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Some things to look for before making a direct share investment

Article by Richard Whan

What sort of things should a potential investor look for before investing in a business?

First and foremost is the integrity and ability of management. If you cannot trust the people making the decisions for a business it would be foolish to invest in it. But how do you go about assessing the calibre of management?

Track record is clearly a good place to start. Not just what the management has done, but how closely it accords with what it has said in the past that it would do. If it has said it will do something and subsequently fails to, without an appropriate explanation, you would have to start asking questions about it.

I also like to look at how much the directors and executives have invested in the company – and I’m not talking about options that have been granted free by the company or are financed by the company with non-recourse loans (which in at least one notable case were not repaid when the share price ended up underwater), but rather in shares that they have brought with their own money. This information is available in the “Directors’ Report” part of the company’s Annual Report.

In fact the Annual Report is essential reading for anyone considering investing in a business. The three financial statements – financial performance (P&L), financial position (balance sheet) and cash flow – each provide different perspectives on the same financial entity and, when used together, can be build a fairly complete picture of an enterprise.

The profit figure generally receives the most attention, but as a lecturer of mine once said, “profit is for accountants – you can’t even buy a beer with it – you need cash for that”. Profit can be “distorted” in a number of ways. Sales can be brought forward and expenses deferred to reflect favourably on the current reporting period.

The “operating cash flow” line of the cash flow statement is a useful check against the net profit after tax in the statement of financial performance. If there is a sizeable difference between these lines you should investigate the reason for the discrepancy.

The balance sheet is simply what the company owns and owes at the balance date. One of the important things a balance sheet can tell us is whether a company is able to pay its bills. Current assets are assets expected to be turned in to cash within a year, whilst current liabilities are debts that need to be paid within a year. Current assets include cash, receivables (money owed by customers) and inventories, whilst current liabilities include accounts payable (money owed to suppliers), tax liabilities (money owed to the tax office). If the current liabilities are more than the current assets you might want to look at how the company is going to pay its bills.

You should also take every chance you can to be at presentations by the company’s Board and management. The Annual General Meeting is the easiest of these to attend and, although companies and their PR consultants try to stage-manage these as much as possible, it is the one guaranteed opportunity each year to see the whites of the eyes of the directors and executives.

These events are often more illuminating in difficult times than when conditions are unchallenging. Does the Board and management squarely accept responsibility for the results or do they attempt to blame anything else - the effect of the Olympics/the introduction of GST/SARS/9-11/the tsunami/the rising dollar/the falling dollar/rising oil prices irrespective of whether these factors have any relevance to their business or not? (As a corollary it will be interesting to note how many resource company Chairs will admit their positive results this year - 2005 - are due solely to their dumb good luck that China’s demand for resources continues to grow at unsustainable rates, shortly after a period during which resource companies had all but abandoned exploration and development, and that prices have risen accordingly.)

These are just some of the things you should look at before investing in a business. Of course the longer you have followed the fortunes of a business the better you will be able to incorporate new information about that business – to distinguish what really matters about that business’ prospects from the noisy chatter of a capricious market.