intended)
Debt Management
The fourth of the six signs of a quality company is debt management. You can’t build a multi million dollar business without taking on debt. Fact. It’s how you manage that debt and your ability to pay the interest payments on time that differentiates good businesses from bad ones. If you don’t pay your mortgage the bank will repossess your house. SIMPLES. I’ll keep with the Fonix/Plug Power comparisons.
As we can see on line three Stockpedia list the Net debt position of each company over the last seven years. Fonix has an increasing minus net debt position which means that not only does it not have any debt but it is increasing it’s cash reserves year on year.
It doesn’t look so rosy over at Plug Power however. In 2021 it had a cash positive position of three billion but now we can see that all its cash has gone and its debt levels are rising. Without any profit to pay the interest payments it has to rely on sources of credit to keep going.
Debt in business is classified two ways. There’s short term debt which needs to be paid back within 12 months and there’s long term debt which is any debt that can be paid off further down the line. In our world we can classify a mortgage as long term debt and a 12 month bank loan as short term debt.
The way to assess whether a company has the ability to pay off short term debt is using the liquidity metric as a guide. The current and quick ratio’s measures the companies ability to pay its obligations towards its short term debt. I won’t bore you with what the ratio’s calculate ( you can google that if you’re interested) but all you need to know is that Stockopedia has it covered. Fonix is on top and Plug Power is on the bottom. The higher the number the more protected the company is. A score of 1.5 is considered a good score here. As Fonix has no debt this section is irrelevant but for Plug Power what’s concerning is that they clearly don’t have enough cash to pay off the interest payments let alone the debt itself. If you find a company with all green on the board you have a company that is looking after its debt.
One last point to make about debt management is the company’s relationship with its creditors. Some times through no fault of it’s own a company has to acquire huge sums of money to stay afloat. Carnival cruises (again no pun intended) had to borrow large sums of money due to them being grounded during Covid and its debt position looks pretty ugly now. However there comes a point where a company becomes ‘TOO BIG TO FAIL’ so as long as the company has the ability to repay and reduce it’s debt gradually this creates calm in the situation and forms a trusting bond between the two parties.
Economic moat
The fifth of the six signs of a quality company is to identify an economic moat. ISM’s come and go. We’ve had royalism, imperialism, communism and now we are in a period of capitalism. There’s isn’t any ISM that is 100% perfect and all have their flaws. The good thing about capitalism is that anyone of us can come up with an idea, get funding and go a build a business. However the bad thing about capitalism is that just because you had the idea first doesn’t mean I can’t find a cheaper way to do it and put you out of business. So a company that can’t protect its’ products or services from competition is not a good business to be invested in.
In chapter 20 of his book The Intelligent Investor. Ben Graham talks about company’s needing to have a MARGIN OF SAFETY. A margin of safety is something that protects the company from competition. Size, patents, copywrite, customer loyalty and brand are all types of margins of safety. Richard Branson loves to take on the big guys and one day he decided to take on Coca Cola. He brought out Virgin cola and swamped the market with a cheaper version of the cola soft drink. Coca Cola in return sent a message to all stockists of virgin cola that was very clear. Stock virgin cola and we’ll remove all the free refrigerators, merchandising and everything else we supply for free. Virgin Cola died a thousand deaths and is no more. That is the power of product protection. When deciding on whether to invest your money in a company ask yourself how can they protect themselves from competition? Is it subject to competition from cheap imports? Can it go online?
Peter Lynch famously made a fortune buy buying Dunkin’ Donuts. It is a donut. It is not subject to cheap Korean imports and it can’t go on-line. It is the best selling donut in the USA and it protects itself with the recipe and the quality. Another example of a margin of safety is geographical location. Let’s face it, you can’t put another Harrods next to Harrods can you?
Growth Potential
The last of the six signs of a quality company is in the growth potential. This metric of quality is subjective because when a company has grown into a size that dominates it’s market and there’s very little scope for future growth, that doesn’t necessarily mean that it’s not a quality company. This is where you’ll find the dividend paying stocks and if dividends is your preferred strategy for investing you don’t need growth potential to achieve that. However, I’ve added it to the list because of the following reason.
The share price of a company will always correlate with the value of the company. This is the 5 year chart of Bloomsbury Publishing. As you can see the company’s revenue has been steadily growing and so has the share price. English has become the world’s international language so everyone and his uncle needs to learn it. Reading is an essential part of learning a new language and every new generation will have to go through the same process. J.K. Rowling can write Harry Potter sequels/prequals and every other quals she can muster for an eternity and she will not have any shortage of customers worldwide.
Now hang on a minute Myles I hear you shout. That’s not always the case is it. The company’s share price doesn’t always correlate with the value of the company does it? And you’d be correct. There are number of reasons for that. Economic outlook, Wars affecting supply chains, Fund managers recalibrating their portfolio’s, Traders trading against each other, It’s a Monday. I could go on. What we can see from the chart is that despite the fluctuations in share price the general trend is upwards as Bloomsbury grows its’ revenue. Put another way, a company’s share price isn’t going to go up if its’ revenue is shrinking is it?
Growth potential for me has to go on the list.
Six signs of a good company – Conclusion
I was talking to a lady in her mid-thirties a few weeks ago and suggested that investing in the stock market is a great way to provide additional income. ‘Ooh, that’s far too risky isn’t it? came the reply. The problem with stock market investing is PERCEPTION. It is perceived to be too difficult, too risky and too complicated. I don’t think there is anything I have written in this blog that is nothing short of plain common sense (apologies for the double negative English teachers) . No heavy accounting knowledge required or complex formulae to evaluate. Stockopedia lays it out in simple terms for everyone to assess. Stockopedia goes one further to.
It has come up with a Stockrank system for each of the 63000 companies they have information on. Based on all the criteria I have mentioned in this blog (and some more) they’ve come up with a quality rank to identify quality before we start to delve into the nitty gritty. Bloomsbury ranks 99. No wonder I’m not selling my shares.
Investing in company’s that don’t make profit (yet), are not as efficient as their rivals, do not look after their cashflow, their debt management is poor, can’t protect their product and don’t have an ability to grow is always going to be a riskier proposition than ones that can and do.
In my next blog, I’m going to discuss what can go wrong in stock market investing. Learning from mistakes is good but learning from others mistakes is far better. Learn from mine. LOL
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