Trade wars, slowing global growth, power failures, nervousness ahead of elections, possible further rating downgrades and some spectacular price collapses in Johannesburg Stock Exchange (JSE) market darlings have led many South Africans to reduce investments in the local market or stop investing.
But there is a way for investors to feel a lot more comfortable about achieving consumer price inflation beating returns by putting money to work on the JSE - by building a core portfolio of shares based on the concept of quality.
What are the characteristics of quality shares?
On the quantitative side, there are three principal areas that should receive attention – profitability, financial strength, and cyclicality of earnings. For example, to weather a decelerating growth environment, a company should have a strong balance sheet, a degree of defensiveness which reduces earning volatility and the ability to sustain profitability.
Profitability is fundamentally important. Stock returns are generally a function of earnings growth and so we evaluate a company’s ability to generate earnings growth over a long period of time.
Other key metrics we look at are return on assets, return on equity and return on invested capital which are all good indicators of profitability. A company’s ability to convert earnings into cash is also an indicator of quality.
Financial strength is vital too. We like companies with sustainable debt levels capable of withstanding economic shocks.
Finally, we prefer companies with low earnings volatility, positive earnings through the economic cycle and a track record of uninterrupted dividends.
Once we have satisfied ourselves that our financial analysis confirms these metrics of quality, we then evaluate additional qualitative factors such as barriers to entry into the business of the company under analysis, the strength of current management and the regulatory and social environment that the company operates in.
What are examples of companies that pass these rigorous quality tests?
Mondi is an international paper and packaging group with production operations in 31 countries with key operations in central Europe, Russia and South Africa. It has the global market leading position in Kraft paper and industrial bags. And the leading position in a number of additional products in its markets.
Over the last five years it has managed to grow compound earnings in excess of 14% per annum in euros.
Having invested €2 billion in acquisitions since 2012, their last reported return on capital employed of over 24% suggests strong management, prudent capital allocation and efficient operations - all the hallmarks of quality.
We also regard Mr. Price as a quality name that should form part of a core portfolio despite recent share price pressure indicative of domestic consumer stress. The Mr. Price Group and its subsidiaries operate 1 041 stores across Southern Africa. Its four-retail chain sell clothing, footwear, accessories and homeware.
Despite new international entrants in the fast fashion market, we believe the company still has no true competitor in South Africa and that its value retail formula works through all economic cycles.
It boasts the highest return on invested capital among its peers, a gross profit margin of over 40%, return on equity of 39% and low debt to equity of 3%. It is clearly a quality company.
When headlines are scary it is tempting is to hide all our savings in cash and hope for the best and forget the basic principles of investing. But we all need our savings to grow at a reasonable rate above consumer price inflation and hoarding cash is not a long-term solution.
The JSE offers many quality shares that when combined in a portfolio, are very likely to perform well over the longer term and allow us to sleep much easier at night.
That’s not to say that volatility isn’t unsettling - it is. But it’s important to remember it’s a function of global capital flows reacting to bits of information and this market ‘noise’ will always be with us.
But just like your neighbour mowing the lawn early on Sunday morning, ultimately the noise stops, and the day moves on.