- Investment strategies
- Why invest in the stock market?
- Buy and hold or technical analysis? Why you need an investment plan
- Value investing and short selling in volatile markets
- Using technical analysis to support value investing
- Investing in the unexpected
- Franking credits, explained
- What is dividend stripping and is it a sensible strategy?
- Investing in quality IPOs
- How to invest in stocks that benefit from a moving Australian dollar
- Reasons to avoid bonds when interest rates are low
- How value investors use Skaffold
- Quality, growth and value = a winning strategy
- Know your investor type and boost your performance
- Technical + fundamental analysis = better buy and sell decisions
- Fundamental investing
- Value investing and the price earnings ratio
- Intrinsic valuation models and methodology
- Value investments or value traps?
- How to find value stocks in a bull market
- Find value investments in expanding markets
- Why capital raisings struggle to add investment value
- How to value an insurance company
- Top stocks
- 5 qualities of top stocks
- How to find stocks with a competitive advantage
- Why return on equity is the best measure of business performance
- Using cash flow to find value investments
- Finding high quality dividend stocks
- Debt is not always a dirty word
- Why Skaffold share investment software makes sense
- Using economic factors to uncover the best investment options
- How do experts find top stocks to invest in?
- Investing in global stocks
- How to invest in international shares on global stock markets
- Benefits of investing in international shares
5 qualities of top stocks
Top stocks have 5 things in common: great management, strong return on equity, low debt, rising earnings and rising intrinsic value.
All great quality companies’ display similar distinguishing characteristics, and as a value investor you need to know what they are to ensure you look beyond short-term hype to more meaningful measures when deciding which stocks to buy.
According to Benjamin Graham, the founding father of value investing, the key to unearthing top stocks is being able to identify what separates them from their lower quality counterparts.
Stocks that stack up well against key criteria, argues Graham, are more likely to withstand financial storms, and because of this are more worthy of a place in your portfolio.
To help you rate the underlying quality of individual companies, Skaffold stock research software has automated the principles of value investing. The filters embedded within Skaffold help to highlight five essential characteristics you should always look for in a stock.
Companies that have these characteristics (also known as key indicators or performance ratios) are more likely to deliver a sustainable competitive advantage – so let’s take a look at them more closely.
1. Company management
Quality companies have good management with a proven track-record in delivering strong and sustainable earnings, cash flow and profitability from a competitive business model within a market offering potential for long-term growth. These companies also have a sound balance sheet and a strong corporate governance structure.
Media coverage, interviews, articles and company announcements, (especially during reporting season) should indicate how well a company has been managed. Similarly, the “Skaffold Score” Evaluate screen provides a snapshot of a company’s overall wellbeing. The proof of the pudding is in how well a company stacks up when evaluated against the following performance ratios:
2. Return on equity (ROE)
A key measure of the return a company makes on the equity in the business, return on equity represents earnings (revenue minus expenses, taxes and depreciation) divided by average equity. Skaffold prefers companies with ROE greater than 15 per cent, preferably more for an extra margin of safety. But it’s important to know how much the balance sheet needed to be geared to deliver those earnings and whether this impacts on the company’s ability to reinvest at the same ROE going forward. The following ratio explains why.
3. Net Debt to Equity
This measure lets you know what proportion of equity and debt a company is using to finance its assets, and is calculated by dividing its total liabilities by stockholders' equity. A company that has more cash on hand than debt is much more likely to weather any financial storms. Skaffold prefers companies with a Net Debt/Equity ratio of 40 per cent or less.
4. Earnings Per Share (EPS) growth
EPS reflects the portion of a company's profit allocated to each outstanding share of common stock, and (EPS) growth projections are a quick way to gauge a company’s future prospects and profitability. Where available, Skaffold provides three years of analyst forecasts, and while they are always estimates, they typically provide good insight into what the company’s future may look like. But it’s equally important to overlay EPS growth projections with regular market updates (including sector or regulatory changes, and competitor activities), plus ongoing company disclosures for a better understanding of a company’s future prospects.
Everything being equal, EPS increases are typically mirrored by a share price increase, and the more a company grows its EPS, the greater the opportunity for its earnings to be revalued upwards. The “Forecast Change in intrinsic value” and “Forecast EPS Growth” available in Skaffold's filter make it easy to identify businesses with the most value growth upside.
5. Intrinsic Value
Benjamin Graham claims that companies capable of growing their intrinsic value – the sum total of the business’s worth based on earnings, dividends, equity and debt – are more likely to provide increasing capital gains to your portfolio as well. Given that a company’s share price cannot overtake its underlying performance forever, intrinsic value becomes a vital metric when it comes to deciding which stocks to buy.
Skaffold’s estimate of intrinsic value and the Safety Margin calculated for each stock can help you make this decision. Remember, while price is important, it always takes second place to quality. Buying a lower quality business with less upside for future growth at a cheaper price is less likely to grow the value of your portfolio in the long run than good underlying businesses trading at a significant discount to full value.