Aviation
Oil production
Food
Anyone who now thought "food" was intuitively correct. But why? A proverb says "you always drink and eat". This is very striking and also misleading but gives a first clue. And of course, it doesn't mean the other two can't make quality companies, but some sectors are very sensitive to economic cycles. This means that in phases of economic downturn there is less demand for the product or service provided. The result: profits plummet. This applies to the sectors whose services are most likely to be dispensed within crises. Holiday trips, expensive sneakers, the new car, etc. It is difficult to do without food or medication.
Let's take a look at the following 3 industries. Which of the 3 would most likely produce a quality company?
Stable business model
Sectors whose business is largely independent of economic cycles or political influence generate more stable and predictable profits.
Stock selection criteria to create your own basic portfolio
When it comes to building a stable basic portfolio as the foundation below your fully managed Penta Portfolio, you can choose between an ETF that simultaneously invests into thousands of stocks at once. You can also buy single stocks which gives you complete freedom over your investment decisions. Yet, it leaves you with the challenge to identify the appropriate stocks at which most private investors fail. Here we describe what to consider when it comes to the selection of single stocks.
Castle moat
Companies whose business is well secured against the entry of new market participants have a high level of negotiating and pricing power.
Fundamentals
Companies that are characterized by high and constant profitability and are able to increase sales and profits in the long term tend to be less susceptible to crises.
Sticking with our examples: What else could be a problem in aviation apart from the cycles? Who flies exclusively with the same airline? Low-cost or business class?
Aviation is a highly competitive industry. New airlines are constantly entering the market, the price war is brutally led by low-cost carriers, and customer loyalty tends to be low. Added to this is the dependence on the fluctuating price of oil. This makes for low pricing power and high competition. Not good conditions for long-term success. This can also be seen in the price development of airline shares. Over a period of almost 40 years, the German Lufthansa share has developed sideways with major fluctuations. Anyone who bought it more than 20 years ago would still be sitting on losses.
The complete opposite is the Mastercard share, which has increased a hundredfold in less than 20 years. The company benefits from the fact that the international credit card business is virtually a duopoly (Visa, Mastercard) with a few niche players (Diners Club, AmEx). The entry of new competitors is cost-intensive, customer loyalty is high. This enables Mastercard to define transaction premiums more independently and to generate high and stable margins. The credit card business is also not "physical" in the sense that oil production is. Investment costs tend to be lower and you benefit from economies of scale.
This also applies to to the automotive industry. Tesla or Rivian are the best proof that the road to mass production can be very long and very rocky. On the other hand, most companies like Ford, General Motors, Daimler or BMW have established structures that have proven themselves for more than 100 years. The problem for all of them, however, is again the cyclical nature of the business, the high level of competition and the sometimes strong regulatory influence of politics (keyword: emissions regulations).
The decisive factor is therefore the sum of all criteria. A single criterion does not make a stock a quality company.
Dividend policy
The dividend policy is a reflection of the company's management. Stocks with high dividends should be carefully analyzed.
As already indicated, IBM pays a rather high dividend of approximately 5% (2023). Amphenol, on the other hand, pays approximately 1%. Regardless of the fact that the total return is the sum of share price gains and dividends, both companies should reliably increase their dividends (this is also a criterion). So what is the problem? Dividends are profit sharing, so they have to be earned. If you take a closer look, IBM sometimes distributes more than 100% of its profits to its shareholders - which can only work by take up debts. This is not sustainable and unless profits increase reliably, it also limits increases in dividend payments in the future. If the company is hit by a crisis, it is very likely that the dividend will have to be reduced. In addition to the consistency and amount of the increases, the payout ratio, i.e., the ratio of dividends to generated profit, is also important. Particularly over a period of several decades, steadily rising profit shares provide enormous leverage and even beat an initially high dividend yield. We have even systematically calculated that through - if you like, read more in our "growth vs. yield" blog.
Technical analysis
Symmetrical price development reflects a stable business model, reduces volatility and facilitates the identification of entry points.
Let's move on to the next point and take a look at an industry that seems to be growing unstoppably and is not yet cyclical: information technology. For this purpose, we will compare two companies that could not be more different: IBM and Amphenol. At first glance, both are strong brands and established companies with decades of history (something we also consider as a criterion).
While Amphenol has brought its shareholders a lot of joy over the past 20 years, IBM's stock has almost stood still over the same period. This is despite the fact that the company shines in the area of patents in A.I. topics and pays a high dividend. The problem lies in the underlying fundamentals. While Amphenol can consistently increase both revenue and profit like clockwork with rising margins, IBM's revenue has been falling for years and its profit margins have also been shrinking. This makes it clear that just being in the right industry is no guarantee. A company must also convince through high and above all stable profitability, increase sales and profits as constantly as possible and, if possible, over a long period of time. On top of that, the level of debt should be as low as possible. Why is this important? Such companies tend to be less susceptible to crises and run less risk of becoming unprofitable or even insolvent. Many technology stocks in particular grow very strongly in sales at the beginning, but do not yet generate a profit (e.g. Cloudflare, Hubspot, Datadog, Okta). Such stocks are too speculative for a basic portfolio and therefore unsuitable to represent the foundation of an investor's portfolio.
One last criterion remains and that is found in the technical analysis of the price development. The basis for this is partly the efficient market theory. This basically states that the market processes all publicly available information in pricing - it discounts it. What is meant by this can be seen very clearly in the figures below. Well-managed companies from growing sectors have a stable and symmetrical price trend. In this respect, the fundamental indicators can be read indirectly from the chart of a stock.
What makes a stock interesting and appealing from a technical point of view is a symmetrical price pattern, and some stocks exhibit such a pattern for more than 40 years. What can be deduced from this is that it is quite easy - in conjunction with the fundamental data - to identify suitable times to buy shares. An example of this is the American insurance company RLI. As can be seen clearly, the price trend is moving in a stable channel.
Currently (March 2023), the share is trending back towards the upper edge. Also from a fundamental point of view, the share does not seem very cheap in a historical comparison and would rather offer itself in the area of $110. This is only a very simplified and striking example, but it illustrates that good entry opportunities can be better determined by a symmetrical price trend. Of course, such a share is actually always a buy compared to e.g., Lufthansa, and the probability that one is still sitting on losses after a few years is very low - no matter at which point in time one buys the share.
The selection of stocks with such a symmetrical trend has several advantages: They are easy to trade, correct rather weakly (low risk of loss) and are therefore more suitable for beginners. However, do not succumb to the mistake of simply extrapolating the historical development of prices linearly into the future - even if it may seem as if we are doing exactly that. Technical analysis is a tool, another piece of the puzzle. No more, no less.
An example of how this would result in losses is the stock of the cybersecurity service provider Cloudflare. Since IPO, the stock experienced a meteoric rise and the general trend followed a nice symmetry. What was not visible, however, is how the valuation rose to astronomical heights at the same time. A valuation bubble formed. While the average for the price-to-sales ratio of the S&P500 is 2, Cloudflare's valuation rose up to 150 times. Then the bubble burst and the price plummeted by more than 80% at its peak. The same analysis can be done for RLI Corp. and one would not find such a bubble. Therefore, the rise is fundamentally justified.
Conclusion
There are several criteria that, when combined, can identify quality companies that have the potential to outperform the overall market in the long term. Of course, there is no guarantee and one should check the criteria regularly. Analyzing these factors however does not represent a detailed stock analysis. For the basic portfolios, we have looked at the companies in more detail and created individual portfolios with distinct focus.
In any case, for most investors, the criteria mentioned above offer initial guidance to at least roughly separate the wheat from the chaff and to get a feeling for whether certain companies can generally be worth buying or not, and also from which sectors one should rather keep one's hands off. Many newcomers usually try to chase the one big turnaround bet but mostly results in losses.
