The final part of this series lists the final three characteristics that investors should look for in companies.
13. In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?
The question above sounds like quite a mouthful, so let me explain it in simple terms.
If a company has to raise funds through the issuance of new shares, it will result in a larger pool of shares, thereby diluting its earnings per share.
Hence, Fisher is saying that companies need to justify this form of fund-raising by ensuring that earnings per share grow at a faster pace than the percentage increase in the number of issued shares.
This question applies to growth companies that have yet to generate consistent free cash flow and have to resort to tapping on capital markets to grow rapidly.
To give a simple example, let’s say a company currently generates S$100 of net profit and has 100 issued shares, therefore its earnings per share (“EPS”) is S$1 ($100 / 100).
Assuming the company issues new shares for an acquisition, the total issued shares may increase by 20% to 120 shares.
The acquisition, however, may only bring in an additional S$5 worth of profits.
The new EPS would then be S$0.875 ($105 / 120), which means the company is worse off after making the acquisition.
Hence, businesses need to justify their acquisitions by ensuring that the net profit uplift justifies their reliance on capital markets to fund these purchases.
14. Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointments occur?
The question above relates to candour.
By nature, management teams are bound to promote their company to shareholders and highlight the good news as a way of generating interest in its business and shares.
As such, it’s rare to find management that does the opposite, being candid about the mistakes they made, and describing the problems they face.
Such candour is not a given.
After all, no one wants to be cast in a negative light.
Doing so would tarnish the reputation of the company and put off potential investors.
Still, this admission of errors will be good for the company over the long-term, even though it may have short-term consequences.
By recognising problems as they crop up and being frank about them, management is in a better position to tackle them and ensure that these problems are nipped in the bud.
Persistent denial of problems or sweeping them under the carpet does not help the organisation to improve its processes or get better.
Investors should be on the lookout for managers who can stand up to scrutiny when things go wrong.
A clear explanation should be provided and concrete steps proposed to rectify the problem(s).
The mistake should be viewed as a constructive learning experience rather than a topic to be avoided.
After all, no one is perfect.
15. Does the company have a management of unquestionable integrity?
There was a litany of fraud cases involving China-listed companies that IPO-ed in Singapore between 2004 to 2007 (now derisively known as the “S-Chips Scandal”).
Many of these companies had poor corporate governance and were staffed by people of questionable integrity.
It is therefore important for investors to question if management has integrity in their dealings, or if they are trying to pull a fast one on investors.
This question may not be easy to answer as it would take regular interactions with C-suite individuals to find out if they are indeed sincere, trustworthy and honest.
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Disclaimer: Royston Yang does not own any of the companies mentioned.
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