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09 Oct | My New Investment Philosophy – Part IV

This post is a follow on from the My New Investment Philosophy, My New Investment Philosophy Part II and My New Investment Philosophy Part III posts I wrote last week and earlier this week.

Let’s dive straight back into the criteria.

Criterion Number 6 – Debt to Equity < 1

Pretty much what is says on the tin, this one. It’s a comparison of a company’s debt levels to its equity levels. A number in excess of one, and the company has more debt than equity and vice versa for a number less than one.

Unchecked, debt’s a budding investor killer – one that tends to catch out the amateur who may be hypnotised by revenue, a company’s spin and has little idea of the machinations of corporate tax software. And whilst debt to equity alone won’t get you far without looking at the fundamentals, an in-check level of debt (and the servicing it necessitates) is a nice spec to have in your corner when screening for potential investments.

Criterion Number 7 – Gearing (less than 1 year) < 33%

We’re back on the debt, short-term this time and the ability to service it.

Gearing under a year shows the proportion of total short-term borrowings (those payable on demand or within 12 months) as a total of equity and debt. A company that’s running its day to day operations with a high level of short term borrowings can be operating in dangerous territory. Short term debt is usually more expensive to service and by it’s very nature can be called in on little notice. If a company can’t meet those calls then the there’s usually only a single outcome and it ain’t pretty. Running a highly (short-termed) geared operation is generally not seen as good management practice and fortunately it’s a practice that can be screened out.

Criterion Number 8 – Cash Flow to Debt > 0.20

Another debt-based criteria – anyone would think we’d had our fingers burnt by a company/companies that have succumbed to silly debt levels. Damn, they’re onto us!

For the record let me just state, there’s nothing wrong with debt. In fact it’s a key element in facilitating the growth of most companies – especially in those fledgling years. Problems arise however, when that debt can’t be paid back.

This criteria ensures companies are bringing in at least one-fifth of there total debt from operational cash flow each year. It doesn’t mean that cash will be used to service the debt but it’s a good place to start.

Criterion Number 9 – Cash Flow Retained > 0

Basically after all is said and done and everyone has been paid – including dividends to shareholders – this criteria ensures our company has at least a little cash flow that’s been retained. That is, there’s been a net increase in cash and cash equivalents for the financial period.

Criterion Number 10 – Operating Margin (%) > 0

Operating Margin (return on sales) shows the pre-tax profit as a percentage of turnover for the last reported period. Basically it’s an indicator of profitability and in our screen it ensures that whatever that company is doing it’s doing it for some profit.

Criterion Number 11 – Pre-Tax Profit x 3 > Debt

I can’t remember where I read this now but it was well argued at the time, so apologies for the lack of credit given. Anyway, we’re back on debt again and the ability to earn enough to cover it comfortably (although comfortably is a fairly subjective term).

Like all of the criteria I’ve touched upon here, this one’s a starting point and good basis for further enquiry.

Unfortunately, this criteria can’t be automatically screened using ADVFN but can be manually screened on any companies that emerge having successfully navigated our first ten criteria. Just get out the old calculator and multiply the pre-tax profit figure by three. If it’s larger than the debt figure, then we’re all good.

So there they are. Plugging these criteria in over at ADVFN will return in the region of 20 LSE companies. From there, the real work begins; sifting through the fundamentals of the companies returned and checking out the real story behind the numbers – not just taking for granted what’s been thrown up by a bunch of calculations. But more on that in the final part of this series, later this week.

Thanks again for dropping by.

Paul
rsvp@investorsoiree.co.uk