Stock Selection  

Selector’s stock selection process is sensible and consistent. The foundation for this common sense approach is the considerable industry experience of our portfolio managers. The stock selection process is termed “bottom up”, we focus on the business first, ensuring that investments are selected based on their individual merit. The portfolio is built stock by stock as each business is subjected to our rigorous stock selection process that generates our best ideas.

The 4 steps of stock selection.

i) Quantitative Screen

Selector initially applies a quantitative screen to a diverse range of companies across many sectors of the Australian share market. The deep industry experience of our portfolio managers provides a comprehensive in house research capability. We have a detailed historic knowledge of the bulk of the ASX Top 300 businesses and their management teams. The quantitative screen is a common sense model that has evolved over many years. It is designed to screen for 4 quantitative factors that the managers believe are primary indicators of the health and sustainability of a business.

Firstly, Selector seeks to measure the return on capital employed (ROCE) over a multi-year horizon. This ratio forms the core of our process for the simple reason that it reflects how well a company is utilising its capital to generate earnings, i.e. its franchise quality. Here we are focused on the ungeared return on total capital. The ROCE should be higher than a business’s total cost of capital; otherwise any new capital invested in the business will reduce shareholder value.

Secondly, Selector seeks to assess various measures of earnings quality of a business such as its cash flow quality. High earnings are not as important as high-quality earnings. High quality earnings are transparent, repeatable, controllable and importantly bankable. Earnings that are the result of large one off events may not be repeatable and are of low quality. Importantly, those businesses that generate earnings but not cash may not be sustainable. When we invest, we make sure the company is taking its earnings to the bank!

Thirdly, Selector seeks to measure the financial leverage of any given business. This is essentially a risk management tool. Our focus is debt. Debt may sit on or off the balance sheet. Examples of off balance sheet debt are the operating leases that the business is contracted to. The main output is a coverage ratio which measures the multiple that EBITA covers the total financing costs of the business. The higher the level of cover the more robust a business is to operational or economic setbacks.

The fourth quantitative screen Selector focuses on is the capital management of a business. This is a measure of management as “stewards of the capital” in the business. This includes share capital issued or bought back by the company, capital required to maintain the operating business and capital required to grow. This factor has a significant influence on the level of returns provided to shareholders.

The 4 measures of our quantitative screen dovetail. A business with a high ROCE and high quality earnings can fund their activities internally from cash flows without aggressive use of debt or ongoing issuance of new equity, convertible notes and other derivative instruments. That means tighter capital and consequently more earnings flowing to shareholders.

ii)    Best Ideas shortlist

The quantitative screen produces Selector’s best ideas shortlist from a wide range and variety of businesses. The shortlist is typically 30 to 50 stocks principally from the ASX300. Detailed qualitative research or “due diligence” is then undertaken on the ideas shortlist.

iii)    Detailed Qualitative Research

The portfolio managers undertake detailed qualitative research on each of the businesses on the best ideas shortlist. This starts with researching the business, its industry, channel checks of the competitive landscape and importantly management interviews. This is where the experience of our portfolio managers becomes our key advantage and where we wear out the shoe leather visiting companies.

iv)    Portfolio Construction

As a result of detailed research on the best ideas shortlist, a selection of 15 to 30 of our best ideas is identified for inclusion in the portfolio. Portfolio construction is the link between our research and portfolio inclusion. It combines sector exposure, liquidity analysis and position sizing with our stock ranking based on our BUYOUT ratio and our 18 point ROADMAP scorecard.

As a result portfolio construction relies on the extensive experience of the portfolio managers with oversight from the investment committee. Importantly, it is our portfolio managers, rather than investment analysts, who have undertaken the detailed research ensuring that high quality information is transmitted through the entire investment process.