At Totus we look to buy good businesses with tailwinds for earnings growth into the medium term. Generating new stocks ideas that meet our criteria is difficult and requires us to cast a wide net. We read widely, organise numerous company conference calls, attend company meetings, travel to conferences and speak to industry contacts. In this wire we identify another way to generate ideas that has delivered two great short-selling ideas in recent months, and also show you two methods for filtering investment ideas to determine the best opportunities. We then illustrate our processes with one high quality stock that has recently passed our filters, is generating significant amounts of cash, trading on just over 13 times earnings, and is also paying a 5% dividend yield.
Whilst there are no short cuts to this hard work, one of the things we study is the buying and selling of company insiders. This strategy has been particularly fruitful on the short side of late, as we have seen a number of large sell downs from private equity and company founders immediately prior to large downgrades. Recent examples that come to mind are Estia and Vocus.
Once we have an idea we then apply financial filters to assess the quality of the business. We first filter for the historic return on invested capital, which is usually a good indication of the competitive dynamics within an industry. We are looking for businesses in concentrated market structures with high barriers to entry. Secondly we look at the historic free cash generation in order to understand the capital intensity of the business and how much cash it generates relative to accounting profit. These two filters enable us to quite quickly focus on the highest quality businesses amongst the ideas that we generate.
One stock that has recently passed our filters is Smartgroup (SIQ), which is a leading provider of employee benefits and workforce optimisation services. This is a business that has high reputational barriers to entry. It is capital light and generates a significant amount of cash. Furthermore, the Chairman has been buying material amounts of stock on market as recently as one month ago. We see regulatory risk as significantly reduced for the sector post Federal Labor’s May announcement of its support for the current FBT regulatory regime. Putting this all together, we can’t find any businesses of comparative quality trading at 13.5x CY17 earnings with a 5% dividend yield.