He says in order to build a world class portfolio investors should use their common sense and follow a relatively simple and low risk strategy as some of the most successful investors have beaten the market by using this approach.
John Kingham is the managing editor of UK Value Investor, an investment newsletter for defensive value investors which he began publishing in 2011 after leaving the computer software industry.
With a professional background in insurance software analysis, Kingham’s approach to high yield, low risk investing is based on Benjamin Graham’s philosophy of being systematic and fact based, rather than speculative. Kingham is also the author of a popular investing book,
“The Defensive Value Investor: A Complete Step-By-Step Guide to Building a High Yield, Low Risk Share Portfolio.”
In his book, Kingham explains how to shortlist shares for investment with the best combination of quality, value, income and growth. He also advises investors on how to conduct a thorough qualitative analysis, timing of buying and selling of shares, and how to combine investments into an easily manageable portfolio to reduce risk and increase returns.
Kingham suggests 10 steps that investors can follow for investing in the shares of high quality businesses. Let’s take a look at these steps.
1. Take a long-term view
Kingham says investors should take a long-term view of any investment that they make.
“Generally long-term is taken to mean five years at least, and I think that’s a reasonable minimum. Why so long-term? Because of the way the stock market generates return,” he writes in his book.
Kingham says if investors focus on the short-term almost all of their gains and losses will come from valuation changes which are by their nature unpredictable.
He says focusing on the long-term instead means dividend income and growth become much more important than the day-to-day ups and downs of the market, and finding a company that can grow its dividend is much easier than finding a share which will go up next week.
2. Stay diversified
Kingham says no matter how much research investors do into a company, they cannot know for certain how it will perform, or what the share price will be in the future. Hence investors should diversify and put their eggs into many different baskets.
Kingham says beyond just the number of investments there are other factors which can be diversified too like industry and geography.
“Companies within the same industry are often affected by the same kinds of issues, so diversifying across many industries can reduce a portfolio’s risk. If a portfolio is diversified across many industries, anything that affects a single industry will only have a relatively small effect on the portfolio. The same thinking can be applied to geography, where a local problem (a recession, earthquake, epidemic, etc.) will have a smaller impact if the portfolio as a whole generates its earnings from across the globe,” he says.
Kingham says risk reduction is also important through diversification because investing is a long-term game.
“If your portfolio is relatively low risk because it is well diversified, you stand a better chance of sticking with equities for the long-haul,” he says.
3. Look for high yield shares
Kingham says dividend income is clearly a very important part of total stock market returns and the obvious way to measure income is by the dividend yield.
According to Kingham on its own the yield is often misleading and it is just as important that the dividend be sustainable in the longer-term, and that preferably it has a good chance of being increased.
“That’s why yield shouldn’t be looked at in isolation, but should instead be considered alongside a company’s ability to pay that dividend, consistently, for the long-term -In other words, its quality,” he says.
Kingham says there is another problem with a simple dividend yield as by looking at today’s yield investors could miss situations where a company has cut its dividend for a short period, perhaps because of a one-time crisis.
“A better approach may be to look at the share price relative to the company’s dividend payments over the last decade. The more dividends that have been paid relative to the current price, the better,” he says.
4. Look for growing companies
Kingham says growth is a friend of the long-term investor and without it the value of any business and the income from it will be eroded by inflation.
“The most important thing is a company’s ability to pay a growing stream of dividends in the future, since ultimately the value of all investments is based on the cash that will be paid out. But we cannot know the future,so we have to look to the past for guidance,” he said.
Kingham says a company that has produced consistent growth in the past is more likely to produce consistent growth in the future and growth over a handful of years is not reliable enough to be used as a guide to future growth.
“Look at growth rates over a ten year period.This will pick out those companies that are growing over the long-term. Dividend growth is what we’re really after, so it makes sense to look for dividend growth over the past 10 years. Dividends are supported by earnings, and earnings come from sales, so it’s also a good idea to look at the growth of sales and earnings over the last 10 years too.All else being equal, a higher growth rate is better,” he says.
5. Look for high quality companies
Kingham says the problem with looking back into the past in order to have a clearer view of the future is that the past can be misleading.
“Sometimes a company will have strong 10 year growth, but it all came in one or two years. This is not reliable, defensive growth. What we want instead is consistent, repeated, high quality growth,” he says.
He says companies that have been consistently successful in the past are more likely to be consistently successful in the future which means that the past growth rate is likely to be a better guide to the future growth of the company.
“Companies that consistently produce growing profits and dividends are usually considered high quality companies.To measure a company’s quality, look at how often it has been profitable in the last decade, and how often it has paid a dividend; the more often the better. Then count how many times it has increased sales, earnings and dividends in the last 10 years; again, the more often the better. By focusing on high quality, high yield companies that can consistently generate market-beating growth, you will be well on the way to creating an outstanding portfolio,” he says.
6. Look for low prices relative to earnings
Kingham says one of the main tools investors can use to value shares is the PE ratio.
“Valuations cannot go to infinity, and they don’t go to zero unless the company goes bust. So, in the long-run PE ratios tend to hover around a medium value, typically somewhere in the mid-teens, although of course they can go much higher or lower in the short-term (creating buy-low and sell-high opportunities for sharp investors),” he says.
According to Kingham, the standard PE ratio has its problems though as earnings from one year to the next can be quite volatile.
So he says that a better approach is to compare the share price against an average of the company’s earnings over a number of years, rather than just looking at a single year in isolation.
7. Avoid excessive financial obligations
Kingham says no matter how prosperous a business may be, if it has too much debt it can be like a time-bomb waiting to explode when something goes wrong.
“Debt is one of the main corporate killers. Fortunately, many of the best companies don’t need to use lots of debt to generate outstanding returns for shareholders.It’s also true that some companies can handle more debt than others. Generally, the more cyclical or volatile a company’s earnings are, the less debt it should have.Stable companies, like supermarkets or utilities,can handle more debt. Although this doesn’t mean that they should handle more,” he says.
Kingham says there are various ways to measure debt in order to find out if a company has too much.
“You can look at interest payments, to see how well the interest on debt is covered by the company’s profits. If interest is more than 10 per cent of profits then it may be a good idea to see if the company needs, or can handle, that much debt.You can also look at the total amount of borrowings and compare it to profits. Some investors look for borrowings to be no more than 5 times the average profit of the past few years.The goal is always to make sure that a company’s debts won’t become too much of a burden if the company falls on hard times,” he says.
By focusing on consistently profitable companies which are conservatively financed, investors can avoid debt related problems.
8. Compare stocks against the market average
Kingham says most investors who pick their own stocks want to beat the market, either in terms of income, growth or both.
In order to beat the market over the long-term a portfolio must generate more returns from one or more of dividend income, company growth, and valuation changes.
According to Kingham, it is therefore a good idea to check potential investments against the market.
“You would generally want to see if a company has a higher dividend yield, lower valuation ratio, and higher, more consistent long-term growth rates than the market. It’s a simple case of comparing each of the four factors of high growth, high quality, high yield, and low valuation to the equivalent values for the market, in order to see how a given investment measures up. To be a truly outstanding investment, a share should be both cheap and from a high quality company,” he says.
9. Follow a systematic investment plan
Kingham says before investing in a company investors apart from looking at their earnings, dividends, debt levels also want to know something about a company’s history, what it does to earn profits, and how the company could develop in the future.
In order to successfully conduct this research, it’s important to use a checklist so that no steps are missed out or forgotten.
“There are many things that can be included on a checklist, but the main areas to cover are the company’s past, its present situation, and its future potential,” he says.
Kingham lists some questions investors may want to consider in their next investment analysis:
- Has it been in the same industry, doing the same thing, for a long time?
- Is the company in the market-leading group?
- Does it have a highly successful and profitable past?
- Has it been free of major crises in the last decade (if so, were they successfully resolved)?
- Does it have any obvious current threats to its economic engine?
- Does it have any durable competitive advantages?
- Is there any chance that its economic engine could become obsolete in the next decade, or that its industry could be massively disrupted?
10. Continually improve your portfolio
Kingham says once investors have filled up a portfolio with twenty to thirty high yield shares from high quality companies they should actively manage their portfolio in the same way that a gardener actively manages a garden.
“When grass grows too high, it gets cut back. In the same way, when a company’s share price grows more quickly than the company, it may no longer have a low valuation and a high yield. When this occurs it can be beneficial to sell,and reinvest the money into another company where the share price is low, and the dividend yield high,” he says.
Kingham says the process of improving a portfolio can easily be achieved by selling the least attractively valued investment in one month, and adding a better investment next month.
“With 30 holdings this will replace six of them each year, giving a 20 per cent turnover ratio and an average holding period of 5 years. Over time this process of continual improvement can add significantly to returns,” he says.
Hence, to create and maintain a high quality, dividend paying portfolio investors need to have a plan for each step, from finding and analysing companies, to sensibly diversifying their portfolio and deciding which shares to hold on to and which ones to sell.
(Disclaimer: This article is based on John Kingham’s book “The Defensive Value Investor.” )