“I don’t want to be the best coach. I just want to coach the best players”
– Ross Lyon, Fremantle Coach
The above quote stayed with me for a while. It helped me come to the realisation that I didn’t need to be Warren Buffett, the best investor in the world, I just needed to invest in the best companies.
Before we get to what makes a great company, we have to know the types of talent available for investors to recruit. Companies are defined by the choices management make. When a company achieves a profit, it has 5 options with what to do with the capital:
Pay a dividend
Invest back in the Business
Make an Acquisition
Pay down debt
Certain types of companies will make certain selections which will then classify them as a particular type of company. Let’s take a look at some of the types of companies available for you to recruit onto your playing list and the risks associated with them.
Blue Chip Stocks
The Patrick Dangerfield’s and Nat Fyfe’s of the world. These stocks have historically done the business. The best of the best. Their output is consistent, no matter the circumstances. In some cases, blue chips make so much money that they can implement all 5 of the capital allocation options described above.
The biggest risk with holding blue chip companies is the ‘she’ll be right’ attitude - thinking a company will remain a blue chip indefinitely. Generally speaking, the performance/output of AFL players tends to follow a bell curve - Brent Harvey being the exception. Performance improves, ramps up, peaks and if they go on for too long, output falls, sometimes gradually, other times rather sharply.
Woolworths (ASX: WOW) is a great example of a company that once dominated the grocery landscape, but is now struggling to compete with the likes of Coles, Costco and Aldi. This is reflective in the performance of its share price. Shareholders that saw the share price rise from $5 a share in 2000 to $25 in 2007 would have thought ‘how good is this!’. Ten years later, the share price remains at $25 a share.
“From a recruitment point of view, we are always looking for value. Value when drafting, recruiting and trading players”. - Brad Lloyd, Fremantle List Manager
Value shares are those that have experienced a form slump and are trading below their underlying value. Market sentiment can, from time to time, create a gap between the market value of a share and its intrinsic value. Money is made when the market recognises that value and re-rates the share price. A great place for the AFL industry to find value players is in the rookie draft or pre-season draft. Clubs give nothing up, except opportunity cost and a spot on their list. Did You Know? Simon Goodwin was pick 18 in the 1996 pre-season draft. Matthew Boyd from the Western Bulldogs was pick 23 in the 2002 rookie draft, and Aaron Sandilands also came from the same 2002 rookie draft. Blue chip players bought at bargain based prices.
If a share price is considered good value, it’s well worth management buying back shares in the company and reducing the amount of shares outstanding, lifting earnings-per-share for remaining shareholders.
There is something called the ‘value trap’ that you need to also consider. A company’s share price seems cheap - yet the underlying value of the company gets worse. Not every company, just like not every player, can reverse a form slump.
Every portfolio needs a Matthew Scarlett or a Stephen Silvagni. But modern football is all about defensive zone structures and the same holds true for your portfolio. Holding one quality defensive company won’t make your portfolio immune to a market downturn. Holding at least four or five will help.
Defensive shares are relatively immune to market and economic downturns because demand for the company’s service or product remains stable. These companies see no fanfare. No praise. They just go about their business producing stable results and reducing the probabilities of your portfolio experiencing severe losses.
The risk of holding too many defensive companies is that you might struggle to kicks a winning score with your returns when the market is rising. An example of a defensive company is AusNet Services Ltd (ASX: AST) which operates Victoria’s primary electricity transmission network, amongst other things.
Growth Stocks - The AFL Youth Policy
These are shares in companies that are young, growing sales (sometimes profits) at a higher than average rate. They’re usually young, small to medium sized and operate in exciting industries such as tech. Their best performing years are ahead of them. Option 2 (invest back in the business) and 3 (make an acquisition) are usually selected by management of growth companies. The aim of the investor is to find these next potential blue chips before everyone else does, give them time in your portfolio and wait for everyone else to take notice.
A great example of a current growth company is Afterpay (ASX: AFY) who has taken the lay-by concept online. Revenue went from $220,261 for the half-year ended 31 December 2015 to $6m a year later. The risk with growth stocks is that they have to fund growth from somewhere, and it is usually from debt.
They’re also referred to as ‘high-yield shares’. They tend to have a history of paying fully franked dividends and don’t reinvest a lot of the profits back into the business. Companies classified as this tend to be mature, where holding onto profits could actually destroy value rather than create it. Option 1 is the main option chosen from these types of companies.
Real estate property trusts (REITs) tends to fit this profile. The rent derived from the property tend to be paid out to security holders. The biggest trap income-seekers fall into is buying shares in a company because of a high dividend (which is derived from profits) however the company earns less profits than expected, impacting the final dividend figure declared.
Some players only look impressive when the overall team is performing well (aka downhill skiers) – I won’t name any names. it’s the same with certain types of businesses that need the overall economy to be performing for their numbers to be up to scratch. Examples of cyclical companies are those that belong to the retail, building and media sectors.
A risk associated with cyclical stocks and capital deployment is re-investing back into the business at the wrong point of the cycle. Or alternatively, making an acquisition at the top of the cycle. Anyone remember BHP Billiton offering over $100 a share for Rio Tinto?
I refer to them as ‘X-Factor’ shares. The opposite to blue chip shares. They’re considered high risk and for good reason. They don’t have a history of returns, and are more full or promises rather than profits. If they come off though, they can really move the needle on your performance.
Since speculative shares usually don’t make a profit or pay a dividend, the risks associated with them speak for themselves. Don’t make the mistake of allocating too much of your capital to such shares. Such shares tend to also occupy a lot of your mindset. When it comes to client portfolios, a speculative share might represent 2% of their overall portfolio, however they have the tendency to spend 98% of the time worrying about it.