How active management can beat the stock market
Leading global stock markets haven’t risen very much over the last 22 years. Despite some peaks and...
When investors are researching funds, they often look at how the managers pick stocks in which to invest. What can be overlooked, however, is how the managers avoid any potential pitfalls or how they take the decision to sell. After all, while it’s exciting to see a stock price rise, it can be less enjoyable watching it fall!
We ask four Elite Rated managers for their biggest investment “red flags”, and why they’re important.
“One red flag can be if a company makes lots of acquisitions. It’s important to find out whether the company is integrating all of these into its overall business model, or whether the structure is just a bit of a mess and disjointed below the surface.
“It’s also important to keep an eye on technical indicators. Does the interest that the company paid over the course of the year, match the amount of debt on its balance sheet? Businesses can sometimes look as though they have not borrowed any money throughout the year, but have paid a very high level of interest. It could be because they borrowed a lot of money one day after its year-end, so that its annual report to shareholders looks deceptively good.
“We monitor our holdings for lots of technical indicators like this, all of which are potentially reasons for us to sell a share.”
“The most important reason for selling a stock, in our view, is because the business model is failing and goes into ‘disaster recovery’ mode. We deal with those quite infrequently but, as soon as we feel we have the evidence, we do sell. It’s about distinguishing the difference between structural flaws and short-term issues.
“We also have a keen focus on valuation. It’s not about how low or high a share price is on an absolute basis, it’s about identifying whether the risk-reward profile of one of our holdings has become less appealing over time. It’s about actively dealing with problems and knowing when to sell a stock.”
“When monitoring the portfolio we try to understand business evolution – it’s about whether company traits which, at time of purchase, were attractive, but are in the process of deteriorating. For instance, a company may not have ever been in debt when we bought it, but may start borrowing money at an exponential rate. Or, it could lose its market-leading position and have other companies nipping at its heels.
“The other aspect is analysing the stock and not just the business. We’re looking for investments at a bargain entry point; in other words, a stock that is temporarily depressed. If it’s a longer-lasting problem and the company’s efforts to solve the issue involves buying other companies, we would sell. We think that’s a temporary paper-over but it’s not the solution.”
“One of the first decisions I have to make as a fund manager is, if shares that I own start falling in value, do I buy more or do I sell out? One of the big red flags which will make me choose the latter is if they aren’t able to protect their investors during the tough times.
“For example, we decided to sell out of defence and security engineer Leonardo last year. We made this decision because, following a profit warning and a subsequent meeting with the manager, we realised its cash flow generation was poor, and the team had a poor explanation as to why that was. It wasn’t clear how it would improve in the near term.
“Cash generation is what really matters to investors. It’s what keeps a company’s debt levels down, improves its balance sheet and, ultimately, drives the stock’s return in your portfolio. If there is a question mark around cash generation and whether profits are coming through, then that is a clear red flag.”