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If I want quality shares in my portfolio, I have to start by identifying quality earnings.
I do this by using the past 12 months of a company’s data, and then by analysing those companies (I only use the top 75%) that showed the best- quality earnings for that period.
But this is only the first step in my analysis: later I will consider value and momentum analyses.
There are three basic factors that will show me how strong a particular company’s earnings were, or how high the quality was:
Accruals
Here we focus on the effect on the company’s cash flow of any changes in assets and liabilities.
A decrease in accounts receivable might indicate an increase in cash sales, which would have a positive effect on the company’s cash flow.
In the same way, a decrease in stock levels and other current assets might indicate an increase in sales; therefore, the lower these ratios, the better.
A decrease in property, plant and equipment expenses can also contribute towards better cash flow.
On the other hand, a decrease in accounts payable, other current liabilities and other non-current liabilities may mean that more cash was used to cover these costs, which could have a negative effect on the company’s cash flow, so the higher these ratios, the better.
Cash flow
Here we focus mainly on cash flow from operations and capital expenditure.
Both ratios are compared to the company’s industry median. If cash flow from operations is higher than the industry median, the company would obtain a higher score, while capital expenditure should ideally be lower than the industry median.
Operating efficiency
In this section, we focus mainly on two factors: the company’s operating profit margin and any changes in the company’s net operating asset turnover.
Again, both factors are compared to the industry median and would lead to a higher score if the company is above the industry median.
After applying this first step in my investment process, I have identified the following 10 shares as good-quality shares:
- Astral Foods
- Anglo American Platinum
- Adcock Ingram
- South32
- Tiger Brands
- Vodacom
- Kumba Iron Ore
- WBHO
- BHP
- AECI
To reiterate: These are only the first ingredients of my recipe.
Quite a bit of homework still needs to be done. Also remember that a diversified portfolio should include more shares than those I have listed above.
However, by identifying quality shares as a first step, you can eventually turn your entire portfolio into one of higher quality.
Schalk Louw is a portfolio manager at PSG Wealth.
This article originally appeared in the 26 April edition of finweek. Buy and download the magazine here, or sign up for our weekly newsletter here.
