How we pick our Five Shares to Watch

Each year picking ‘Five Shares to Watch’ gets harder. The outcome of Brexit has been a recurring concern. But we’ve also had elections, the shift to a digital economy and underperformance of traditional value stocks to think about too.

However, 2020 has really driven home the key message of our Five Shares to Watch process. Twelve months ago, not many of us would’ve believed a pandemic would see large parts of the global economy grind to a halt for most of the year.

We think the only way to deal with those unexpected challenges is to invest in a diverse range of financially strong businesses. While there might be bumps along the way, this gives your investments the best chance to grow over the long term.

Remember though, investments can fall as well as rise in value, so you could get back less than you invest.

The five shares to watch process

The process of picking the Five Shares to Watch starts in early October. As a team we sit down and discuss the sectors, styles and geographies we think look promising for the coming year.

We might pay particular attention to growth companies one year, value stocks the next, businesses with exposure to emerging markets or natural resources companies. Every year will have a mixture of companies on the list, but this initial conversation sets the general direction.

Before the end of October, each member of the team pitches six or so companies they think should be included in the list. Each company is reviewed in detail by another member of the team, before a final decision is made towards the end of November.

By the end of November the five shares have been finalised.

What do we look for in a company?

Over the years we’ve developed a bit of a checklist for companies to make the list. None of these are hard rules, and we can make exceptions, but we think they’re traits that have generally helped deliver better results.

1. Profits

This might sound obvious, but we’ve always focussed on profitable businesses for the Five Shares to Watch. A surprising number of technology businesses are loss making. While they might have great growth potential, they’re also much higher risk.

One of the major problems with unprofitable businesses is they’re reliant on the goodwill of lenders and shareholders for funding. If investors turn cold, they can face a real struggle to survive. We prefer businesses who have more control over their own future.

2. Cash

Regular readers might think we’re a bit of a stuck record reading this, but we also focus on companies that generate cash. While accounting shenanigans can sometimes make a company look more profitable than it really is, cash is far harder to fake. It’s either in the bank or it’s not.

We like companies that generate a reasonable amount of free cash flow every year. This money can be used to fund growth and pay dividends.

3. A healthy balance sheet

What makes a balance sheet healthy is debatable. Some companies run without any debt at all. For others, particularly in industries like utilities, property companies, miners and oil & gas groups, debt is a fundamental part of the business.

What’s important is that any debt is easily serviceable by the profits the company generates – another reason to steer clear of businesses that can’t reliably deliver any profits in the first place.

When net debt goes above 2.5 times EBITDA, we need plenty of reassurance that profits are as reliable as they can be. Remember ratios shouldn’t be looked at on their own and aren’t a guide to the future.

Net debt – the amount a business owes, minus the available cash it has.

EBITDA – a rough and ready measure of the cash a business generates. Also known as earnings before interest, tax, depreciation and amortization.

For more cyclical businesses, where profits rise and fall with the wider economy, that threshold can be much lower.

4. Valuation

Valuation is arguably the really crucial factor when it comes to investing in individual companies.

If the price is low enough, it might seem like something is worth buying. However, we don’t tend to support rummaging around in the bargain basement when it comes to picking companies. It’s too high-risk. We also believe that there’s a price at which even the best company in the world is too expensive and not worth buying.

That makes valuation a delicate balancing act.

When it comes to assessing valuation, we use a variety of measures depending on what best fits the stock. They range from price to earnings ratios, to more complex metrics like price to earnings growth (PEG), price to book and free cash flow yields. However, in all cases we’re comparing businesses to their long running average value to what rivals are valued at.

As part of our analysis we have to take a view on a business’s long-term growth prospects.

Companies that are growing fast deserve a higher valuation. But sometimes those valuations are so far off the longer-term average, the company would have to deliver a truly transformational result to justify the new price.

Lots of those transformational stories fall short. And even when they don’t, most of the benefit is already in the price. That leaves new investors taking on a lot of risk without the same potential for returns.

This year’s five shares

The ongoing global pandemic, along with damage to the economy and looming Brexit decisions have all made this a tough year to be picking shares. However, there’s always something happening. If it wasn’t those issues it would be something else.

Once again we’ve focussed on picking what we think are good, profitable companies at reasonable valuations. In the long run we think that’s what serves clients best.

Investing in individual companies isn’t right for everyone. Our five shares to watch are for people who understand the increased risks of investing in individual shares. If the company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

This article isn’t personal advice. If you’re not sure if an investment is right for you, please seek advice.

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