Getting started in shares

The ultimate goal of any investor in the Australian stock market is to outperform the returns achievable elsewhere. An investor can base investment opportunities on size, sector, longevity on the exchange or even potential reputability.

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The team at KOSEC seek to bring businesses to our clients that are considered ‘fundamentally-sound’. Explored individually, indicators such as revenue, earnings, operating margins, debt-to-equity and return on equity are interrelated concepts that collectively come together in the analysis of whether a business is potentially ‘healthy’. Below we will illustrate our strategy by examining healthcare sector heavyweights CSL Limited (ASX: CSL) and Cochlear Limited (ASX: COH).

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Revenue

The ability to generate revenue is at the forefront of any business, irrespective of whether it is listed on the Australian Securities Exchange. A company’s ability to generate revenue typically indicates market demand of a product or service provided. However, purely examining single-year revenue levels is not an accurate reflection; a company must exhibit increasing revenues, and therefore product demand, over numerous years (preferably for at least three years). The close observation of these patterns enable the team at KOSEC to be more informed regarding the company’s ability to sustain revenue growth moving forward, rather than risk being somewhat misinformed due to a one-off or sporadic contract win which could potentially impact single-year readings.

Revenue ($ per share)

FY2014

FY2015

FY2016

FY2017

FY2018

Cochlear Limited

14.10

16.17

19.75

21.82

23.67

CSL Limited

11.93

15.36

17.57

19.70

23.40

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EARNINGS

Whilst revenue enables the team at KOSEC to gauge the demand for a product, there are other factors to consider.

The underlying earnings generated by a company provide the company two options; reinvestment into future growth or shareholder distribution (dividends). These amounts are dictated by the company’s payout ratio which can be adjusted at the Board’s discretion.

It is possible to attain negative earnings over numerous years in the process of ensuring future revenue. This is commonly seen in biotechnology companies where high research and development (R&D) expenditure is generally required initially in order to potentially increase future revenue following potential commercialisation of a product.

Earnings (cents per share)

FY2014

FY2015

FY2016

FY2017

FY2018

Cochlear Limited

164.20

254.80

330.00

389.10

421.30

CSL Limited

285.70

374.50

310.10

381.10

505.80

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OPERATING MARGINS

A company’s operating margin is directly affected by the above two indicators (earnings and revenue); this is measured by calculating how much revenue is spared after variable costs of production. An investor can potentially draw two conclusions from a company’s ability to increase its operating margins annually with respect to its market position and product demand; these being that the company is well-managed and has lower potential business risk. Operating margins are dependent on the sector; for example, consumer discretionary companies are often unable to attain higher margin levels as compared to companies in the information technology space. In spite of this, a ‘fundamentally-sound’ business will be able to sustain, and potentially even grow, its operating margins annually, as illustrated below through CSL Limited.

Operating Margins (%)

FY2014

FY2015

FY2016

FY2017

FY2018

Cochlear Limited

19.10

25.60

26.20

27.70

27.80

CSL Limited

33.60

34.40

27..40

27.90

33.7

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RETURN ON EQUITY

Basing company performance solely on nominal values found in financial statements is generally inconclusive due to size differentials. Return on equity (ROE) is a more accurate indication of a company’s ability to generate earnings as it uses the equity capital of shareholders.

The top-down investment approach utilised at KOSEC provides our clients with the most opportune businesses within the best-performing sectors in the Australian market at a given point in time. The return on equity metric is most appropriate for comparing two businesses in the same sector or industry as ROE is dependent on the asset levels of said businesses. It is important to note that asset levels vary between different industries.

Return on Equity (%)

FY2014

FY2015

FY2016

FY2017

FY2018

Cochlear Limited

28.50

41.0

42.10

41.10

39.70

CSL Limited

41.30

49.40

41.50

42.30

41.60

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DEBT-TO-EQUITY LEVELS

Examining a company’s debt-to-equity ratio allows an investor to determine the extent to which the respective company is reliant on the accumulation of borrowed funds. This is typically acquired by companies from lending institutions to facilitate the financing of future capital expenditure. The major hindrance a higher debt-to-equity ratio provides a listed company is the interest obligations it is required to adhere to. If this ratio is higher, it can indicate a potential risk to the sustainability of these obligations.

Though a lower debt-to-equity ratio is preferable, a high value can be justified by its utilisation. CSL Limited has historically been rather reliant on debt financing for its investment in new manufacturing facilities as well as clinical trials conducted. This potential success is exemplified in its historic share price movement, particularly over the last five years as it has been more reliant on raising capital via debt facilities.

Debt to Equity Ratio (%)

FY2014

FY2015

FY2016

FY2017

FY2018

Cochlear Limited

72.10

59.90

43.10

40.30

24.20

CSL Limited

59.80

83.00

122.40

125.60

107.50

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INDICATORS IN ACTION

Above, we have delved into the major criteria used by the team at KOSEC to determine which businesses on the ASX are ‘fundamentally- sound’. Throughout, CSL Limited (ASX: CSL) and Cochlear Limited (ASX: COH) are utilised as case studies. Both CSL and Cochlear positively demonstrate the aforementioned indicators. The performance of these companies and the ASX200 index over time can be seen below.

Historical Performance (%)

1 year

3 year

5 year

CSL Limited

36.22

88.57

189.69%

Cochlear Limited

9.93

98.83

207.85%

ASX200

-4.89

15.76

9.09%

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CASH FLOW

As the term implies, cash flow seeks to determine the cash generated by a company. Non-cash expenses such as depreciation and amortisation as well as one-time capital expenses are also taken into consideration. Examining a company’s cash flow allows one to avoid making the mistake of being guided by manipulation of financial statements that may be affiliated or associated with lone considerations of a company’s earnings. Both cash flow and other financial statement line items, in combination, holistically seek to provide an indication of the financial strength or status of a listed company.

Cash flow is particularly important for companies such as CSL and Cochlear, given its ability to guide investors on the returns generated from relatively high levels of capital expenditure. Negative cash flow is paramount for investors to consider, as heavy capital expenditure may  potentially derive payoff in the future or alternatively signal potential poor investment decisions. An investor does, of course, seek to minimise their risk exposure when investing in equity markets. To ensure this, a propensity to recognise consistent historical cash flows, rather than placing reliance on uncertain future results, is beneficial. Remembering though, uncertainty can be the result of industry-wide and macroeconomic factors rather than being purely company-specific.

Debt to Equity Ratio (%)

FY2014

FY2015

FY2016

FY2017

FY2018

Cochlear Limited

195.2

329.7

323.3

452.0

448.1

CSL Limited

297.4

375.3

342.7

355.2

567.0

Note that the purpose of showcasing CSL and Cochlear is to illustrate the filtration methods utilised by the team at KOSEC, rather than imply similar returns for every opportunity brought to our clients.

The intention of this is to reinforce Markowitz’s longstanding financial theory that it is most prudent to bring opportunities with potential to outperform the market, whilst minimising the risk one is prone to. The success of this strategy has been demonstrated throughout, most prominently through the historical share price success of CSL Limited (ASX: CSL) and Cochlear Limited (ASX: COH).

Why Choose KOSEC?