Methodology

Introduction

As part of our investment research process, we have adapted the value-based investment approach developed in the mid 1960ties and still utilised to this day by a registered US-based investment advisory firm, which also publishes a regular investment publication.

They have developed a proprietary investment strategy for US shares, which allows them to pinpoint specific entry and exit points with regards to dividend paying companies.

While we believe that some of their screening and valuation methodologies are not appropriate for UK listed shares, their overall investment strategy appears to be sound.

Their investment strategy is based on Dividend Yield Theory, which follows a value-based approach to investing. The Theory states that when a company has a historically high yield, investment capital is attracted to the stock causing price appreciation and when a company has a historically low yield, investment capital flows out of the stock causing price depreciation.

Focus is on high quality companies

Their investment strategy weeds out lesser ‘solid’ companies from the highest quality companies. The later ones are the companies with solid and reliable long term historic track records based on a number of valuation metrics.

It’s the highest quality companies that have survived numerous economic cycles without cancelling dividend payments. It’s these types of companies that have the resources to:

  • attract the best managers

  • invest in ongoing research and development of new products and services from which additional sales, earnings and ultimately dividends grow.

In the main, it’s these company’s products which are well known, widely used and perceived as ‘best value’. Their services are regarded as the most trustworthy. Most of them are (increasingly) present in lesser-developed countries, where growth potentials are still extraordinary.

These are also the companies whose sales, earnings and in some cases, dividends grow continuously throughout virtually all economic conditions.

Finally, it’s these type of companies whose Boards recognise the importance of paying dividends, even in periods of major economic and market upheavals when their share prices are often unnecessarily ‘depressed’, creating potentially great buying opportunities.

Understanding quality and recognising value

Ultimately, quality is revealed and reflected in managements’ ability to grow and guide a company through the inevitable economic up- and downturns as well as the competitive business environments in which their companies operate.

The only reliable way for investors to recognise an excellent management team, is by their long term financial performance and its continuity – in particular by their ability to increase net earnings as well as dividends over long periods.

Financial performance is the obvious measure of quality. This includes measuring a company’s record of earnings, dividends, debt-to-equity ratio, return on equity, dividend payout ratio, book value and cash flow.

Investment performance, as measured in long-term capital gains and dividend growth, is the most important objective of any long term total return investors.

High quality companies clearly have a reputation for dependability. One that has a long history of corporate excellence.

Paying rising dividends for an extended period of time, plays a very important role in determining a high quality company. Dividends will not be maintained or raised if future earnings are in doubt.

How to recognise high quality undervalued companies?

In order to identify fundamental quality, we have adapted the selection criteria of the aforementioned US investment publication as follows:

When combined into one “filter”, most shares are eliminated from our investment research process. If a company meets all six criteria, it’s clearly a high quality company that merits investment consideration.

Of the six criteria, the level of institutional ownership is the least rigid. What is important though is evidence of widespread institutional interest in a company.

What next?

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