Investing in equity markets for many can be an emotive process. Some investors may avoid certain companies or sectors where perhaps they have suffered previous losses, while others may invest in companies or names they are familiar with. Despite their preferences, investors have often told me that they only like to invest in ‘good’ companies. 
Naturally this leads to the argument of what constitutes a ‘good’ company - is it an investment perceived as having low risk or a company that is expected to outperform its respective index? Is it possible to construct a portfolio with more favourable risk/return characteristics than a traditional benchmark?
Traditional finance states that financial markets are completely efficient as the market participant knows every piece of information and always makes rational decisions. Conversely, behavioural finance states emotional biases can affect investors when making investment decisions. For example, some investors might suffer from the ‘endowment’ effect of having inherited a stock position from a family member that they may be reluctant to sell. Investors may also be influenced by behavioural biases such as conservatism - not updating their view on a company after news that would contradict their current opinion. Performance figures show that managers can not only outperform a benchmark but significantly underperform as well.
So how do we construct a portfolio of these so-called ‘good’ companies? Conventional stock analysis techniques are sometimes referred to as a ‘top-down’ or ‘bottom-up’ approach, or both together. In ‘top-down’ analysis, the focus is on selecting a group of industries and investing in the best companies within that sector, while ‘bottom-up’ analysis focuses on the company and its financial performance. One way to employ a ‘top-down’ method is to take a chosen stock universe, such as the S&P 500, and by using various criteria, eliminate unfavourable companies, while investing in those we hope will perform well.
Examining a company’s financial performance provides a good starting point for this process and over a period of five to ten years such an analysis can reveal valuable indicators to potential investors. For example, gross and operating margins may indicate if management has been effective if margins are in excess of the opportunity set average, or if the sector presents high barriers or economies of scale. By looking at the free cash flow of a company, we can observe what percentage of the profits generated is converted into operating cash flows and whether these levels are consistent. Such analysis serves as a useful determinant to identify which companies look more attractive than others. By using this technique, a list of companies can be compiled with strong and consistent financial performance.
Although this provides a starting point, it still doesn’t tell us whether a company is cheap or expensive relative to its current market price. In order to determine this, we could discount future cash flows, either cash flows the investor would receive as dividends or free cash flows generated by the company itself. As with any type of forecasting model, the output is only as good as the input data, and by using sensible assumptions we can arrive at a value - or range of values – that reflects the company’s worth.
This type of analysis can also useful in determining what the market forecast is for the future financial performance of the company. When attempting to determine the value of a company we often have to assume a terminal growth rate i.e. having made financial assumptions for five or ten years, what do we expect the growth rate of earnings to be after this period to perpetuity? The lofty valuations we saw in the Q3 2018, especially in some of the US technology names and smaller UK companies, had priced in very high levels of earnings growth, so high some investors might have said those levels weren’t sustainable in the long run.
Companies that can consistently generate higher than average returns on reinvesting cash flows may trade at a premium as the market is anticipating continued financial growth. Strong financial performance should, in the medium to long term, be reflected in the stock price with short term market distortions providing a good entry point to add to portfolios.
By putting these methods together, we hope these companies continue to post strong financial figures and their share price performs strongly over the long term. Such a strategy based on outperformance, often referred to as an active strategy, will not suit every investor, as many will simply want to mirror a benchmark index.
Kevin Balakrishna is senior portfolio manager at Thomas Miller Investment. The views expressed above are his own and should not be taken as investment advice.