Investing: what to look for when selecting stocks

If customers will cross the road to pay for the service then you have a stock that has a future.

If customers will cross the road to pay for the service then you have a stock that has a future. Picture: Dylan Robinson/NCA NewsWire

For the year ahead I have two key forecasts. One is that private credit will gain traction as an important asset class and may also feature more prominently in advised portfolios, especially for those seeking uncorrelated returns, lower volatility and regular attractive income.

I also stuck my neck on the block and suggested that if disinflation and positive economic growth dominate the economic backdrop, investors will adopt more risk and buy select small-cap stocks, closing the gap that emerged in 2023 between them and the mega-cap technology companies.

Today I thought it would be useful to describe what to look for amid the smaller companies. To begin, you need to discern the difference between speculation and investing.

Speculation is betting on stock prices, hoping to pick one that zigs and avoid those that zag. Getting this right requires an almost omniscient understanding of when other investors will zig or zag, and that has nothing to do with investing, although plenty of “investors” adopt this method or add it to their fundamental analysis, with varying success.

In contrast, investing involves the appreciation of stocks as pieces of a business. That leads first to the analysis of a company’s quality and its prospects. The quality provides something of a safety net while the prospects, and especially the identification of a path for profits that exceeds expectations, provide the lubricant for higher-than-average returns.

It’s easier said than done but putting together a portfolio of companies whose business is understood, is simple, and whose earnings march upwards over the years will deliver satisfactory returns because, despite all the distracting outside influences such as wars, elections and financial crises, share prices eventually must reflect the value and performance of the underlying business.

If the first step is to identify a company of high quality, then here’s what to look for. Ideally, you want a business able to do two things: first, sustainably generate high rates of return on equity capital with little or no debt; and second, be able to reinvest a high proportion of its profits at equally high rates of return on equity.

To achieve this, the company requires a sustainable competitive advantage – something a competitor cannot undermine. It could be a geographical advantage, the purchase of an asset at prices now unavailable or the ownership of a process or method equally unavailable.

It could also be a brand, personality or reputation that cannot be dislodged or replicated or the possession of the network effect. Whatever the source, the most valuable competitive advantage is the one that allows a company to raise the price for its product or service without a detrimental impact on unit sales volume.

If you can find a business that is able to charge more than its competitors, and customers still cross the road to buy its product or service, you have found something special.

An equally valuable business is one that can increase its price without any negative impact on volumes.

REA Group (a subsidiary of News Corp, owner of The Australian) comes to mind in Australia as a business that charges more than all its competitors and still has more listings than any other site.

Thanks to the network effect, REA Group has the most home seekers looking for a place to buy. Picture: Getty Images

And thanks to the network effect, it also has the most home seekers looking for a place to buy. REA also has a history of raising prices and remains number one.

Unsurprisingly, REA Group has generated excellent average returns on equity over the last decade.

Now, once you have identified a company with the above attributes, it helps if it can also expand its reach and replicate those returns.

Many investors, for example, have been able to identify the high-quality monopoly characteristics of the Australian Securities Exchange. The issue for ASX investors is that the company cannot put a stock exchange on every street corner and, therefore, is unable to replicate its success, quickly or otherwise.

What you want is a business with a large, untapped, addressable market and the plan to capture some proportion of it.

For what it’s worth, I believe in many cases management has little input into the success of their businesses, especially those in the digital space. Sure, they may have come up with the idea, but in many cases, it is the customer that anoints these business models. Management simply hangs on to the coat-tails and goes for the ride.

Finally, we come to the hardest part of investing: establishing what growth the company might be able to achieve.

Remember, investors tend to overestimate the short term and underestimate the long term. This is a function of their impatience.

Regardless, we would like to find a company – one with all the above attributes – whose ability to grow can be faster than the market currently predicts or can be sustained for longer than the market anticipates.

The “growth time horizon” is more important than you might think. Growth at a relatively modest 8 per cent per annum that can be sustained for 20 years is more valuable than growth of 20 per cent per annum that lasts for only five years.

When growth is faster or can be sustained for longer than anticipated, the market tends to re-rate the company, and investors receive a boost from the expansion in the price-earnings ratio, as well as the gains from the better-than-expected growth in earnings.

I am of the view that between now and 2026, we will experience reasonably good, if not excellent, returns from equities. Given the compression in small-cap PE ratios that occurred in 2022 and which were sustained in 2023, I believe they have the best prospect of delivering outsized returns.

Of course, even if I am wrong, investors who find high-quality businesses able to generate double-digit earnings growth can achieve those same double-digit returns if they simply buy and sell shares in those companies at the same PE ratio. You won’t need an improvement in the popularity of small caps to do well.

Roger Montgomery is founder and chief investment officer at Montgomery Investment Management