Building a Core China Portfolio – Part 3, Assessing Quality

2 Sep

Our aim is to find companies that fit the following bill:

  • high quality
  • low balance sheet risk
  • no-left field risk
  • quality of earnings (i.e. cash conversion)
  • favourable capital allocation vis-a-vis equity holders
  • strong competitive position
  • solid drivers

If a company does not fit our profile, we reject it and move onto the next one. If it does meet our profile, we can move onto estimating sustainable income and putting an upside/downside value range on the firm. With comfort about the quality and risks, and a fair value range (with a high margin of safety) one can decide whether now is the right time to purchase the stock, or whether to keep monitoring (and amending with new information), and waiting for the right moment to pounce.

Now, time is our most precious commodity.  With that in mind I start my list above with an assessment of quality and balance sheet risk. It is fairly easy to get a quick assessment of these 2 criteria, and know whether it’s worth spending further time on a deep understanding of the company’s business model and working on a valuation.

The measure of quality is returns. As a potential equity investor one must ensure that the company has a good track record of returns on its equity (ROE).

Yet how does one define quality. The first basic benchmark is to look for companies with an ROE of at least 15%. This is not fool proof, and will often be industry dependent. However, on average the market is returning around 12%, and with many companies beating that average, below 15% represents a healthy level at which to reject a company with comfort in the knowledge that there’s still a huge universe to choose from.

(Note – It usually yields greater rewards to find quality and wait for a good entry price rather than go for low quality at a very discounted price. It’s just common sense that sustained low quality is less likely to improve than a discount opportunity is likely to close on a company with sustained quality).

The second thing to ensure is that a company exhibits a sustained (or growing above the benchmark) return over a period of many years. A track record is important for obvious reasons. I will add though, the success of a company is clearly heavily dependent on management. With one of managements’ primary task being the successful allocation of capital in a firm (in order to create value i.e. grow its returns above the cost of said capital),  a good track record of sustainable returns is a great yardstick for the competence of a management team, and with all other things being equal, is a good indicator of future success of the teams execution (this naturally has its caveats and should not be relied upon in isolation).

The next thing to do is chose a number of peer companies and compare how our company under analysis has performed compared with the competition. If the company has severely underperformed I suggest rejecting it at this early stage and moving on.

If the company has:

  • had only a couple of poor years
  • had a sudden jump or drop
  • performs relatively well compared with peers
  • or has even performed well or very well

…then it is worth breaking down the components of its ROE to understand what’s driving that performance and or blips, what’s causing the differences etc… and then making an initial decision about the company’s quality.

What are the components of the ROE?:

ROE = [EBIT%]  x [Asset Turnover] x [1-Tax Rate] x [Leverage]

(Note – this is ROIC x leverage)

Anyway, this blog entry has been very theoretical. In the next entry we will apply these ideas, present and have a close look at some of the data.

I want to leave you though with something more concrete.  In my last entry on building a core China portfolio (https://ravendragon.wordpress.com/2010/08/25/building-a-core-china-portfolio-%E2%80%93-part-2-the-shortlist/) I presented a short list of 100 companies that deserve further inspection (https://ravendragon.files.wordpress.com/2010/08/china22.gif).

We decided to start looking at VTech Holdings (HK 303). Below is a graph of VTech’s ROE between 1993 and 2010.

On first inspection it looks great. It increased steadily from 1993 to 1998 to high 30%’s (easily above our benchmark 15%). Then it collapsed when the tech bubble burst (will need further investigation). Subsequently, the company has posted returns sustainably in the high 30%’s, reaching 50% for a couple of years. Even 2009/10 was very strong.

Conclusions thus far – let’s keep looking at Vtech!

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