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There are plenty of approaches to investing. And even more opportunities to invest in. Most investment funds won’t be able to avoid big scandals such as the Steinhoff one because they are forced to invest in certain shares because of the way indexing works. And because of Steinhoff’s size, funds had to invest in the company, or risk underperforming the JSE if Steinhoff continued to rise.
But you, as an individual investor
aren’t hampered by the size of companies. You can invest in anything to beat the index.
And, if you use an investment style that’s more scientific, rather than closer to guessing or gambling, you can be much more certain of the safety of your money – and the chance for big growth!
The investment style I’m talking about has served me well over the years, leading my Red Hot Penny Shares readers to 7 years of uninterrupted positive returns, making a total return of 380%, compared to the JSE’s 126% for the same period.
So what is value investing anyway?
In short – value investing
means buying shares that are selling at prices lower than they are worth.
These shares typically have a ‘margin of safety’ built in. That means, if the market should crash or bad news come out, the shares are already so cheap your losses will be limited.
This is opposed to pure growth shares, which are often so expensive that even when profits grow the share price drops, because profits didn’t grow ‘more than expected’.
The financial info value investors look at is also much more likely to flag fraudulent companies, or at least raise warning bells!
What value investors look out for
Some of the biggest single things value investors look out for before investing in a company is high debt levels, and profits that aren’t backed up by cashflow.
But here are a few concrete items you can check on your list before investing in a share:
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Warning Bell #1 – Big profits, low cashflows
I like to simply use the Cashflow: Attributable profit ratio.
This ratio is:
CASH GENERATED BY OPERATIONS / (RETAINED INCOME + DIVIDENDS – EXTRAORDINARY PROFIT) * (12/NUMBER OF MONTHS)
This ratio tells you if the profits that a company made – are backed by ACTUAL cash coming into its bank account, or if it is simply PAPER transactions that don’t add real value for shareholders.
If this ratio is above 1, the company’s profits are of high quality. If it is below 1, they are of lesser quality. Many data providers give you the values of this ratio for shares, so you don’t have to calculate it yourself.
In Steinhoff’s case, the ratio was 0.68 in June 2016 and only 0.04 in March 2017. That means that a very small proportion of its profits were backed up by actual money coming in from businesses, and the majority was based on intangible paper profit…
Warning Bell #2 – Big, and growing debt burdens
Value investors don’t like debt. While I invest in companies with debt, I prefer it when their debt is shrinking. Not constantly growing.
You can use the Debt: Equity ratio here. The ratio compares the debt of a company to the value of its shares to shareholders.
The higher the ratio becomes, the more debt a company has.
In Steinhoff’s case, the ratio increased from 0.54 in December 2015, to 0.67 in September 2016, and 0.76 in March 2017. During the same time, Steinhoff actually more than doubled its debt load from 5 billion Euro to a whopping 12.15 billion Euro.
In a company that’s profitable, this is a warning bell to investors. If there are big profits, why does the company continually need to raise debt to run the business?
Warning Bell #3 – Growing stock levels, growing debtors, growing revenue
If a company keeps growing revenue like clockwork it might be good. But it might also be cheating.
Now look at inventory, is inventory also consistently growing?
Well, now look at its Debtors.
If they are also consistently growing the company might be using the guise of ‘sales on credit’ to inflate its revenue. The growth in inventory is a sign that its not managing to really grow organic sales, so it tries to lower inventory and increase revenue by selling on credit.
I’ve seen cases where a company delivers inventory to a client – and books this as sales to its revenue. But the client has the right to return any unsold inventory to the company. That would then lead to a reversal of the revenue.
Again, looking at the Steinhoff example, over the last year and a half the company grew debtors by 52%, a whopping 628 million euros.
What’s important to note here is the amount debtors grew by is nearly equal to the company’s entire profit.
Would you invest in a business that makes a Eur700 million profit, but increased debtors by Eur628 million? Clearly that tells you the majority of profits are actually debtors that haven’t paid the business (and perhaps even never will as in Steinhoff’s case).
The fact is, sometimes we invest even with these warnings present – because the herd is doing so. In Steinhoff’s case everyone was storming into the share and everything looked great… Until it didn’t.
So, when you invest… Do your homework. Invest in value. And watch out if there are warning signs!
Here’s to unleashing real value