Reporting season is always a great opportunity to help separate the signal (business fundamentals) from the noise (share prices).
As companies start to drop their half-year results, it’s worth framing up what it is you’re looking for. How you do that will depend on the particular investment strategy you employ but, if you have a longer-term focus, here are a few things to think about.
Start at the top
Revenue represents the top of the funnel and — assuming you have positive gross margins — the more the merrier. You can’t ever have too much.
What matters, of course, is how the actual result compares with expectations. Companies “miss” forecasts all the time (although, clearly, it’s the forecasts that were a miss), and market prices can react swiftly and significantly. It’s easy to allow that to colour your view of the result, but you need to look at the result in your own context.
Did you make the investment based on a specific target for the next half-year revenue result? It’s more likely (and sensible) that you bought shares based on a view of how the business would grow, on average, over many years.
So if a company’s reported revenue is materially off what you were roughly anticipating, the real question is whether it was due to the usual vagaries of business and short-term cyclical factors — or something more structural relating to the company’s economic strength.
It’s not always easy to tell, but it’s concerning when a business is consistently underperforming relative to competitors and also against management’s previous indications.
Acquisitions and divestments can obscure things too, so it’s always worth looking at things on a pro-forma and per share basis. Buying growth is often easier than organic growth, but often it leads to shareholder value destruction — especially if a lot of new shares have been issued.
Understanding the machine
Sales are great, but what matters is how much money makes it to the bottom line.
There’s loads of things to consider here — gross margins, fixed costs, capex etc — but the big picture is that you want to see increasing efficiency. A businesses that can grow sales without too much of a lift in operating costs becomes increasingly profitable as it scale. It’s also a great sign that it’s offering a product or service of real value.
As above, you need to allow for what may be transitory factors (eg a short term spike in the cost of raw materials), but generally speaking you want to see a business that is growing, or at least maintaining, its net margins. Although one important exception is growth investments.
Things like hiring new sales people, undertaking R&D and acquiring capital equipment are obviously all paid for upfront, before they have the chance to help drive revenues. But despite the impact this has on near-term profit, it is absolutely a good move if the company gets an attractive return on the investment.
It’s your job to work out whether you think the investments the company is making are worthwhile. But if there’s good sales momentum, an improving competitive position, and the company is staying within it’s areas of strength, you can give management a lot more rope.
Cash is king
A company’s reported statutory net profit and the free cash flows it generates are two very different things, and it’s the latter that really matters at the end of the day.
Capitalised costs, changes in working capital, asset revaluations and a host of other things can muddy the water, but in general it’s always good to see healthy and growing free cash flows. That is, the money left over after paying for operations and investments.
If you don’t, there at least needs to be some conviction this will soon be the case. And, also, that there’s sufficient cash in the bank to see the company through, or at the very least that it has access to inexpensive capital.
Looking ahead
The market is always forward looking. The only relevance the latest results have is in how they help inform our expectations for the future.
Share prices can easily fall in the wake of record results, as is what happened with CBA and Nick Scali recently. This usually happens because the market was already expecting good results, but was also expecting a stronger outlook than what was indicated.
Again, this is a question of teasing apart the cyclical from the structural, and deciding whether or not the longer term trajectory of the business remains on track.
One word of caution: take overly specific guidance from management with a big grain of salt. Not even the CEO can anticipate what industry conditions will be like in the year ahead. And be extra wary of those that lean heavily on highly ambitious longer-term aspirations, without having first demonstrated a good deal of traction.
Many of the best CEOs refuse to give any guidance beyond their general expectations, and even then they are very conservative and highlight some of the expected challenges.
Keeping yourself honest
Finally, it’s always worth remembering that the easiest person to fool is yourself. As a shareholder you WANT the company to have good results. You’re heavily inclined to put a positive spin on things, and to downplay any negatives. It’s called the endowment effect, and it’s one of the more pernicious behavioural flaws for investors.
This is why it’s so valuable to journal your investment thesis.
Writing down the reasons you hold a certain stock (and the reasons you wouldn’t) will not only help clarify your thinking and identify areas of weakness, but it gives you something you can use to hold yourself to account.
When a company reports, it’s not about whether the numbers hit the consensus view of analysts — it’s about whether or not the general investment case is still on track, and if that’s properly reflected in the current market price.
The challenge real challenge, of course, is one of objectivity and discipline. But if you can manage that, you’ll have a serious edge on most in the market.
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