Quality firms often reveal themselves with tempting financial indicators. But if the metrics are too good, they can act as a contra-indicator that might contribute to delivering a poor performance in my portfolio.
Margins
One way of spotting a company with a strong trading niche is to look for healthy net profit margins. A healthy margin suggests that the firm’s business doesn’t suffer too much competition from other players, which could drive profits down.
However, it pays to become suspicious if margins are too good. Perhaps a fashion retailing company finds its stuff in vogue and demand is high. Riding such a wave of popularity could make it easy for the firm to squeeze out a juicy margin. But very high margins have a nasty habit of reverting to an average margin. In the case of our fashion retailer, once-fashionable items could become less popular and selling prices might need to fall to encourage sales. Paying too much for shares when margins are unsustainably high means my investment could plummet as margins contract and profits fall.
It’s better to find businesses with lower, but still healthy, profit margins. Sustainability is key, so a record of steady earnings is important. If the profits are smaller in the first place, the potential for nasty surprises is less. However, it’s best not to go to the other extreme either, where profit margins are either wafer thin or non-existent.
Growth
I’m often tempted to look for higher-than-average rates of growth in earnings in the hope that such robust expansion may indicate the existence of a superior business, and it might. The challenge is that I’m usually not the first to notice such stunning growth rates and the shares sit on high trailing price-to-earnings (P/E) multiples. If growth continues at the same rate, my investment might work out well, but if it doesn’t, those shares could fall a long way.
One way of dealing with the over-valuation problem is to search for opportunities amongst firms with lower rates of growth than some of the extreme good performers. Sometimes firms growing their earnings in high single digits can reward me better than firms delivering double-digit annual gains in earnings. With lower rates of growth, companies often sell for valuations that are more reasonable and there’s always the chance that any improvement in earnings can cause an upward rerating to a higher P/E rating.
Value
It’s good to look for decent businesses selling at temporarily depressed valuations as measured by indicators such as the price-to-earnings ratio, dividend yield and price-to-book value. However, if the value indicators are too good it’s likely that I’m looking at a clunky business that deserves its low rating.
The trouble with businesses that are selling too cheaply is that I need a complete reversal of the company’s fortunes, a turnaround, to ‘out’ any value. That way of investing is a risky strategy, more likely to end in investing losses than gains.
It’s better to look for value indicators registering less extreme low values. One way of proceeding is to search for good quality companies with a track record of growth and a temporary setback that’s depressing the share price. The metrics will probably not indicate extreme value, but could indicate an opportunity to buy a decent firm at a reasonable price — one that makes good investment sense.