People are attracted to the markets for all kinds of reasons. Some want to speculate on the latest hot sector in the hope of turning a quick buck.
If they get it right, they can generate a better return than parking their money in a bunch of stocks that will likely only generate the market return.
These short-term traders focus on price and momentum. Their aim is to latch on to a quick break upwards and get out before the stock price pulls back. Spending their time poring over company reports is not for them.
At the other end are private investors and managed funds who hold onto stocks for perhaps decades. They’re prepared to hold their shares through all the wobbles the markets throw up from time to time.
If they’re going to tie up their money for a long time, these long-term investors will want to be as sure as they can that they’re backing the right horse. That’s why they’ll spend a lot of time checking out a company’s financials; that is, how much debt the company is holding, and whether the company is generating enough cash to finance this debt.
Plus, there’s a whole range of other factors. Is the company generating cash? And if so, is it enough to reinvest in the company, as well as send some dividends to its shareholders?
Then there are the broader macro themes. Not only in the sector the company operates in, but the health of the economy as well.
Companies that are growing their earnings and dividends are what we’re on the lookout for at Total Income. However, while most of the above parameters are readily quantifiable, there is one aspect that isn’t. That is, how to gauge a company’s management. After all, it’s management that ultimately determines much of a company’s success.
Take an iron ore producer, for example. Even a poorly-managed one can generate good profits when the iron ore price is strong. But if it takes on too much debt and doesn’t manage its expenses, it could come undone when the cycle turns the other way.
Good management…or just ‘right time, right place’?
While a company might increase profits, it could have as much to do with the sector it operates in as it does the quality of its management. Sometimes the results of a management’s strategy might not come to light until well after the CEO has moved on.
Because of that, it can become subjective assessing management performance in the short term. However, the longer your time-frame, the clearer it becomes.
One of the more common ways management can destroy shareholder value is through dud acquisitions. Perhaps they’ve bought other companies at the top of the cycle and taken on a lot of debt to do so.
Think of Rio Tinto Ltd’s [ASX:RIO] disastrous US$38-billion buyout of Alcan in mid-2007 — just before the whole market came crashing down. Rio ended up writing off over US$30 billion of the purchase price over the next five years.
Big write-offs like this are always front-page news. However, there are other less dramatic ways management can erode the value of a business. One of these is untimely share buybacks.
When companies are doing well and the cash is rolling in, companies have to decide what to do with all that money. As just mentioned, one option is to expand the business by buying other companies.
After paying out its dividend, a company can use excess cash to retire debt or buy back its own shares. While shareholders are usually keen to get extra dividends, a share buyback can also add value if done at the right time.
And that’s a pretty big if. The problem is that excess profits and cash often come at the end of the cycle. That can often be the same time as when share prices begin to peak. If companies conduct share buybacks then, they will end up paying too much and eroding shareholders’ capital.
It’s a tough thing to get right. In theory, the best time for a company to do a buyback is when everything is cheap. That is, at the bottom of the cycle. With the uncertainty that comes with this period, however, a company will want to hold on to its cash instead.
While acquisitions and buybacks are sporadic events (if they happen at all), there is a simpler way to assess a company’s management: pull up a price chart and compare it to its peers.
Inevitably, the market rewards the companies that perform the best. That is, those companies that continue to grow sales and their cash pile over long periods. Moreover, companies that increase their dividends sustainably over the long term for income investors.
All the best,
Editor, Total Income