In Search of Great Stocks, Part I
A good start when searching for great investments is to look for a good company and then buy its stock at the right price. Some investors use gut instinct, which often times just isn’t accurate enough. Some use check lists which might have too many details and can cause investors to miss some great opportunities because of small defects which don’t have a material effect on companies’ performance.
In this article, I will introduce you to my method of how to find a good stock using "big picture analysis.” Let’s start with 3 qualities a good stock should have.
• Large future growth
Many investors love this quality, especially Peter Lynch, because on average growth stocks can return very large capital gains. When speaking of growth, I mean future growth, not past performance. I look for at least 25% EPS growth annually over the next 3 years. Usually, growth comes from growth of the industry, expanding into a new market and/or gaining market share from competitors. A strong company that has a large market share and operates in a mature industry can’t be considered to have this quality because there is no room for growth. Many Chinese stocks exhibit great growth. (Cost cutting or price increasing which generates bottom-line results is another way to generate EPS growth, even though sales volume doesn’t increase.)
• Great cash flow
I look for companies that don’t need a lot of money to invest in accounts receivable, inventories, or expensive plants or equipment to grow their business or just sustain their competitive position. Sectors in which we can find this quality are, for example, retail businesses, online businesses and the insurance sector. These kinds of companies can have excess cash to pay dividends and to make share repurchases.
• Low competition
A company which operates in a highly competitive industry can have difficulty sustaining profit margins because when industry players have a high margin they attract many new competitors and/or cause old players to expand capacity. When there is more supply in the market, price will be decreased due to price wars. A good company needs to have a high barrier to entry, an established distribution network, differentiated products, a recognized brand and/or cost leadership to make it difficult for others to compete.
A company does not need to have all three qualities to be worth investing in. Just 2 out of 3 qualities are fine because finding a company that has all 3 qualities and has an attractive valuation is like looking for a needle in a haystack. From the three above-mentioned qualities, we can divide worthy-to-buy stocks into 4 groups as shown in the diagram below. I refer to it as my “Stock Selection Diagram” or “SSD” for short.
• G-CF stock (Large future growth with Great cash flow)
Usually, a high-growth company needs a lot of money to invest in new equipment, more accounts receivable, and more inventories. Where we can find G-CF stocks which do not need to invest a lot of money is in online businesses, retail businesses, the insurance sector and so on which do business in emerging markets such as China and other Asian countries, except Japan. Because this group of stocks does not need a lot of capital, new competitors can easily enter the industry and this can result in high competition. If investors can’t find any reasons to believe that a G-CF stock has special advantages over competitors which will enable it to become a great company in the future, we shouldn’t make a long-term investment in it. A good time frame for holding this kind of stock is not more than 3 years and the suitable strategy is hit-and-run. The last tip on dealing with this kind of stock is to keep an eye on many G-CF stocks because this is the group of stocks that has great potential to become great stocks if they become big enough to establish cost leadership, distribution power or brand recognition.
• G-LC stock (Large growth with Low competition)
A G-LC stock can grow significantly while sustaining a high margin but the downside is it needs lots of money to keep business running. In the growth stage, we shouldn’t expect any dividends from it, moreover, we should prepare for a lot of dilution along the way. Examples of this kind of stock are distributors, which need to invest a lot in working capital and establishment of their distribution network, and energy/utility companies, which need licenses from the government. When investing in a G-LC stock, investors should look closely at cash flow in the cash flow statement to determine whether it is enough for the company’s investment plan or not. Some G-LC stocks which become bigger and have stable revenue and income might have easier access to loans, which can decrease dilution risk.
• CF-LC stock (Great cash flow with Low competition)
A CF-LC stock doesn’t need much money for inventories, new equipment or R&D budget. Many famous and mature companies in America are in this group, for instance, Coca-Cola (KO) and Wal-Mart (WMT). A CF-LC stock usually has a high payout ratio or continuously buys back its shares, so the best strategy for investing in this group is to buy when a company has a temporary problem or when the stock market has a big decline and brings down the stock to a low P/E ratio. Most ex-great stocks, when the growth stage has passed, become CF-LC stocks which are still interesting for investors who love sustainable dividends.
• Great stock
This is a great company with all 3 qualities. It can grow continuously, sustain a high margin by getting bigger and creating durable competitive advantages through its distribution network, brand recognition and economies of scale while still being able to pay a dividend or buy-back a lot of its shares, which makes EPS growth even higher. When a great company sees a big opportunity in the market, it might not pay any dividend and use more cash to capture as much market share as possible to hinder new competitors and we might see huge growth in this situation, say more than 50% a year. Some great companies that have a lot of excess cash might eliminate potential competitors by taking them over and consolidating their position in the industry. A great company run by an exceptional management which always thinks about maximizing shareholder’s wealth will have a very high ROE. Investing in this kind of stock has proven to be the fastest way for investors to become successful, just like Warren Buffett.
Conclusion
Good investing isn’t only selecting a good stock but also buying it at a reasonable price. In my opinion, the 3 groups of good stocks (G-CF, G-LC and CF-LC) should be priced around a 10-20 P/E depending on their fundamentals. Great stocks are very hard to find, especially with low P/E ratios. We usually see them when they become very well known and have a very high P/E ratio. The best strategy to invest in a great stock is following many good stocks in order to have a chance to see one that gains some attributes which enable it to become a great stock and then buy a lot of it while it’s still cheap and is still not recognized by many investors. A great stock should be priced at least around a P/E of 30. Some might even be worth very high P/E’s, around 50-70, if their 3 qualities are very strong.
When analyzing stocks, my SSD might help you to do your work easier. I’ve used it myself and it is easy to remember.
“Large future growth,
Great cash flow,
Low competition”
In Search of Great Stocks, Part II
In Part I of this series, I categorized good stocks into 4 separate groups which were G-CF, G-LC, CF-LC and Great stocks as shown in the Diagram. In this article, let’s have a look at some examples of stocks in each group through their cash flow statements so investors can gain a clearer understanding. Annual cash flow statements from Google finance are a good tool for preliminary analysis.
These examples are just a rough analysis and as I haven't thoroughly examined their fundamentals, I might underestimate or overestimate their potential.
The bad thing about this kind of stock is we should expect low dividends or none at all during a growth stage. Investors should always be prepared for dilution, if the management trend is to be aggressive on their future plans.
KO and WMT used to be Great stocks for a very long time. These two companies are good examples of Great stocks that grow for a long time, become a mature business and still have 2 qualities to be good stocks that are always worth investing in.
More thoughts on Great stocks and CF-LC stocks.
Most of the stocks in Warren Buffett’s portfolio are Great stocks or CF-LC stocks that used to be Great stocks. Buffett loves great cash flow companies that have little competition. (In his words it might be called Durable Competitive Advantage, DCA). He doesn’t care whether the company has growth or not because he can use its excess cash or dividends to buy other Great or CF-LC stocks and make growth for himself. So, if you can’t find any high growth stocks but can find many CF-LC stocks at reasonable prices, you will be able to create virtual growth by buying many CF-LC stocks as a portfolio and then use the dividends to reinvest again and again.
More to come…
In the next article I will give 3 examples of Great stocks, analyze what they look like, and show the potential of Great stocks that are deserving of very high P/E ratios.
In my earlier articles, Part I and Part II, I’ve written about how to select good companies to invest in and examples of 3 groups of good stocks. In this article, I’m going to write about examples of great stocks so that investors can understand how to use my Stock Selection Diagram more effectively.
There are non-cash items from changes in fair value of derivatives that have to be excluded to see the real net income. I’ve adjusted them in the table below.
Up until now, Chinese dairy manufacturers imported probiotics mostly from Europe and Japan. CHBT entered into the bulk additives probiotics industry over a year ago and just started production at its new plant in Qingpu. It is now the biggest domestic player in China.
The quality of its products is equal to or better than that of its foreign competitors while prices are 20-30% lower. Entry into the industry is very difficult because the standard of food production is so high; it requires high technology; and it is hard to get licenses from the government. CHBT’s being a cost leader also gives it an advantage in terms of competitiveness.
The probiotics industry has been growing exponentially due to very high growth of yogurt and animal feed products. The probiotics consumption is predicted to grow from 3,400 tons in 2006, to 10,000 tons in 2010. (Source: Domestic Probiotics Market Analysis and Forecast Report by Beijing Leadership Management Consulting Co. Limited.)
Another source from Euromonitor has shown that, in 2009, China finally overtook Japan as the heaviest consumer of probiotic cultures, reaching over 10,000 tons (Actual consumption number reaches 10,000 tons faster than Beijing Leadership Management Consulting Co. Limited has predicted.) Euromonitor International predicts that by 2014 this will have risen to almost 18,000 tons, accounting for nearly 30% of global consumption. (Source: Euromonitor).
CHBT’s net income growth is very high and stable. Net income growth has averaged 37% annually for the past 4 years, mainly from it supplement products. For the new market segment, bulk additives, CHBT has the largest capacity in China at 300 tons a year which represents a market share of only 2.xx% in 2010. When CHBT runs its 300-ton plant at full capacity in the next 4-5 years, it will have a market share of only 1.xx% of 18,000 tones in 2014. This means there is a lot of room for CHBT to grow very fast.
CHBT doesn’t have to invest much in working capital as we can see that overall CFOA is a little higher than net income (excluding changes in fair value of derivatives.) Moreover, the probiotics industry is not a capital intensive business, so CHBT has invested around 50% of CFOA over the past 4 years in order to grow net income at least 50% annually for the next 4-5 years.
CHBT’s valuation
My forecast is that CHBT’s EPS will be $1.92, $3.33 and $5.23, during 2010-2012, which is 65% annual growth for the next 3 years. At $13.61, the P/E ratio is 7.1 times and the PEG is very low at 0.11. In my opinion, this is a great opportunity to buy a great stock at a very low price.
Great stocks usually have very high P/E ratios. In my opinion, they should be priced at least at a 30 P/E and some might be worth more than 50, depending on their fundamentals. So, to be successful in investing in great stocks, you need to buy them before others realize their potential or when there is a temporary problem which brings the price down to a cheap level.
CHBT is one great stock that is unknown to many investors. Additionally, it is having a temporary problem, which I have written about in myprevious article, so we can buy it at a very low-price. I will give more details on CHBT in my next article.
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