The easy way to buy top companies at the right price

A new book really does tell you how to identify good companies and buy them at reasonable prices.

How to Pick Quality Shares, by Phil Oakley

Although a highly readable technical book, How to Pick Quality Shares is rooted in the experience of its author, investment analyst Phil Oakley. Earlier in his investment career he bought troubled companies at very low prices in the expectation they would recover. These days he prefers quality companies, and he's prepared to pay more for them.

Many investors, myself included, have followed this path. Initially, we're attracted to so-called bargain stocks because it's easy to gain confidence from low prices. You only need to divide the price by something valuable and widely reported, like book value, the accounting value of the firm or earnings, the profit it earns in a year, to establish the shares are cheap. But, like cheap wine, Phil says there are often good reasons mediocre and poor companies are shunned by investors, and not so valuable after all.

Once burned by cheap stocks that just get 'cheaper', you soon realise you must either learn to discriminate between stocks that recover from those that don't, or invest in better quality shares, those that will profit handsomely for many years to come.

Phil focused on quality for the same reasons I did. You don't have to be particularly clever to identify quality companies and, once you've found them, you shouldn't have to replace them any time soon. Trading bombed out shares is, to me, much more demanding. You put all that effort into finding companies with recovery potential, only to sell them once they achieve it. The churn is exhausting, though there are investors that can handle it.

Three-stage process

Phil boils good investing down to a three-stage process: Finding quality companies by calculating and examining the 'interest rate' they earn on the money they invest; avoiding dangerous companies by examining the debt, operating leases, and pension obligations they carry; and buying the shares at a reasonable price by comparing the 'interest rate' you might earn from the investment to the 'interest rate' you might earn from other investments.

It's worth dwelling on this concept of interest rates, both within the business and for shareholders, because much of the book is concerned with calculating them. The internal interest rate is return on capital employed (ROCE), or free cash flow return on capital invested (CROCI), how much money the company earns in accounting or cash terms expressed as a percentage of the money it has invested. It's the same calculation as the interest rate on a bank account, the return you earn expressed as a percentage of the money you have saved.

For shareholders there's an added complication. We rarely earn the internal return. Our return depends on the price we pay for the shares. If we value the shares more highly than the book value of the capital, the investment the company requires, our return, will be lower.

The shareholder's interest rate is the earnings yield, the price we pay divided by the profits the company makes expressed as a percentage. Phil prefers to use a version of the same calculation he dubs the cash yield, which substitutes an estimate of maintenance capital expenditure for depreciation and amortisation costs, because companies sometimes depreciate their assets at rates that don't equate to the reinvestment cost.

Neat package

I suppose if you were very diligent, and had little concern for the value of your own time, you could save money and find much of this information in Phil's catalogue of articles - he's a respected commentator for the investment software firm that produces ShareScope and SharePad.

You could also find some of it in my articles on Interactive Investor, and in the writings of intrepid bloggers and investors. Phil's standing on the shoulders of giants like Warren Buffett and Terry Smith, who propound quality investing from their monumental pulpits, without providing fine detail on the techniques they use.

Before this book, private investors seeking to improve their technique have had to ferret out the nitty gritty themselves or, like Phil, serve an apprenticeship as a professional analyst (and then unlearn all of the wrong-headed stuff they also learned).

There's a library full of books that will tell you what a profit and loss account is or how to calculate a price/earnings (PE) ratio, but there are very few for the general reader that will explain the PE is an unreliable measure that can be improved, and what to do about it.

As a veteran reader of entry-level accounting and investing books, I think one of the things that distinguishes Phil's book is the fearlessness of the author in telling readers what they don't need to worry about. Most books approach investing in an academic way, kitchen sinking every accounting ratio and leaving readers with a mountain of analysis to do and no way of knowing which results matter and which don't. They'll tell you about six different profit measures, but not which one you should pay most attention to (I'm relieved Phil thinks its EBIT, or operating profit).

Knowing techniques won't turn us into Buffetts, or Smiths and it won't make us Oakleys either. Technique must be married to business acumen, and emotional discipline, if we are to succeed. But technique is important, and the more confident you are in your analysis, the less emotional you are likely to be and the more business insights you are likely to gain.

Phil knows…

Phil knows this, and I'm going to demonstrate it by quoting three paragraphs of the book which don't describe techniques but explain why you should employ them:

A good habit to learn when you are analysing a company is to do your own number crunching first before you read or listen to what the company has to say. By doing this you build up your own picture of the company and its performance and then see if the company confirms your findings.

I always find this is a very useful exercise as I have already learned a great deal before reading the company's comments. These comments then enhance my understanding and can help give me an edge over less diligent investors who rely on what the company says.

The other great benefit is that you learn to completely trust your own judgement and let the numbers describe the company you are looking at. Sometimes you will find that the company's comments about its own performance bear no resemblance to what has actually been going on. Management can often be overly optimistic or fail to address problems candidly. This is often a sign to stop researching a company, or to sell the shares if you already own them.

How to guide…

That's the "why". The rest of the book is the "how". You will learn how to measure profit and cash flow, how to use Du Pont Analysis to analyse the drivers of profit, how to check a company is spending enough to grow, when it's OK for a company to spend more cash than it earns, how much debt is too much debt, and how to account for hidden debt.

You will learn how to work out a value for the company by discounting future cash flows, why most people don't bother, and why it's useful, nevertheless, in revealing the growth anticipated by the current share price. You will learn how to use the cash profit to set a target price for the shares. Just about the only thing Phil can't give you is the patience to wait for the share price to hit that target, only experience can do that.

Most of these techniques are demonstrated on a high-quality share, Domino's Pizza, and a rogues gallery of low quality shares from Globo to Tesco. My one criticism is the book does not get into intangible assets which, in my view, shouldn't always be treated like tangible ones.

Reading How to Pick Quality Shares was cathartic for this reasonably seasoned investor. It enabled me to reflect on how I analyse companies, and made me realise I could sharpen up a few areas. I wish I'd been able to read it 20 years ago at the start of my investing journey, but I'm glad I've read it now.

Contact Richard Beddard by email or on Twitter.