“Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years" Warren Buffet
Recently we outlined our case for the benefits of long term investing, thus thought it was appropriate to highlight the benefits of a bottom drawer stock. Whether you are investing for your children, your grandchildren, or for your own nest egg, there is a place in any equity investors’ portfolio for a reliable, steady compounder. A bottom drawer stock might not double tomorrow, but it should provide solid returns over a long-time horizon – with lower downside risk. In this article we outline 5 signs to look for when picking a stock for the bottom drawer.
You are probably thinking this one is pretty obvious. And it is, on face value – but underneath there are several key factors to look for when working out if a business will be able to grow sustainably through economic cycles. The first thing to check is the industry in which the business operates – will it be around in 10, 20 years’ time?
Stocks in industries going through periods of significant disruption, such as traditional media, telecommunications, or unsustainable industries which face increasing headwinds from environmental, social or corporate governance (ESG) concerns such as coal mining, rarely belong in the bottom drawer. On the other hand, industries with long-term macroeconomic-driven demand tailwinds and monopoly-like industry structures are ideal places to look for contenders.
The business itself needs a sustainable and increasing competitive advantage (like scale, unique IP, brand strength or reputation) with the ability to fund its own growth internally through strong free cash flow generation.
We hear a lot about quality of earnings, and what that means. The way we tend to think about it is simply – how certain or risky are the earnings of the business? We want to find businesses with higher earnings certainty in order to avoid large surprises to the downside, and the subsequent capital destruction that can happen in just one day.
Traits such as diversity of product and customers, defensive or population driven demand, recurring or annuity-style revenue, and long lead times between order and sale are ideal. Quality can also mean clear disclosure of earnings and conservatism in presenting the accounts.
Finally, a company with quality and reliable earnings has the potential to provide shareholders with a consistent dividend stream, which has the potential to boost shareholders’ total return .
It is rare to buy a company with the above traits for a steal, however it is important not to succumb to overpaying, because in the long run your returns are defined by your entry point. A small or micro cap stock with a very high valuation multiple can indicate very high expectations for earnings which can mean a greater risk of disappointment at a later date. Therefore, a good bottom drawer stock is one that has a reasonable valuation and is not priced to perfection. There are certainly cases where companies in their early days or pre-earnings can be priced extremely expensively and then deliver outstanding returns – however this comes at too high a risk to be a bottom drawer stock.
Also, another consideration as part of the valuation assessment is whether the company has a valuation floor if things took an unexpected turn and the company’s results fall short of the lofty expectations. This could be the value of its tangible assets on the balance sheet (less net debt), or strategic value of its assets, for example, infrastructure or monopoly assets.
While a good compounder may transcend its original management team, there is no business that is immune to poor management. To invest your money into a company over the long-term requires trust in that company’s board and management team. One sign that management are there for the long-term and for the interests of shareholders is if they are large shareholders themselves and won’t be heading for the exit any time soon. Aligned managers will also want to build their bench strength so there are multiple, highly skilled company leaders waiting to succeed their predecessor when the time comes.
The way management communicate to the market is also important to consider. Be careful of companies that have historically overpromised and underdelivered or have aggressive accounting practices as this can be a red flag for a potential future downgrade.
It is not to say that a buy and hold strategy is the right one – nor does it mean that you should “set and forget”. Every investor needs to understand the current dynamics of the business they have invested in, and if the situation changes such that the original thesis doesn’t stack up, it could be time to sell the stock. A good long-term holding will consistently follow its strategy and should achieve its targets and guidance over time.
Potential red flags may be a management team venturing into non-core operations, or buying assets in different jurisdictions, or even spending capital on lower returning projects.
There is more art than science to picking a stock for the bottom drawer, and it is extremely difficult to find a company that satisfies every point. Admittedly, as with all investing, there is a bit of luck involved. But knowing the signs that support and hinder a stocks ability to stay in that bottom drawer is crucial to long term value creation.
Important Information: This material has been prepared by NAOS Asset Management Limited (ABN 23 107 624 126, AFSL 273529 and is provided for general information purposes only and must not be construed as investment advice. It does not take into account the investment objectives, financial situation or needs of any particular investor. Before making an investment decision, investors should consider obtaining professional investment advice that is tailored to their specific circumstances.