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What does an equity analyst look for in a company?

A closer look at how our Equity Analyst Nicholas Hyett looks at shares and the 3 things he likes in a company.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.


All information is correct as at 30 September 2021 unless otherwise stated.


Since my day job is looking at individual companies, it's perhaps unsurprising that I hold individual shares.

Over the years I've developed a personal investing style – learning from costly mistakes as much as successes. I've shared the details of that approach below. It's generally worked for me, which of course is not to say that it will work for anyone else. After all, there's no 'right way' to invest.

Shares as part of a portfolio

Individual shares make up something like 10% of my investments, spread across a fair number of companies. Investing in individual companies is a risky business and few investors have the financial resources or the time to build and manage a well-diversified portfolio of companies.

Instead shares can help you tilt a portfolio of active or passive funds towards investment themes or companies you think are particularly promising.

Investing in individual companies isn't for everyone though – if a company fails, you risk losing your whole investment. You should make sure you understand the companies you're investing in and their specific risks. Investments and any income they produce will rise and fall in value, so you could get back less than you invest.

This article isn't personal advice. If you're not sure if a particular investment is right for you, seek advice.

What do I want in a company?

Dividends

In an era of tech giants, a focus on dividends sounds old fashioned. However, there are several reasons why I prefer businesses that make regular returns to shareholders.

In order to pay dividends, a company must be making a profit. Profitable businesses don't rely on external funding to keep themselves going or invest in future growth. It also implies a company is generating genuine free cash flow, particularly if the dividend has been maintained or grown for some years. Profits come in many forms, but dividends are usually paid in cash.

I tend to think dividends say something positive about management teams too. A board that's prepared to pay profits back to shareholders has at least half an eye on investors' wellbeing rather than corporate empire building.

These traits are particularly important in smaller companies. Small companies are inherently higher risk, often don't generate a profit and can end up collapsing. However, those that generate profits and enough cash to pay a dividend are often at the higher quality end of the spectrum.

The graph below shows the relative performance of companies in the AIM 100 index ten years ago – comparing those that paid dividends and those that didn't. The results speak for themselves – though remember past performance isn't a guide to the future.

Chart showing AIM share returns comparison

Scroll across to see the full chart.

Past performance isn't a guide to future returns. Source: Lipper IM, 30/09/21.

Debt

There's a school of thought that says debt is always bad for a company's balance sheet. I disagree. Debt in moderation has the potential to boost results and fund expansion that would otherwise require the issue of new shares.

Take the hypothetical example of a property company below. With no mortgage, the company's properties generate a 5% rental yield. If the group can fund some of its portfolio with debt at a lower interest rate than the rental yield on the property, they'll benefit. Not only does it need less capital to buy the properties in the first place, but its annual shareholder return is also higher.

Scroll across to see the full table.

0% Mortgage 20% Mortgage
Property Portfolio value £100m £100m
Mortgage (at 2.5%) £0m £20m
Equity invested £100m £80m
Rent £5m £5m
Annual interest £0m £0.5m
Income after interest £5m £4.5m
Annual shareholder return after interest 5.0% 5.6%

Sometimes called financial leverage, debt used like this has the potential to improve results. The important thing is companies invest in projects with a higher rate of return than the interest rate. Remember this is just an example. What you actually receive will depend on your individual holdings and there are no guarantees.

Of course, debt needs to be kept within sensible limits. Unfortunately, there's no iron rule for what classes as sensible – it depends on the exact details of the particular business. Most businesses with a net debt to cash profits (EBITDA) of less than one, are probably exercising a sensible degree of caution.

Valuation

In some ways this is the most important question of all. There's a price at which even the worst business is a bargain, and another where the best business is too expensive.

I certainly wouldn't consider myself a bottom fisher – seeking out the cheapest businesses at the cheapest price. Instead I'm looking for a good business at a good price.

Valuation is important because it plays a huge role in your likely future returns. The graph below shows this. When FTSE 100 PE ratios have been low, future returns have been high, and vice versa. Like all ratios and measures, it shouldn't be looked at in isolation.

FTSE 100 PE ratios and subsequent ten-year returns

Scroll across to see the full chart.

Past performance isn't a guide to future returns. Source: Refinitiv, 30/06/1993 to 30/09/21.

How do you establish whether a company's good value? Again, hard and fast rules are hard to come by, but a good place to start is when the price to earnings (PE) ratio is below its ten-year average. We publish ten-year averages for the companies we cover in our share research.

Of course, even when shares are trading on low valuations, there's no guarantee they'll deliver a good return. One thing I cannot stress enough, is opportunities to buy good businesses on low valuations are few and far between. That makes me an infrequent trader. I rarely place more than a handful of trades in a given year – high frequency day trading this is not.

Looking to the future

I can already hear the criticisms that my approach is outdated.

'Share buybacks are the new dividends'.

'Debt is cheap, it's time to borrow as much as possible'.

'Tech companies can look terrible based on old valuation techniques but some have generated good returns'.

There are reasonable arguments behind each of those points. Mine is not the only way to invest, and will tend to miss out on the riskiest but most spectacular individual shares. However, I've tended to find it delivers results, with fewer major losses.

That's enough for me.

READ MORE

Explore our Investment Times autumn 2021 edition for more articles like this.

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    Net debt to EBITDA – measure of indebtedness.

    Net debt/EBITDA = net debt to EBITDA.

    Price to earnings (PE) ratio – a key measure of valuation.

    Share price/earnings per share = PE ratio.

    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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