By Elio D'Amato in the Australian Financial Review 27 March 2017
Often we talk of investing as a science, a predictable and measurable outcome driven by inputs and outputs. When it comes to investing, the equation is simple, or so the theory goes. The company must be fundamentally strong and growing or paying a good dividend.
But experienced investors know that there is also an element of art that needs to be applied when making a decision, particularly in this modern investing age when so much can impact prices in the short term.
At Lincoln Indicators, we first assess a company's financial health and the management's ability to meet key ratios that measure a company's growth or income generating capacity. Once a company makes the grade, we then pull out a blank canvas and begin "painting a picture" of whether the quality elements exhibited by the company are likely to remain in place.
The reason investors need to do this is because, even though the company may look good today, the share price will often be directed by what happens tomorrow. Identifying potential road bumps can help make a risk-adjusted call when considering a stock for inclusion in a portfolio.
This process starts by assessing the future earnings growth trajectory and/or the company's capacity to pay dividends. We listen to what the company says about opportunities ahead, we look at peers in the same industry and their results. We then review a range of industry markers to give us insight on whether the company is facing headwinds or tailwinds. Ultimately, we want a margin of safety within our assessment parameters.
We next try to identify any risks, such as operational, geographical, currency, governance, market, key person and commodity risks, that could materially change the fundamental fortunes of a business.
Weighing up risk
It is important to note that the presence of a risk should not be the sole reason to not invest in a stock. In fact, it is the risk element of share investing that makes this asset class so rewarding for investors over the long term. However, when you identify a series of risks that are deemed significant, you may wish to make a call as to whether you should be exposed.
We have followed this process through the latest reporting season. Two stocks that appeared on our radar, yet we made a risk-adjusted call to exclude from the portfolio were Fletcher Building, New Zealand's biggest construction and supplies company, and homewares retailer Harvey Norman. We held Harvey Norman shares before the reporting season.
In the case of Fletcher Building, we wanted more certainty that a one-off loss of $31 million on a major construction project would be just that, a once off. It unfortunately wasn't and the company subsequently issued another downgrade after an internal review of the building and interiors unit within the construction division. In the case of Harvey Norman, we were unable to gain access to management in order to build comfort around the outlook for earnings within a shifting retail landscape, the emergence of new competitors and lingering concerns over business practices. We therefore decided to make a risk-adjusted call and subsequently removed it as a star stock.
Though these cases highlight times where a risk-adjusted call worked, there will be times where all the best analysis and planning in the world won't help to avoid the occasional hiccup. Further, steering clear of a company because of an active risk may cost you, should the company prove to the market the risk is being managed.
You won't be right 100 per cent of the time, but being "forewarned is forearmed", and understanding possible risks before you invest helps prepare you for any possible outcome. If deemed significant enough, err on the side of caution and avoid the stock altogether. It will help make the "art" of investing more manageable to implement.
Elio D'Amato is an AFR Contributor and Director of Research and Education at Lincoln Indicators.