Picking a share: Why a firm’s history matters

In the last installment of a two-week series, PETER KAMAU delves into why the historical performance of a business you intend to buy shares from, matters

It is imperative to understand that behind stocks there are real businesses with real performance issues. We must therefore, adopt the philosophy that when we buy stocks, we are buying businesses. 

Historical performance

Usually, you want to know if the business has good returns. The higher its return on equity, the more profitably the company can reinvest its earnings. The higher its return on equity, the faster its value increases from one year to the other. To be able to appraise its performance demands that we understand the business and the forces, internal and external, that influence its operations and profitability. This calls for knowing the fundamental numbers and ratios used to gauge and monitor performance and having clear criteria for stock choice and trading based on these parameters. The key numbers are sales, earnings, assets, cash flow, equity, debt and performance ratios like return on equity. These numbers are found in the annual reports.  Not having criteria can only lead to a pickie pickie ponkey style of choosing stocks. By using this style, lady luck may come your way sometimes but ultimately, you will probably end up losing. 

Choosing financially strong businesses, that have consistently performed well in the past and which have a high probability of continued growth into the future, is key to stock selection. 

Can I trust the current management to continue running the business profitably and to my benefit?

A business’ future results depends primarily on the quality of its management. You can tell good management by the financial results. While people may lie, numbers do not and even if the financial numbers are cooked, you can smoke it out. A great way to spot a shady management team is to find a gaping disconnect between hard-core key financial numbers and what the CEO is peddling about the state of the company. The CEO’s most important job is to allocate capital rationally; to run the business so that it earns the highest possible return for its owners. It is not to increase the perks or invest in unrelated businesses. If you do not like the way the business is run, you have no reason to buy it. If you do, it is like boarding a matatu with a drunk driver yet there are many others being driven by sober ones. You can only blame yourself if you get involved in an accident.

You want managers who have integrity, are honest and candid; who tell shareholders the bad news and do not try to hide or gloss over it. You should prefer managers who have a stake in the business. If the boat sinks, they also risk drowning.

Is the price of the business fair?

If we are really to make the most out of any business, we must buy it at the cheapest price possible so that when we sell it in future, we will reap maximum profit while at the same time lowering our risk of losing the initial capital. That price would be the bargain or sale price. But how do we know it is the bargain price? We would need to know the current true worth or value of the business to prove that indeed it is a bargain price. The true value, also known as the fair or intrinsic value, is ideally the correct price and what the business should be currently selling for but it is not. Calculating the value of a business is not rocket science. There is ample information in books and on the internet on how to do it.

The reason is because the market is not efficient and from time to time, it misprices businesses in the short run. At times, the market will offer a price lower than the correct one and at others, it will offer a higher price.

Profits can be made by purchasing the mispriced business - when it is well below the true value - and then waiting for the market to recognise its “mistake” and reprice the business correctly. When that happens, it is time to sell. 

If you can get good bargain prices, you cannot go wrong. This bargain aspect is what is referred to as the margin of safety. It is what cushions you against loss and gives you space to recover should the market suddenly turn against you. The bigger it is, the better. When you get a good one like 50 per cent off, it is time to go for the jugular. 

The basic idea of investing is to look at stocks as a business, use market fluctuations to your advantage and seek a margin of safety.

Wonderful companies are found in sectors of the economy that are flourishing. They are leaders in their industry and have competitive advantages over their peers. 

The foregoing criteria should suffice to help you fundamentally land on good choices of stocks. Throwing darts, like many do, will only lead to financial ruin.

The writer is the author of  The Ultimate Framework for Success in Shares

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