What I’ve learnt as an equity research assistant

Deciding which companies to invest your money in can be challenging.

While taking a long-term view helps narrow the search, it doesn’t help answer why some companies have a better chance of standing the test of time, and why others continue to underperform.

My time in the share research team, as part of my graduate trainee programme, has helped me answer these questions. Here’s what I’ve learnt.

This article is not personal advice. If you’re not sure about an investment decision, you should seek advice. Ratios and figures shouldn’t be looked at in isolation.

Don’t compare apples with oranges

Comparison is key when it comes to analysing stocks. When deciding on any investment, it’s worth recognising who’s the competition, and how it’s performing.

Comparing industries

No two businesses are the exact same. If they were, microeconomic theory would tell us the market’s perfectly competitive, and neither company would make investment-worthy profits.

That’s why businesses try to differentiate to gain a competitive advantage. This could mean offering a unique customer experience, or a niche product not sold by others. Some companies have such large set-up costs, the barriers to entry are too high for others to compete, giving them strong pricing power (more on this later).

Having knowledge on different sectors and industries is useful. While it makes sense to compare supermarket to supermarket, it might not make sense to compare supermarkets to wholesale food producers – their business models are completely different, despite both selling food.

Size matters as well. A multi-national company with billions in revenue might not have much in common with a smaller name serving one market.

Underlying figures

Once you’ve considered if companies are operationally similar, it’s worth turning to the numbers. Companies will often report two different figures, underlying (or adjusted) and reported.

Underlying often provides a clearer picture of the company’s operations on a continuous basis. These figures exclude one-off items like exceptional charges or short-lived investment spend programmes. These one-off items will be included in the reported figure.

To avoid a distorted view of the company, it’s often best to compare underlying figures. Caution needs to be taken here, though. If a company continues to exclude recurring items in the underlying figure, it can distort how operationally strong it is. It’s always worth looking at previous years for a sense check.

Separating the good from the bad and ugly

Companies that perform well over time often follow a set of similar characteristics. These characteristics aren’t proven at any one point in time, but shown over many years. That’s why historical reports are useful.

Besides the quantitative measures we look at below, qualitative measures like strategy, quality of management and corporate responsibility should also be considered. These measures can also funnel into more consistent results over time.

Strong operating margin

Operating (profit) margin is a great indicator of a company’s health. It tells us how efficiently a company’s able to generate a profit though its operations.

Operating margin = Operating Profit (EBIT) / Revenue

Both operating profit and revenue can be found on the income statement.

A high operating margin, relative to its peers, is a positive sign. It indicates a higher quality of earnings as the company’s able to generate more sales relative to its cost base. That said, it’s best to use it over time.

A company with an increasing operating margin indicates a continued improvement in sales relative to costs, freeing up profits to invest in growth – no mean feat in today’s environment. A strong and stable operating margin over time suggests a company could weather any potential storms ahead.

But the question now turns to how a company can do this. One method is through pricing power.

Pricing power

Pricing power is essential to supporting profit, especially during a high inflationary environment like today.

Companies have pricing power when its position in the market is strong enough to be able to pass higher prices onto consumers without affecting sales. This becomes more important during periods of high cost inflation, as without subsequent price increases, operating profit can lag.

Take consumer staples or healthcare as an example. Demand is unlikely to drop off a cliff even as incomes get squeezed. So, the ability for these companies to raise prices without impacting sales will help reduce the effect of higher costs. This should help stabilise operating margins.

Recurring revenue

Investors generally prefer consistency. That’s where recurring revenue comes in. A company able to generate a large portion of its money from recurring revenue (revenue expected to continue in the future) will be more sheltered from external shocks.

Noteworthy recurring revenues come mostly from business to business (B2B) sales like the Software as a Service (SaaS) sector. But there are examples of business to consumer sales (B2C), like streaming platforms or utilities industries.

Lots of businesses might rely on a product or service provided by a company to keep operations running smoothly, making them more likely to continue paying even during tough times. This is what makes B2B revenues stand out. On top of that, a high-quality product or service should pay for itself in marketing, reducing the need for large client acquisition spends and large marketing budgets.

Business to consumer (B2C) recurring revenues are slightly different. While B2B sales are likely to remain strong, some consumers in the B2C market might slash spending on subscriptions, like streaming platforms have recently come to find. Utilities are, of course, an outlier here.

Either way, recurring revenues will provide more clarity on future earnings, allowing a company to plan accordingly during tough times.

Manageable debt

Having excessive debt in a high interest rate environment can be detrimental to long-term growth.

When interest rates rise, the cost to service that debt rises too. If a company finds itself using all its cash profits to service debt, it could miss opportunities to invest in growth, stunting long-term prospects.

Not all debt is bad, though.

Debt can be used to a company’s advantage, through what’s known as financial leverage. Taking on debt to fuel expansion and achieving a higher rate of return than the cost of debt will grow the business.

That said, there are risks. There’s no guarantee the investment will return a higher rate, so caution needs to be taken when looking at what a company does with debt and whether the company can afford to pay the debt back.

Of course, in times like today, minimal to no debt is preferable. There's no hard and fast rule for what counts as sensible debt – it depends on the exact details of the business. A litmus test would be net debt to cash profits (EBITDA). If this figure is less than one, the company’s probably exercising a sensible degree of caution.

Bringing this together – valuation

Choosing and comparing companies with characteristics that are known to stand the test of time is a good place to start for success over the long term.

But there’s another big factor to consider before any decisions are made, and that’s valuation. While price is what you pay, valuation is what you receive.

One of the most spoken about measures of valuation is the price to earnings (PE) ratio. A high PE ratio, relative to its peers and long-term average, means the company is highly valued. This is usually a telling sign investors expect growth ahead of the competition. At this point, investors need to decide if they agree or disagree with these expectations.

On the flip side, loss-making companies have less meaningful price to earnings ratios due to negative profits. But some of the world’s most valuable companies reported considerable losses for several years, showing the limitations of PE ratios. For any investment to be warranted, the company must show a clear path to profitability in this case.

But a company displaying positive characteristics and trading at a modest price to earnings ratio compared to its peers, could present an opportunity.

Remember as with any investment, there are no guarantees and the focus should generally be on the longer-term. Past performance isn’t a guide to future returns.

Investing in individual companies isn't right for everyone. That's because it's higher risk, your investment depends on the fate of that company. If that company fails, you risk losing your whole investment. If you cannot afford to lose your investment, investing in a single company might not be right for you. You should make sure you understand the companies you're investing in and their specific risks. You should also make sure any shares you own are part of a diversified portfolio.

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