How to Pick Quality Shares: A book review

Phil Oakley’s new book, How to Pick Quality Shares, details a three-step process for selecting profitable stocks.

It’s the kind of investment book I like because it’s mostly focused on numbers and ratios, and it approaches the topic of investing in a down-to-earth and step-by-step manner.

I found the book particularly interesting because its general goals are very similar to my own (buy quality companies at attractive valuations) but the details of how to achieve those goals are almost entirely different.

A three-step process for selecting profitable stocks

As per the book’s subtitle, Phil follows a three-step process to selecting shares. This process is designed to answer the following questions:

1. Is it a quality business?
2. Is it a safe business?
3. Are its shares cheap enough – Are they good value?

That sounds almost exactly the same as my own stock-picking process. In fact, it’s probably very similar to what most sensible investors do, especially if they’re after good returns from stable, lower-risk companies.

However, words like “quality” or “safe” are a bit vague. I like concrete definitions and fortunately, this book has them by the bucketload.

How to find quality companies

The first part of the book focuses on how to find those much sought-after quality companies.

But what is a “quality company”? Here’s a quote from the book:

“Great companies generate high levels of profits or cash flows on the money they invest, which I refer to as the company having a high interest rate.”

So by quality, Phil’s talking about companies that generate high returns on investment, consistently and over long periods of time.

There is of course much more to it than that, and I would say the second key component is growth:

“We are looking for companies that increase their sales over the years and turn those growing sales into growing profits.”

Looking for highly profitable, consistently growing companies is not exactly a novel idea. However, everybody has their own way of finding these companies, so it was interesting to see how Phil approached the task.

He basically looks for three things:

1. Relatively consistent growth of sales and profits over at least the last ten years (dividends aren’t mentioned, but I’d assume he would prefer steadily growing dividends too)
2. Consistently high profitability over the last ten years
3. Healthy levels of free cash flow over the last ten years

The focus on ten years of data is music to my ears, as this sort of long-term focus is something I’ve banged on about for many a year.

I think it makes much more sense than simply looking at results over the last year or two, which is what many people do.

“Relatively consistent growth” or “high profitability” are still woolly terms though, so here are a few examples of specific metrics that Phil uses in his analysis:

• Look for consistently growing profits, as measured by normalised EBIT (earnings before interest and tax, Phil’s preferred measure of profit), year after year
• Look for an EBIT margin of more than 10% in almost every one of the last ten years
• Look for companies that have a return on capital employed (ROCE) consistently above 15% over the last ten years
• Look for companies that turn all of their operating profit into operating cash flow

And there are plenty more rules in the book if you like that sort of thing (as I do).

I thought the most interesting ideas in this part of the book were Phil’s focus on lease-adjusted ROCE and also free cash flow, partly because they make sense and partly because I don’t use either of them.

Lease-adjusted ROCE: This sounds like a reasonable thing to do. It involves adding off-balance sheet “assets” such as rented property onto the “capital employed” part of the balance sheet. This will reduce ROCE (profitability) for companies that are heavily dependent on rented property, such as retailers.

It’s very sensible, although I think I can poke a few holes in the idea. However, it’s definitely something I’m looking at using in future.

Free cash flow: There is something of a cult of free cash flow at the moment, where many investors think it’s the most important metric of them all.

That may or may not be true, but I haven’t yet worked out how to turn free cash flow into a reliable indicator of quality.

That’s because free cash flow can be very volatile, largely because capital expenses (capex – a key value in the calculation of free cash flow) can be very cyclical and intermittent.

For example, many companies will spend almost nothing on capital investments for several years and then make huge investments in factories or other long-life assets in other years.

Personally, I prefer to look directly at capex rather than free cash flow, but that doesn’t mean one approach is better than the other.

It may be that free cash flow works best if you restrict yourself to investing in very stable, “capital-light” companies such as Domino’s Pizza (UK & Ireland), which happens to be the main example used throughout the book.

So, having found a quality company with steadily growing revenues and profits, good profitability and strong free cash flows, the book then draws our attention towards common risks and how to avoid them.

How to avoid dangerous companies

Here’s a good quote from the book:

“Investors spend far too much time thinking about how much money they can potentially make from owning a share and not enough time thinking about how much money they could lose if things go wrong”

For Phil, the biggest investment risks come from the following three types of debt:

1. Borrowed money from banks and other lenders
2. Hidden debts that come from renting property
3. Defined benefit pension fund deficits

The first type of debt – borrowed money – should be familiar to most investors. Companies need money in order to build factories or fund research and development, and they’ll often borrow it from banks rather than raise it from shareholders.

The reason is that debt is usually cheaper than (shareholder) equity. A bank will expect annual interest payments of perhaps 5% on a loan whereas investors will typically expect annual returns of more than 7% on their equity.

The problem with borrowed money is that it increases financial leverage, where the fixed nature of interest payments can cause small changes in revenue to drive large changes in profits (this is good when revenues are growing, but bad when they’re falling).

It also means that if profits fall far enough then it may be difficult for the company to pay the interest on its loans. At that point, the lending banks may shut down the company and sell off its assets in order to recover their loans (and shareholder will typically lose all their money).

Phil has a variety of rules relating to borrowings, such as:

• Interest cover must be at least five, but preferably above ten
• Debt to free cash flow should be consistently below ten

The book also contains lots of detail on other factors, such as fixed or floating interest rate debts, the timing of when debts need to be repaid and issues relating to having debts in different currencies.

The second type of debt – hidden debts relating to rented property – is more interesting for me because it’s something I don’t look at.

The basic idea is that lease agreements for rented properties are a liability in the same way that a loan is a liability.

Why? Because when a company borrows money it agrees to make specific payments (to the lender) over a number of years, and when a company rents property it agrees to make specific payments (this time to the landlord over) a number of years.

Phil goes into a lot of detail about how to analyse companies with rental agreements.

One of his main metrics is fixed charge cover, which is like interest cover but uses rental payments instead of interest payments. His specific rule is:

• Fixed charge cover should be above 1.3

But there is, of course, much more to it than that.

The final type of debt is pension fund deficits, which is something I’ve been looking at for several years.

For many companies, especially companies that were once state-run monopolies, pensions can be a real ball and chain around their ankles.

The example given in the book is BT, which has a colossal £51 billion pension liability and a £7.6 billion pension deficit (a deficit occurs when a pension fund’s liabilities are larger than its assets).

The company is also committed to paying around half a billion pounds into the pension scheme, every single year until at least 2030.

That is cash which cannot be invested in the business or returned to shareholders as a dividend.

Phil likes to compare pension deficits to the company’s market value and he also looks at factors such as the pension fund’s sensitivity to interest rate changes.

Although I take a different approach, I’m glad that Phil chose to mention defined benefit pensions in the book. I think they’re a liability that more investors need to take seriously.

At this point in Phil’s three-step system, you will have found some quality companies with steady growth and good profitability. You would have also weeded out any dangerous companies with high debts (visible and hidden) and large pension deficits.

The final part of the book focuses on the share prices of the remaining high-quality, low-risk companies. More specifically, it shows you how to work out if they represent good value for money.

How to value a company’s shares

Some investors will look for high-quality, low-risk companies and invest in them regardless of price. Others will look for shares where the price is cheap relative to revenues, earnings, free cash flows or assets, and invest in them regardless of whether the company is high or low quality.

Both Phil and I sit somewhere in the middle as we believe that high-quality, low-price stocks are usually the best place to be.

“A common mistake by investors is to think that buying quality companies is all that matters, and that the price paid for the shares is irrelevant. This is not the case.”

The book contains a good explanation of the discounted free cash flow valuation model, which is as complicated as it sounds.

It’s the theoretically correct approach to valuing a company, but it’s very sensitive to the assumed discount rate (i.e. your desired rate of return) and most investors use simpler ratios instead.

These simpler ratios are usually ratios of price to revenues, earnings, free cash flows or assets, but Phil’s approach is a little different and is borrowed from none other than Warren Buffett.

The idea is to estimate “owner earnings”, also known as cash profits. Cash profit is similar to free cash flow, but it should be less volatile than free cash flow because it uses a smoothed version of capex (which, as I mentioned earlier, can be very volatile from one year to the next).

This lower volatility makes cash profits a more stable and reliable number to compare price against than free cash flow. This makes a lot of sense to me and smoothing out earnings is something I do with the PE10 ratio.

Phil’s approach is very different to mine, but again that’s good because it means I learned something new.

Once you’ve calculated a value for cash profits (which the book shows you how to do) you are then given several different valuation metrics.

I think having more than one valuation metric is a good idea because you’re less likely to get a false signal if you wait for all three valuation “lights” to go green at the same time.

The three cash profit-based valuation metrics are:

• cash profits yield
• earnings power value
• Maximum price

Cash profit yield is simply cash profits as a percentage of the share price.

If the cash profits yield is very low (perhaps less than 5%), you can use a spreadsheet to work out how much growth over how much time it would take for the cash profit yield on the purchase to reach an acceptable level.

Earnings power value (EPV) goes in the opposite direction and calculates value based on the current cash profits and your desired rate of return (the discount rate). If the current share price is way above the calculated earnings power value then investors are probably paying a premium on the expectation of future cash profits growth.

The question is, how much of a growth premium are you willing to pay, given that future growth is rarely a sure thing?

Maximum price is very similar to earnings power value but uses a minimal interest rate rather than the one you’d like to achieve. Phil suggests using something like inflation plus 3%.

Can quality be more important than price?

At the very end of the book, Phil raises the question of whether price really matters if you’re a long-term investor in quality shares:

“There is some evidence to suggest that paying what might seem to be a moderately expensive price (slightly more than the suggested maximum) for a quality business can still pay off in the long-run. The caveat here is that you have to be prepared to own shares for a very long time. Perhaps forever.”

I agree that you have to pay up to buy quality companies, but if you start thinking that price doesn’t matter then you’re on a dangerous path.

It’s too easy to point to the recent surge in the share prices of bond proxies, which are companies with steadily rising sales and profits over many years. For years, value investors have said that bond proxies are expensive, and yet their share prices have kept on going up.

Price, it seems, doesn’t matter. Instead, what goes up, keeps going up.

Of course, if you think that then you’d have to ignore the feeble dividend yields on many of these bond proxies. You’d also have to ignore bond proxies like Coca-Cola, which has gone nowhere since 1998 (that’s 20 years, more or less), despite more than doubling its revenues and profits in that time.

Why has it gone nowhere? Because the starting price in 1998 was ridiculously high, giving the company a dividend yield of less than 1%. Investors were just overoptimistic and they paid the price with virtually non-existent returns.

So yes, you have to pay up for quality but don’t take the idea too far.

A quick read with some interesting ideas

Overall I thought this was a good book. It’s full of practical ideas with lots of detail on how to calculate the various ratios. However, you will need to have some experience with income statements, balance sheets and cash flow statements to get the most out of it.

But if you have experience with accounting statements and you’re looking to invest in quality shares at a reasonable price, then this book could be a solid addition to your investment library.