Investment Analysis

Analysing shares

Analysing shares

Background

Once an investor decides to include shares in their portfolio, the inevitable question arises : how do they choose which ones to buy out of the thousands on offer ?

Whilst there are many different approaches for choosing shares, we will share how Lonsec, as a research house, goes about its share research process. This can provide DIY investors with a framework that they can compare to their own, or tap into to enhance their share selection process.

Investment Philosophy

The starting point in the investment research process for investors is to clearly identify their investment philosophy when it comes to investing in shares.

Lonsec considers the primary purpose of investing in equities is to generate dividend income, capital growth or a combination of both and it is this risk versus reward relationship that determines the attractiveness of those shares as an investment.

For any given company, the level of risk to capital and the level of risk to income are not necessarily the same. In order to differentiate between these inherent risks, Lonsec’s equity research sets out to capture and highlight the various characteristics of each stock in a simple, yet effective manner.

This approach is tailor made for SMSF investors as it assists trustees in selecting the right stocks for their particular situation.

Research Approach

The next step for investors is to clearly identify a research approach.

For example, Lonsec’s approach utilises a combination of qualitative and quantitative analysis methods to provide answers to three key investment questions at an individual stock level:

  1. Which stocks are eligible to buy? (Rating: Approved / Not Approved)
  2. What are the investment risks of each stock? (Risk Profile: Income / Growth)
  3. Is the stock trading at a reasonable price? (Action Signal: Undervalued / Overvalued)

By initially focusing on three key variables such as these, investors can reduce the large universe of stocks down to a more manageable list that fits their needs.

Which stock are eligible to buy?

Lonsec’s proprietary quantitative models utilise a database comprising a wide range of historical and forecast data points to determine and classify the Income and Growth risk profile for each security in the ASX200.

The quantitative model will derive a suggested Approved or Not Approved rating by combining the Income and Growth Risk ratings for each stock. The Income and Growth risk profiles are derived from up to eight years of actual data and two years of forward consensus data. Lonsec’s equities research team then combines the outputs of the quantitative models, the latest consensus earnings forecasts and Lonsec’s own earnings forecasts to ratify the investment view and derive and maintain bespoke valuations for each of the ASX200 constituents.

The valuations and investment views for each company are monitored on a daily basis to capture the latest changes in the outlook for each company. Once assigned, the rating of ‘Approved’ or ‘Not Approved’ should be relatively stable for each stock as it is a long term assessment of the medium to long term prospects of a stock.

Lonsec considers this to be a key attraction of its rating process versus the shorter term ‘Buy-Hold-Sell’ broker approach. However, a small number of stocks may change rating each year when a material change (positive or negative) occurs and Lonsec adjusts its return and risk ratings on the stock.

What are the investment risks of each stock?

As well as an overall research rating, Lonsec’s quantitative model will derive a risk profile based on the risk to Income or Growth. This is achieved quantitatively by screening each stock by a bespoke set of factors relevant to each risk factor, resulting in stocks being allocated to four distinct ‘buckets’ – Attractive, At Risk, Low or Inferior.

Lonsec’s assessment of a company’s Income Risk profile follows a structured framework of assessing ten key financial metrics to arrive at an overall Income risk rating for the company.

This risk rating is combined with the expected dividend yield of the company, over the medium term, to classify the company into one of the following categories:

  • Low Income — reflecting a below-market dividend yield, whilst exhibiting lower dividend volatility and a relatively lower risk profile than the broader market;
  • Attractive Income — reflecting an above-market dividend yield, whilst exhibiting lower dividend volatility and a
    relatively lower risk profile than the broader market;
  • Income at Risk — reflecting an above-market dividend yield, whilst exhibiting higher dividend volatility and a
    relatively higher risk profile than the broader market; and
  • Inferior Income — reflecting a below-market dividend yield, whilst exhibiting higher dividend volatility and a
    relatively higher risk profile than the broader market.

The key financial metrics assessed are those which are most likely to impact the company’s ability to pay dividends. Some of the financial metrics assessed include:

  • Historical earnings and dividends track record;
  • Forecast earnings and dividend expectations and trends;
  • Balance sheet strength;
  • Divided cover and payout ratio;
  • Historical volatility of earnings and dividends; and
  • Free cash flow generation.

Lonsec’s assessment of a company’s Growth Risk profile follows a structured framework of assessing ten key financial metrics to arrive at an overall Growth risk rating for the company. This risk rating is combined with the expected earnings growth of the company, over the medium term, to classify the company into one of the following categories:

  • Low Growth — reflecting a below-market growth rate, whilst exhibiting lower earnings volatility and a relatively lower risk profile than the broader market;
  • Attractive Growth — reflecting an above-market growth rate, whilst exhibiting lower earnings volatility and a relatively lower risk profile than the broader market;
  • Growth at Risk — reflecting an above-market growth rate, whilst exhibiting higher earnings volatility and a relatively higher risk profile than the broader market; and
  • Inferior Growth — reflecting a below-market growth rate, whilst exhibiting higher earnings volatility and a relatively higher risk profile than the broader market.

The key financial metrics assessed here are those which are most likely to impact the company’s earnings. Some of the financial metrics assessed include:

  • Historical sales and earnings track record;
  • Forecast earnings expectations and trends;
  • Balance sheet strength;
  • Historical volatility of earnings;
  • Free cash flow generation;
  • Return on Equity;
  • Book value / NTA growth; and
  • Track record of outperformance

Is the stock trading at a reasonable level?

The next step is a familiar one to experienced investors. Is their any value in the investment your looking at ?

A key part of Lonsec’s investment process is to use the research process to aid it in creating a bespoke set of earnings forecasts to both ratify the investment view and derive and maintain bespoke valuations for each of the ASX200 constituents.

This bespoke valuation is the bedrock of an Action Signal for each stock which highlights whether the current share price represents an attractive entry point for each stock based on valuation upside. Lonsec adopts a flexible approach to its ASX200 valuation modelling and this is largely based on the sector in which a stock resides.

The core valuation technique is a Dividend Discount Model (or DDM) and this accounts for the majority of industrial stocks. However, where a differentiated approach is justified then this will be adopted, i.e. Discounted Cash flow (or DCF) for resource stocks as the economic life of an asset is defined.

Lonsec’s Action Signal will naturally change with movement in the share price and / or Lonsec’s assessment of fair value. Movement between ‘Undervalued, Fairly Valued or Overvalued’ will be mostly dependent on share price movements. Lonsec’s fair value will be reasonably stable in the short term but will change over the medium to long term, in-line with analyst views based on the company and industry outlook and macro-economic conditions. In circumstances where the Company’s valuation requires an urgent review due to a material event, Lonsec will place the fair value under review. In this situation, Lonsec will remove the fair value for the stock and advise that its valuation is currently under review in the ‘Action Signal’ section. This status will usually only apply for short period of less than five business days.

When a valuation is under review, the rating is not affected as only the fair value is being reviewed. As well as the Action Signal, Lonsec’s Stock Viewpoint will also provide an indication of the forecast expected returns split by Income and Capital growth from an investment in this company at the last traded price. The Income is represented by the expected dividend yield over the next two fiscal years. The Capital growth component is calculated by comparing the current market price to Lonsec’s fair valuation for the company in each particular year. The Forecast Return projections are based on a number of variables and forecasts that are subject to change / review on a regular basis.

Bringing it all together

Along with summarising all of the above, Lonsec’s Stock Viewpoint reports also present a series of charts that provide a visual snapshot of some of the key financial parameters that are likely to impact the share price performance of the given company. The charts are grouped into four different segments, namely Growth, Income, Financial Strength and Valuation. These charts display up to 10 years (where available) of historical and forecast data to provide a real-time snapshot of the company’s track record with respect to its earnings, dividends, balance sheet strength and secondary market valuation metrics.

This is very helpful for investors looking for companies that have a stable track record in these important metrics.

 

Research done for you

As evidenced from all the above, the stock research process can be a time consuming and resource intensive task at the professional level.

Thankfully, the outputs of Lonsec’s research process is now readily available to DIY and self managed investors. The research table provides the ability to filter the top 200 stocks by a range of criteria, along with the stock viewpoint reports, and model portfolios of best ideas.

CLICK HERE to find out more on the full spectrum of research available.

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