As investors go about their routine of screening and searching for viable investment ideas, I felt it would be useful to highlight a few important filters to make use of. The idea is to save as much time as possible when screening so that we do not end up spending unnecessary time on companies with poor prospects, but can instead devote our attention to ideas worth working on.
Filters are defined as screening tools used by investors to eliminate unsuitable companies, and consist of financial and operational metrics. Investors are free to set their own tolerance limits on what they feel is acceptable or not. Here are five important filters which investors can use, in no order of preference.
1. Profits or losses
One key filter which investors should use is whether the business is generating profits or incurring losses. As a rule, I usually eliminate companies which incur persistent losses, and not just base this on one year’s financial performance. There are also cases where a loss may be incurred due to a one-off large impairment or write-down of an asset or acquisition, and this should be adjusted accordingly to obtain the core profitability of the business. Cyclical companies may also incur losses due to being at the low of an industry cycle, but if the company is financially sound, it would be able to recover in the later years.
2. Consistent negative free cash flow
A business which generates constant negative free cash flow is one which relies on external financing for daily operations. This is a characteristic which should make investors sit up and take notice, as it indicates a big red flag. I normally use the average of 5-years of free cash flow data to conclude on the consistency of free cash flow generation.
3. Elevated levels of debt
High levels of debt are yet another filter which investors can use. This is measured by using the debt-equity ratio, and also looking at the times-interest earned (defined as the operating profit divided by interest expense). If the debt-equity ratio is higher than 50%, this usually rings alarm bells for me. Times interest earned is a metric which measures how much of the finance costs of the company is covered by its operating profit; the higher the number, the better.
4. Serial acquirer
By studying a company’s recent history, an investor will be able to deduce if the company relies mainly on organic growth or acquisitive growth. Companies which are serial acquirers present a higher level of risk, in my view, as they need time and resources to integrate these new acquisitions into the group. There is also the possibility of over-paying for such acquisitions, while some acquisitions may turn out to be lemons, creating a further drag on profits.
5. Frequent changes in top management
Staff turnover is fairly normal at the rank and file levels, but if this occurs within top management ranks, it qualifies as a red flag. Frequent changes in management may signify a deep-rooted problem with the company’s business model, which drives away management who cannot find a solution for it. Poor practices and governance issues may also be some other reasons why companies cannot retain their C-suite management.
The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.