Icon Guide

Most of the companies in the market are, well, average. And that’s okay! In fact, these sorts of companies are the workhorses of my portfolio. While they may not stand out from the crowd, they are good, solid companies, growing at a rate roughly in line with the overall market. Because they are not particularly exciting companies to own, you can often find great bargains in this space if you look hard enough.

I like these companies to have a history of generally profitable operations. Losses for a year or two during recessions are perfectly acceptable, though, and are quite commonplace in this group. While I’m not expecting them to shoot the lights out, I do like to see a number of avenues whereby they can continue their steady pace of growth, or, if I’m lucky, even accelerate it.

As with all my portfolio companies, these companies have to be financially strong, without too much debt. They need to be able to pay off all their debts with less than 3 years’ worth of annual earnings. If they have built up a nice pile of cash, that’s even better.

Generally, these are small or mid cap companies. Larger companies tend to trade at higher valuations and get their own category (see “the whale” below). I would expect these sorts of stocks to trade in line with the average p:e ratio of their fellow small cap stocks. If the stock is in my portfolio, though, I’ve probably been able to buy it for a good deal less than that.

These are great investments if you can find them! They are the sexy stocks with strong growth prospects, doubling in size every 3 or 4 years. Their debt levels still have to be low, though. If they are fueling their rapid expansion by leveraging up their operations, I’m not interested.

These companies can offer turbo charged returns if the underlying earnings soar at the same time as the p:e ratio rises to meet investor’s high growth expectations. But this is a double-edged sword. The p:e can come crashing down again if growth targets aren’t met. A big part of this kind of investment lies in assessing the current prospects for continued high growth and new developments have to be watched closely.

These companies have absolutely nothing going for them. Earnings have been flat or declining for years. They are probably in a dying industry or have too much exposure to some old, legacy technology. Maybe the company is just very badly run. Whichever it is, investors have abandoned these companies and perhaps therein lies opportunity. If the price is low enough, even these stocks can make good investments.

Every company deserves a shot. Maybe they will surprise you.

Here the earnings don’t tell the whole story. The company may not even have any. But it does have some valuable assets sitting on its balance sheet. It can be as simple as a big hoard of cash. Or it could be an underappreciated parcel of land. Or a fleet of helicopters. Whatever it is, the market is valuing the stock at significantly less than the company’s tangible book value.

These kinds of companies often find their way into my portfolio. They are companies that have fallen on hard times. As a result, their share price is in the dumpster. Often, the company is losing money. But I see reasons to believe that the company’s problems are temporary and that it will live to fight another day.

I want there to be a good history of profitable operations preceding the onset of difficulties. For my p:e calculation I’ll go back and use an earnings figure from before the downturn. This could be the most recent peak in earnings if I’m confidant of a full recovery or an average of some of their best years, or it could be a dumbed down version of their past earnings to reflect any harsh new realities such as the more recent sale of a division or the issuance of new shares.

As with all of my other holdings, I’m looking for a strong balance sheet, but this criteria carries extra weight in this situation. If the company is losing money, the debt has to be very low and a cash hoard that can see them through the worst of the downturn is much preferred. As well, although the company may be losing money, from an accounting perspective, I like to see operations that are cash flow positive, again offering some reassurance that they can weather the worst of the storm.

Investors are willing to pay up for the relative safety and security of a larger company. If the company has a market cap over $1 billion (in Canada. US whales are bigger) and has demonstrated a long, stable history of profitable operations through good times and bad then it deserves a higher price. P:E ratios tend to run higher in this group, so it is best to compare prices to other whales, not to the minnows that are flitting about around them.

This stock pays out a nice, fat dividend. Nothing like getting a regular paycheque deposited into your brokerage account every month. Personally, though, I tend to be dividend agnostic. Whether earnings are used to pay out a dividend or buy back shares or used to re-invest in future growth, I am confident that the money will accrue to me in one way or another, if not in the form of dividends then in the form of capital gains. However, there are a lot of dividend lovers out there, so if a company makes it into my portfolio by one of the other routes and happens to have a high dividend, I will flag it as such.

All the talk of p:e ratios and book values can get a little boring. It’s nice to spice things up every now and then. These are riskier, more speculative companies. They may be in the earlier stages of their development, just tipping over into profitability in the last quarter or two or they might be a riskier turnaround play, hemorrhaging money but with loads of rebound potential if they can just get through this rough patch.

The risks and rewards are amplified for this kind of stock and I often put less of my own money into these kinds of ideas than I do into the other, more mature plays.

Earnings can come and go and that prize piece of real estate that is sitting on the company’s books? Turns out it’s actually a piece of alligator-infested swampland in Florida. But cash is cash. When things go south in a hurry a big wad of cash is a very reassuring thing to have. And if things don’t go awry, it can be used for all sorts of pleasant things like acquisitions, buybacks or juicy dividends. If a company is cash rich, I’ll tag it with the money bag icon.

I’ve done a fair amount of investing over the years in Hong Kong, buying mostly small, mainland Chinese companies. I’ve also looked at investments in South Africa, Eastern Europe, Russia and The Philippines. These companies come with their own unique set of risks and rewards and often trade at a discount to their less corruption-prone peers. There can still be money to be made, but you need to enter these investments with your eyes wide open.