Putting it all into practice and conclusions

Hello, I'm Russ Mold, AJ Bell's investment director. Welcome to this series of six short videos designed to help you understand companies, how they present their numbers and not just the science of those numbers, but the art of interpreting them. Cutting through the complexity, the noise, and seeing how they then, over time, can shape a shared price and how the company, through its strategy, its management
can also, over the long run, affect its share price.

And all of this may help you in the very short term in terms of trading but it can definitely help you over the long term. We would like to think, taking into account such issues such as valuation as you assess, not just reward, but risk when it comes to individual companies, or even a passive or an active tracker fund of an index, or indeed a professionally managed phone that leans in a particular strategy or direction.

So we've already talked about it price and sentiment, value and fundamentals. They are a little bit different. One, you can argue, leans more price in sentiment. You can argue leans more towards trading, which may well work for you. Again, it's looking at what works for you and your strategy, your personal research process and your own personal time horizon.

Target returns, appetite for risk. Then the counts, as we discussed constantly in our head, to help there a way of keeping score. But that just a flash point. Just a bullet point. They need to be interpreted over time and the need to be assessed. Profit and loss account plus cash flow plus balance sheet and all of that that needs to be assessed in the context of strategy and then share price valuation.

Because in the end, very crudely, and I say very crudely, multiple times earnings equals share price. Price times earnings, equal share price strategy, governance management balance sheet predictability, growth will all shape the P the multiple. The E will come from key performance trends, the strategy, the company economic cycle growth cycle of product cycles, lots of other things that we've also talked about.

So multiple times earnings equals price. Multiple can move around according to how bullish or less bullish a business is. Investors. If you think about a business the E will move up and down according to all sorts of different things as we've discussed, but generally price times, volume minus cost. And so keep a checklist of the key performance indicators.

The key things that move the PNL, the cash flow and the balance sheet. And you're going a long way. Then you're looking at what will really help you perhaps pick an opposite entry point, an opposite exit point if you need one for a stock. So now we're going to give you some practical, historic examples before we do that, of probably of all the slides that you've seen, if you've very kindly sat through all six videos, this might be the one you're really waiting for.

The ultimate checklist, the scratch and sniff list, as it were, of good things to look for, things to probably avoid, or at least pay a very low multiple for if you really want to take the risk. Because of course they could get better and then the multiple will start to go up. Maybe the earnings will as well. Strong cash flow, high operating margins, exceptionals that are exceptional, that don't crop up every single year.

Growth is definitely better organic and it's definitely better if they sell, if they try and do something better, company, try to do something better, not cheaper. They don't rely on joint ventures because they they keep the cash flow locked in them. And you need decent interest cover and dividend cover, ideally above two times in both earnings and cash flow.

The stinky things. These are the things you really got to be very aware of sales, profit and cash flow growth. It's out of sync, particularly over time. Gibberish. Footnotes. Trying to explain things. Restatements. Again, we've praised companies for their transparency. If there's opacity or complexity, you need to think about what's being fudged and potentially why. And if you don't understand it, just walk away.

There's no there's no obligation to play it. Sometimes high margins are nice, but if they're too high relative to peers, are they up to something? Patisserie Valerie, which went bust, was making operating margins double lows of Starbucks really operational, plus financial gearing. Again, how much does profit change relative to 1% change in sales? Add that to a lot of debt.

Remember that the interest has to be paid. Doesn't matter whether profits are high or low. So again there's you're going to pay a lower multiple for business with both just because the risks the upside is potentially higher. But the downside is potentially higher. And also watch for things like off balance sheet liabilities. Not so many of them now because leases are on balance sheet, but the bit contingent liabilities, legal liabilities and other things buried in nil 52 down the back of the accounts.

The small print really matters, as we'll come onto in a minute. Stick with those five things on each side. They'll probably spray a good degree of pain. So here's a practical example. We've talked about how a lot hundred company consistent growth profile, high margins, good dividend growth track record running about 40 odd years. So it's doing something right okay.

Now this is not again investment advice or recommendation because the share price moves up and down a lot. And valuation is a key part of that. But look over time consistently growing cash flow, high margins, all builds nicely paid dividend growth, good starting point. You still have to think about valuation. Are they going to do anything that changes that.

Hopefully not. But again not a bad starting point. And again you can see here that little rule of three of my friend Michael Cahill revenue growth, operating profit growth, cash flow growth over time pretty much. Thank you very much. All nice and clean and good cover for the dividend. Good cover for the interest bill. Happy days doesn't mean the share price goes up all the time, but it's a premise that's at least a helpful one.

And again, you've got here look look at the net debt to equity ratio. There's just not much debt on there relative to the equity. And again with those high margins it can pretty comfortably fund any interest payment that it's got off. Pretty straightforward a nice simple company. Well it's a well-run company. And there over time is the share price.

And again this proves my point. Even a really good company isn't always the right, isn't always a buy. You can argue because there are times when investors get too excited and perhaps pay a wrong multiple. So again, there's always that fair price thing of mungus from that checklist that we talked about in an earlier video, Imperial Brands. Now, I've put this in there because it's controversial.

Some investors will run very strict environmental, social and governance schemes. And what such tobacco with a ten foot stick some will just take the view. Well, I'm here to make money, protect my wealth, accrete my wealth. I'll do it anyway I want to. That's something that you can decide. But what's really interesting here is look at how operating free cash flow has been relatively consistent over time, and the market doesn't believe that could be possible because stick volume cigaret volumes are going down.

Yet through pricing power and cost cutting, it's been able to pretty much maintain that operating free cash flow, which has surprised the market. And we'll come on to the effect that's had on the share price in a minute. But looking at the dividend, there was a target under a previous management team to grow the dividend by 10% per annum.

Remember cash flow was flatlining. They were doing, I think, a good job to manage that. At some point cash flow of of the division got skinny and they were also at the same time looking to invest in next generation products. Something had to give and it was the dividend. The daily was cut. Now the dividends growing again, and the fact that now the company feels sufficiently flush to run share buybacks, which is what surprised the market because it managed to keep cash flow fairly stable despite the decline in stick volumes.

But again, over time, after a bit of a wobble looks that if cash flow and profits are growing back in unison again. So you can see how that picture can change. But even something is as innocent as a 10% target. To grow the dividend every year ultimately causes company a lot of pain. The balance sheet isn't necessarily pristine, by the way, because there's been some big acquisitions in there and some big asset writedowns to equity growth hasn't fit that fitted the bill if we remember that one from earlier on.

But again, look at the pain that that was caused by that cut in the dividend, but also how the share price has begun to respond as cash flow is stayed flat despite this decline in sticks and the dividends begun to be rebuilt. And again, a fundamental understanding of the business model, the levers available to management price times volume minus cost equals profit.

How that converting to cash flow would have given you a really interesting perspective on Imperial Brands, both when things were going wrong and then when it turned around again. Now it's up to you to decide how that picture will look going forward, because I'm sitting in a position to give you any investment advice. Now, here's another one. This is a company that's been growing like Below Midwich.

It's a distributor of audiovisual equipment. So it's inherently a relatively low margin business. Okay. Because it's a distributor. A distributor doesn't make the stuff itself, but nevertheless, it's been growing the business. But how? Acquisitions, that's not inherently a bad thing. The business has grown like a rocket. Profits have gone up, but net debt has gone up. As you can see from the bars, there.

And look how the markets responded. There's been fantastic growth, but the market has gone okay. Your E has gone up. But I'm going to mark your M or your P down because of the risk associated with the debt. And as it now turns out, the things coughed up a profit warning okay. So and again that's a challenge because it's still got the interest of to pay.

So yes lots of growth. And I'm not knocking management but it's a very fragmented market. There's lots of opportunity there. But the market didn't like the profile. The growth was it didn't like how it was achieving it. And again this is what we mean about three dimensional picture profit and loss account, cash flow balance sheet numbers, strategy and valuation.

This is a classic example. And it's a small cap stock. I won't read this. Pause the video and read it and you'll the heart will bleed. You will weep. This was a this was into server company that went bust a 4250 company. If you encounter this sort of stuff in a set of reporting accounts, I'm not going to give you any advice, but it's not normally a great sign.

It's all I'll say. And Carillion, we've done this example already again, of how look how thin the operating margin was relative to sales. If anything went wrong, cash flow was already brittle. It was going to get even more brittle. Was wasn't really covering the different anyway. So Carillion was not a certainty to fail. But when something went wrong there was no margin for error.

And this is the point. This is what this research is there to help you with. Build in that margin for error. Build in your protection while at the same time finding upside. Carillion may be able to turn it around and get those projects going. There could have been zoom the other way, but it didn't pan out that way.

And again, that one went badly wrong. And again, the 3D view profit loss account, cash flow balance sheet numbers, valuation strategy would have help you sniff out what turned to be wrong. And they're just for record or into certain carillion's share prices. So we've hopefully pulled it all together for you across six videos. It's not I'm not going to pretend to you this is not easy.

It takes time and doing your own research while it brings its rewards does need time and there's no shame in saying, actually, you know what? I'd rather watch the telly and pay for it. Managed to do it for me or buy an index. Track it. It's there's no shame in that. There really is. And I've been doing this for 30 years and I'm still learning every single day.

But it can be done. And if you want to pick your own stocks or your own funds, this is the kind of research that you really need to be doing to measure reward with risk. Upside from the profit and loss account quality from the cash flow, downside from the balance sheet protection. That is what you're really, really looking for.

Again, this difference between sentiment and price and fundamentals and value their accounts that great the helpful. But they're a starting point only. They only cover a short period of time. They're backward looking. They are prone to embellishment because management teams have incentive to please the banks. Their shareholders trouser their bonuses. I'm not accusing them of anything illegal, but
we're all inhuman.

And again, as Mr. Monger says, if you know what the if you know what the incentive is, we can have a pretty good guess of what the outcome would be. So a checklist will really help you here. What's the investment case? Five points. If they've all been ticked off then either maybe the share price has gone too far, or maybe there's another new five points.

Keep a checklist of key performance indicators and sensitivity and keep a checklist for valuation. Why do I think it's cheap? Why do I think it's expensive? Where's my downside outweighing my upside. And those things will help you now last ultimate checklist. Pause the video. This is maybe the holy grail of the good and the bad. The ugly, longer version of the 5.1 that we did at the start.

So pause the video. This will help you hopefully about an awful lot of trouble. Now, the problem that I think you'll find, by the way, not many companies actually fit all ten. Those that do are probably quite highly priced. You probably will be. The good news is you're cutting out an awful the stocks that you'll never touch. The bad news is there will be times when they go up anyway, and you just have to overcome fear of missing out if you really want to stick to the fundamentals.

But again, that's what's going to work for your particular process. Thank you very much for your time. I hope all six videos were useful and if this popular demand might come back to you on valuation a one day.