Whether you are investing for your children, your grandchildren, or for your own nest egg, there is a place in any equity investors’ portfolio for a reliable, steady compounder. A bottom drawer stock might not double tomorrow, but it should provide solid returns over a long-time horizon – with lower downside risk. In this article we outline 5 signs to look for when picking a stock for the bottom drawer.
You’re probably thinking this one is pretty obvious. And it is, on face value – but underneath there are several key factors to look for when working out if a business will be able to grow sustainably through economic cycles. The first thing to check is the industry in which the business operates – will it be around in 10, 20 years’ time? Stocks in industries going through periods of significant disruption, such as traditional media, telecommunications, or unsustainable industries which will inevitably die out such as coal mining rarely belong in the bottom drawer. On the other hand, industries with long-term macroeconomic-driven demand tailwinds and monopoly-like industry structures are ideal places to look for contenders. The business itself needs a sustainable and increasing competitive advantage (like scale, unique IP, brand strength or reputation) and the ability to fund its growth internally through strong free cash flow generation.
We hear a lot about quality of earnings, and what that means. The way we tend to think about it is simply – how certain or risky are the earnings of the business? We want to find businesses with higher earnings certainty in order to avoid large surprises to the downside, and the subsequent capital destruction that can happen in just one day. Traits such as diversity of product and customers, defensive or population driven demand, recurring or annuity-style revenue, and long lead times between order and sale are ideal. Quality can also mean clear disclosure of earnings and conservatism in presenting the accounts.
A great example of a company satisfying both growth and quality is Vista Group International (ASX: VGL), a NZ based cinema software company that has a large global market share, recurring revenue, very sticky customers and a further growth engine being the Movio (analytics) business. Movio has no major competitors and offers a compelling return on investment for customers. Not to mention that the number of cinemas globally is growing at high single digits, representing a growing market over time.
It is rare to buy a company with the above traits for a steal, however it is important not to succumb to overpaying, because in the long run your returns are defined by your entry point. A stock with a very high valuation multiple can indicate very high expectations for earnings which can mean a greater risk of disappointment at a later date. Therefore, a good bottom drawer stock is one that has a reasonable valuation, not a ridiculous one. There are certainly cases where companies in their early days or pre-earnings can be priced extremely expensively and then deliver outstanding returns – however this comes at too high a risk to be a bottom drawer stock. Also, another consideration as part of the valuation assessment is whether the company has a valuation floor if things took a turn. This could be the value of its tangible assets on the balance sheet (less net debt), or strategic value of its assets, for example, infrastructure or monopoly assets. Event Hospitality and Entertainment (ASX: EVT) is an example of a stock with a valuation floor being its NTA in the form of property assets. With a current market cap equivalent to the fair value of its property, in our view there is limited downside risk.
While a good compounder may transcend its original management team, there is no business that is immune to poor management. To invest your money into a company over the long-term requires trust in that company’s board and management team. One sign that management are there for the long-term and for the interests of shareholders is if they are large shareholders themselves. Aligned managers will also want to build their bench strength so there are multiple, highly skilled company leaders waiting to succeed their predecessor when the time comes.
Bapcor (ASX: BAP), an automotive aftermarket parts provider in Australia and New Zealand, is a good example of where management have shown a long-term commitment to the company through disclosing the 3-year contract extension of CEO/MD as well as alignment through a meaningful shareholding. There are several skilled managers already in place across the business and the recent appointments of key roles at the C-suite and EGM level further ensure the company is in good hands for some time into the future.
The way management communicate to the market is also important to consider. Be careful of companies that have historically overpromised and underdelivered or have aggressive accounting practices as this can be a red flag for a potential future downgrade.
It is not to say that a buy and hold strategy is the right one – nor does it mean that you should “set and forget”. Every investor needs to understand the current dynamics of the business they’ve invested in, and if the situation changes such that the original thesis doesn’t stack up, it could be time to sell the stock. A good long-term holding will consistently follow its strategy and should achieve its targets and guidance over time.
Bapcor (ASX: BAP) also delivers with regard to consistency, the management team have been clear in their messaging to the market through detailed disclosure and sensibly setting earnings expectations. So far since its IPO in 2014, the company has been able to consistently deliver results within their guided earnings range.
Potential red flags may be a management team venturing into non-core operations, or buying assets in different jurisdictions, or even spending capital on lower returning projects.
There is more art than science to picking a stock for the bottom drawer, and it is extremely difficult to find a company that satisfies every point. Admittedly, as with all investing, there is a bit of luck involved. But knowing the signs that support and hinder a stocks ability to stay in that bottom drawer is crucial to long term value creation.
Important Information: This material has been prepared by NAOS Asset Management Limited (ABN 23 107 624 126, AFSL 273529 )and is provided for general information purposes only and must not be construed as investment advice. It does not take into account the investment objectives, financial situation or needs of any particular investor. Before making an investment decision, investors should consider obtaining professional investment advice that is tailored to their specific circumstances.