Dr Ajibola Awolowo
An English adage says “There are more than one way to skin a cat”. Not wanting to be outdone, a Yoruba proverb says, “There is more than one road into every market”. I am sure I can get an Igbo and Hausa proverb that will say the same thing. There is no one size fits all in most things in life.
There are many ways to pick stocks. You can decide to throw a dart at the stock market pricelist page of a daily newspaper and buy whichever company the dart hits. You may decide to choose one company over the other simply because you like the name of one but not the other. You may buy based on some features on a chart that displays the various prices and corresponding volumes that a company traded in the past.
What I am about to discuss, however, is my own way of filtering the thousands of companies that are available to be bought daily. This method is not perfect but it is perfect for me. Will it be right for you? Maybe. Maybe not. We all view life through the flawed lens of our past experiences which is unique to each and every one of us. What works for me may not necessarily work for you.
Having sounded that caveat, I would like to explain the flawed lens through which I will be addressing this topic. I strongly believe in the style of investing popularly called Value Investing which was first expounded by Benjamin Graham and popularised by Warren Buffet.
Value investing is built on a few foundational principles. First, behind every ticker symbol is a company. The profitability of the company eventually determines the trajectory the ticker symbol follows. This may be difficult to see in the short term but is always crystal clear when the focus is on the big picture.
Secondly, most times, the market is efficient and values the ticker symbol at or close to the value of the underlying company. On few occasions though, the value of the ticker symbol (price) varies widely from that of the underlying company. These occasions provide investors an opportunity to buy or sell these companies.
Now that you recognise the flawed lens through which this write up will be written, we can dive into the meat of the article.
The first hurdle that a potential buy must cross is to come into my consciousness. It is impossible for me to buy a company I have never heard of or do not know its name. Companies come into my consciousness via many different routes. It may be that I bought a product and looked at the label to see who produced it, who distributed it or who sold it to me. A book can tell me who published it or who printed it. Prescribing a medication several times and getting good feedback from my patients may lead me to check who produced it or who is marketing it.
In all our various professions, we come across a multitude of companies each day. The problem is that many of us are not consciously looking out for them. An electrician knows the best cables in the market. He might have found a profitable cable producing company without realising it. A plumber knows the best PVC pipes in the market. Why not dig further about the company that produces it? A civil engineer knows the most reliable construction companies in the market. Why not look at the company’s financials? You get my drift?
Another way that I become aware of companies is from social media and various investor forums. I belong to various groups on Facebook, WhatsApp, Twitter and Telegram. Someone might mention a company that I have never looked at which will then cause me to take a better look at that company.
If all this fails, Warren Buffett gives the best advice – “Start with the A’s”. When looking for interesting companies, look through all the companies in alphabetical order. It might be a tedious task but the more stones you turn over, the more likely you are to find a hidden gem.
The process that eventually leads to the purchase of any company is quite laborious and time consuming. It will be counterproductive to try and perform an in-depth analysis of all the companies on the Nigeria Exchange Group or any exchange worldwide. There must be a filter that can easily be used to sift off companies that are a total waste of my time from those that may hold some promise.
This filter that sifts off worthless companies from diamonds in the rough is the second hurdle that companies must scale. This is the hurdle of profitability. Once a new company comes into my consciousness, I download the company’s latest quarter financial statement just for a quick glance. If the company is persistently loss making (this quarter and the corresponding quarter in the last financial year), there is no point doing any further research. Companies that have persistently made a profit over the last few quarters or years deserve much more of my time and attention since they are finite. I cannot waste them on unprofitable companies.
Next, because all profits are not equal, it is always best to own the most profitable companies. This brings us to the fourth hurdle – Gross and net margins. Gross margin is the difference between the revenues and cost of goods sold, divided by the revenue. It is expressed as a percentage and looks at what percentage of the revenue becomes gross profit. Net margin on the other hand looks at what percentage of the revenue eventually trickles down to become profit after tax.
Let us look at a few examples. In the third quarter 2021 result of Dangote Cement company, they reported a revenue of N1.02 trillion, gross profit of N618 billion and Net profit of N278 billion. This gives a gross margin of 60% and net margin of 27%. This means that for every N100 of revenue, N60 became gross profit and N27 was pure profit.
If we compared this to the result from Lafarge Africa Cement company in the same period, revenue was N219 billion, gross profit N63.9 billion and net profit was 40 billion. Their gross margin is 29% while net margin is 18%.
It is obvious that, although, both companies are quite profitable, the margins from Dangote Cement eclipses that from Lafarge. My time will be better spent digging deeper into Dangote cement than Lafarge Africa.
Companies that have high gross and net margins as compared with others within their industry are particularly attractive. High margins either signify that a company has a lower cost of production as compared to its competition or customers love the company so much that they are willing to pay more for its products as compared to other companies. This means that the company has a moat or a competitive advantage and is a position of strength.
Note that everything we have done so far, first to the fourth hurdle, can be done within minutes. From being made aware of the company, downloading its latest quarterly result to glancing to see if they are making profit. If they are making a profit, what are their gross/ net profit margins? The company with the highest gross/ net margins gets the most of my attention while that with the least margins can wait.
If you do this diligently, you will weed out most of the companies on the exchange and know where to focus your analytic skills. This is because the real hard work in analysing companies is about to commence.
We would talk more about the next few hurdles in the next part of this article. Watch out!
Dr Ajibola Awolowo can be reached via valuenigeriawithajibola@yahoo.com