newsletter 9 - prospects for the business 23rd october 2014

I’m looking for ‘a good business’.  And I expect to find it, even for companies on low prices relative to the Net Current Asset Value. This requires investigation and understanding of some vital qualitative elements:
 
Earnings power
 
One indicator of good prospects is a satisfactory level of current earnings and dividends, and/or a high average earnings power in the past.  No projections of great things to come, other than those relying on ‘facts’ proven in the data.
 
And don’t rely on past data alone: it may mislead.  Take Tesco, for example, the past ‘facts’ look very strong.  But as we all know, the competitive environment can change on the ground.  We must scan beyond the data for signs of vulnerability.
 
Earnings power is not the current earnings, but is derived from a combination of actual earnings over a period of years (5-10 years) and estimated future earnings over say five years in the future taking into account the competitive strengths of the business vis-à-vis rivals, suppliers, customers as well as the potential for new rivals to enter the industry and for substitute products/services damaging the firm (e.g. the internet provides a substitute for travel agents, recorded music distribution and book selling).
 
More on competitive position
 
Some industries are structured so that they provide the players within them a high return on capital employed.  These firms can sell their products at a high margin over the cost of production. Other industries are notorious for the perpetually poor return on the shareholders’ cash that they use.  It seems that they are locked into poor bargain positions with customers and/or suppliers, they have several rivals all clamouring for market share launching into calamitous price wars.
 
Quality of management
 
There are two aspects:
 

1. Competence.  Examine and compare their words and performance over a long period
2. Shareholder orientation. If you have competent and energetic managers you still will not get very far unless they also possess the quality of integrity, particularly with regard to serving shareholder interests.

 
Financial stability
 
You do not want to be in a company with high levels of borrowing or highly variable income flows – steady as she goes is much more relaxing.  Industries that are not subject to much change are likely to be stable; so bio-tech and computer game software is out, industries such as selling boring widgets is in (probably).
 
The next blog will apply some of these ideas to French Connection