The world’s a big place with thousands of companies to invest in. But how do you pick the best ones?
Sustainable Growth Advisers principal George Fraise and his team look for companies that are good value from the perspective of business owners, as opposed to shareholders who invest in only a small stake.
“We think about it from the point of view that if we owned the whole thing, what would we be prepared to pay for it?” he says.
They use free cash-flow yield as a key metric in assessing value from that point of view (a measure of free cash flow divided by market capitalisation).
Free cash flow takes into account capital expenditure and ongoing operating costs, so it’s a better measure of earnings that will end up investors’ pockets. Friase and his team look for companies with at least two times free cash flow. In general, the lower the ratio the less attractive the stock.
“Growth is likely to continue to be scarce,” Fraise says. “It’s going to happen in some areas but not others, and you are going to have to be very selective about where you invest.”
The SGA analysts look for high-quality, high-growth companies. They are attracted to companies that have a dominant market share (which leads to pricing power); companies whose products are used frequently (as that leads to repeat revenue); and companies that have the potential to expand outside their existing markets.
The analysts pay little attention to price and earnings momentum because they aim to hold for the long term. SGA picks a portfolio of between 25 and 35 stocks, which they hold for three to five years.
And they don’t worry too much about the macro picture. Instead, they try to identify companies that will perform irrespective of economic conditions. That means looking for companies whose products or services are “woven through the daily lives of people around the world”, Fraise says.
Danish company Novo Nordisk is a good example. It specialises in the treatment of diabetes and accounts for 4 per cent of SGA’s global portfolio. Diabetes is becoming more prevalent worldwide as emerging nations become more affluent, creating a massive market opportunity. Fraise says the market for the company’s products will grow regardless of China’s economic growth rate.
French yoghurt and food producer Danone is another example. It has been hit lately by its exposure to European markets but Fraise says it’s still a strong company with growth potential.
The company holds a huge share of the global yoghurt market and also produces baby nutrition products. China is one of its key markets for baby nutrition with Chinese consumers prepared to spend big on products that will help their children grow up healthy and bright.
The company has a solid market position in Russia, too. Some 51 per cent of its sales in 2011 came from emerging markets.
Another company which Fraise expects to grow regardless of economic conditions is Brazilian beer and soft drink producer Ambev. SGA has 3.1 per cent of its portfolio in the stock.
Ambev has caught the eye of Stephen Thornber, fund manager at Threadneedle Global Equity Income. The stock has been in Threadneedle’s portfolio for five years and fits with the macro themes that the manager has been following: emerging market growth and consumption.
“[The company has] a high and sustainable dividend yield, growth, and a sound financial structure that supports both the growth and the dividend,” Thornber says.
Fraise says the easy availability of information about stocks and markets, and the ability for hedge funds and others to trade with incredibly high frequency does make markets more efficient in the short term – but not in the long term. There are still numerous opportunities to identify companies that have been mispriced by the market on a long-term basis.