Dr Ajibola Awolowo
If you are reading this, there is a good chance that the first part of this article left a good impression with you. If, however, you have not read the first part, I would strongly encourage you do just that as we will be building on the foundation laid there.
We discussed the first four hurdles companies must get past in their quest to end up in my portfolio. That part of my analysis is quick, easy and straightforward. Only companies that have scaled all these hurdles go on to the next stage of my analysis. To briefly recap, these hurdles are:
- The company must come into my consciousness.
- The company must consistently be making profit or there must be a cogent and temporary reason why they have failed to do this.
- The company must have a high gross margin.
- The company must also have a high net margin.
After this point is where the hard work begins. The next thing I do is to create an Excel spreadsheet where I summarise the company’s result over the last 5 years at a minimum. To get the data, I either download the annual reports for the last 5 years from the company’s website or look at the last few pages of the latest annual report where a 5-year summary can usually be found.
The key figures I concentrate on from the income statement are the revenues, costs, gross profit, net profit and the gross/ net margins. For the balance sheet, I focus on the total assets, total liability and equity while on the cash flow statement, my focus is on the net cash generated from operations and capital expenditure.
The reason it is important to look at all these numbers over a 5-year period is to see their trend over time. The ideal company should have revenues, gross profit, net profits, total assets, equity and net cash generated from operations rise smoothly from year to year while costs, total liabilities should be falling. Unfortunately, the ideal company does not exist so we would have to make some concessions along the way.
I am keenly interested in not just if these figures are rising over time but how fast they are growing. The higher the rate of growth, the better that company is. A company that has grown its revenues, profit, equity at a cumulative annual growth rate of 15% is better than another that has only grown at 10%. This is the 5th hurdle – High cumulative annual growth rate in revenues, gross/ net profits, assets and equity.
For the 6th hurdle, I look at some key ratios which tell me how efficient and profitable this company is. Ratios such as Return on Equity and return on assets tell me how much profit a company is making from its equity or shareholders fund and its assets respectively. As a rule, I do not buy companies with a Return on equity less than 15% and return on asset less than 3%. When I look at the trend of these ratios over the last 5 years, I do not want to see them decreasing. They should be increasing or at the least, maintained. If they decrease in one year, there should be a logical explanation for this such as what happened during the corona virus pandemic. This is the 7th hurdle – Rising or stable ROE and ROA over the last 5 years.
The 5th, 6th and 7th hurdle are very important because they tell me if a company has a durable, long lasting competitive advantage. In capitalism, long term profits at high margins are unsustainable. Capital tends to flow from areas of low profit to those with a promise of high profits; this is the hallmark of competition. Look around you, if a successful business opens near you, it is only a matter of time before another one offering similar products opens close by as well.
For a company to generate/ maintain high profit margins and returns on equity/ assets over time, they must possess some characteristics that protect them from competition. This is what is called a moat. The stronger the moat, the more wonderful that company is. My aim is to buy only the companies with the biggest and strongest moat as it almost assures long term profitability.
The 8th hurdle looks at how much debt the company has. The lower its debt, the better that company is. Debt is a double-edged sword. It can be a quick fix to solve problems but it also makes the company vulnerable to certain macroeconomic factors such as interest rates hikes. Over the last five years, what is the trend in the company’s borrowings (long term and short term) and the debt/equity ratio? In business and in life, debt is unavoidable but too much of it is one of the fastest routes to ruin.
I must say that any company that has made it past the first 8 hurdles must be doing something special. If they have made it this far, they must be in the top 5% of the exchange and would probably be the best or second best in their industry. The 9th hurdle I consider is how much I understand the business. How does this company make its money? It sounds basic but you will be amazed at how many people buy companies they cannot, in 1 or 2 sentences, explain how they make money. In what industry does this company operate? What are the factors that lead to downfall of companies in this industry? How does this company generate its revenues?
It’s easy to see that some companies are easier to understand than others. If we consider a company like Flour Mills of Nigeria PLC, you will need to understand the sugar, flour, pasta, vegetable/ cooking oil markets to begin to grasp their numbers. You would also need to look at the books of their subsidiary companies like Honeywell Flour and Northern Nigeria Flour mills which makes understanding them a little more complex. You cannot compare this with trying to understand a listed Real Estate Investment Trust (REIT), for instance, where all you need to grasp is the demographics and real estate market of a particular region/ country.
We should, however, bear in mind that hard to understand companies have fewer eyes looking at them which translates to a higher chance of finding a price/ value mismatch. This higher prospect of making a profit should be weighed against the amount of work needed to understand the company and the potential downside risk if one misses an important variable hidden in all the complexity.
The penultimate hurdle I make companies jump over is on the quality of its management. Managers are employees of the company, and by extension – the shareholders, who have the task of running the daily affairs of the company. They must understand the business, have excellent interpersonal skills and have a knack for getting the job done. They should be people with foresight who can see the big picture and improve the long term prospects of the company rather than focus on the short term.
I want my managers to not just have leadership skill but to also have integrity. They should be trustworthy and have an impeccable character. They should be men of their words who are not afraid to show their human side by admitting their mistakes and not sweep them under the carpet.
I assess this by reading through the annual reports over the last 5 years, listening to the interviews granted by management and previous investor/analyst calls. In the annual report, I pay particular emphasis on the Directors report, letter from the Chief Executive Officer and the salary structure of management.
Do they use elusive words or are they factual? Do they speak freely about the headwinds the company faces? What do former and present employees say about management? What promises did management make in the last 2 to 5 years? Have they fulfilled those promises? Did they explain why they could not meet up or just assume we have forgotten? Does management own shares in the company? The greater the stake they have, the better it is. As Warren Buffett says, you cannot make a good deal with a bad person. You cannot have a good company with a persistently selfish and unskilled management team.
This brings us to the 11th and final hurdle that companies must scale before they trigger a buy rating into my portfolio – Valuation. We will talk about this in the third and concluding part of this series of articles.
Dr Ajibola Awolowo can be reached via valuenigeriawithajibola@yahoo.com