Section 3 – The stock picking rules explained

So let us look at the rules again in shortened form. I will be repeating these rules sever times as we progress through the Grindertrading journey.

Revenue has increased and forecasted to increase (also known as Turnover)
PBT has increased and forecasted to increase
EPS has increased and forecasted to increase
Net Debt is less than 3 x PBT (credit giving to a Naked Trader rule)
FCFPS is greater than or close to Earnings per share (EPS)
ROCE is double figures
It pays dividends
The Outlook is positive
The 1-year chart is on a steady upward trend

Revenue
Revenue is the income a business receives for carrying out its normal activities before any expenses are deducted. It is the top line figure on the Income Statement (also known as ‘Profit and Loss Account). A shop’s revenue is the total goods that it has sold. In most business revenue is stated when goods are delivered to the customer; whether bought on credit for future payments or paid for cash immediately. Revenue is also known as sales and turnover. Although it is revenue that is found on the income statement. A banks revenue could be interest from loans.

Why is the revenue part of my stock-picking rules?
Revenue is important to Grindertrading because we want to see strong sales growth and that forecasters predict that growth is going to continue. In percentage terms, Revenue growth over 10% is ideal, although on occasions just a small percentage increase is okay if every other rule passes. If the revenue declines then this can indicate problems and while this may be short term it is best to avoid.

What are the issues with just relying on revenue?
As with all investing rules, there is no ‘golden grail’ set of rules. A business can grow its revenue by acquiring other businesses. Merging business together has its own set of problems and we require further rules to ensure that growth is organic.

PBT – Profit before tax (pre-tax profit)
PBT is a measure of the company’s profitability. It is calculated by taking the revenue figure and deducting a number of expenses known as ‘cost of goods’, other operating or administrative expenses and interests paid. It is the profit before taxes are paid. In the most basic term a furniture shop that manufactures and sells chairs. The costs of material to make the chairs, electricity to run the machines, heating and lightening costs, postages and packaging costs, salaries etc are all deducted from the revenue. If the expenses are less than the revenue then the company has made a profit. If expenses are greater than the revenue (i.e it costs more to make the chair than it sold for) then the company made a loss.

Why is PBT part of Grindertrading?
You will have probably heard in business news headlines like ‘Shiny Shoes plc share price rises sharply as the company reports record profit’. CNN’s Quest Means Business advert yells ‘what a profitable hour’. Along with sales (revenue), profit is notably used to describe the success of a company. There are a number of profit terms used in accounting including Operating profit, net profit, EBIT etc. PBT is the profit term usually highlighted in the key fundamentals of annual reports and financial statements (more on that later). It is a key fundamental that is easy to find and is understandable.

What are the issues with just relying on PBT?
A profit is recorded when the goods have been sold either on credit or on cash sales (or a mix of the two). PBT can be adjusted by accountants (creative accounting) to make the figure look higher. There are a number of ways to include (or exclude) expenses in the profit calculation. Sales can be recorded straight away while expenses can be delayed. Some recurring charges are actually recorded as one-time charges etc. Profits can also increase by acquiring other businesses. There is a multitude of sins that scrupulous companies use to artificially boost profit.
I like PBT to be around the growing percentage of the revenues although usually, they can be a little lower. For instance, it is not unusual for revenue growth to be around 15% and profits growth to be 12%. This is all ok but if revenue growth was 25% and profits growth 8% then this means there have been large expenses deducted and this is something I would rather avoid.

EPS – Earnings Per Share
Earnings can be called the bottom line of the income statement. It is the profit after tax is paid plus deductions for some extraordinary items. Earnings per share is the profitability on a per-share basis. Basically dividing the earnings figures by the number of the company’s shares in issue. Earning per share was once seen as significant because it can be tied to the share price in form of the Price to Earnings Ratio (PER).

Why is EPS part of my stock-picking rules?
EPS is another headline term used when reporting financial results. You in your investing journey may hear now and again on news sights headlines ‘Share price jumps on earnings surprise’. Brokers do their best to try and forecast the future sales, profits and earnings of the company that it covers. An earnings surprise means that the forecasters have understated potential earnings, so when actual earnings published are a lot higher then this surprises the markets and the share price can significantly and positively react. I like to look for EPS growth percentage around that of PBT growth.

What is the issue with just relying on EPS?
The further down the bottom of the income statement the more adjustments are made and the possibility of manipulation. EPS is the bottom line, further down from PBT. It can contain large adjustments (extraordinary items) that must be separated from the normal activities of the business but is included in the final calculation of EPS. There are also different types of EPS. Basic EPS (or normal), adjusted EPS, diluted EPS etc. This can all be confusing. My general rule here is that all EPS differences should be as narrow as possible. For instance, if Basic EPS is 5p then I want adjusted EPS or diluted EPS or any other EPS figure around 4.5p to 5p. If these adjusted EPs figures were 3p or 2 p or worse then I would be concerned about all the adjustments being a warning sign and rather not invest.

Net Debt
Net Debt is a balance sheet term and helps to understand the strength and viability of the business. This figure takes into consideration long-term debts like bank loans, short-term debts like overdrafts, plus any cash in the bank accounts. It considers the working capital of the company. Can all short-term assets (current assets) like goods to be sold, or customers who are paying back their credit (debtors/receivables) if liquidated can cover all the debts? If the cash held is higher than the debts the company is in a net CASH position. Oh boy for us that’s a good position to be in.

Why is Net Debt part of my stock-picking rules?
As explained Net Debt is a check on the balance sheet. While we want to invest in businesses that can grow in revenue, profits and earnings; we want to check that the business has little chance of collapsing. A business that grows by acquisition and mergers (rather than organic) often have large debt balances to pay for the takeovers. These types of growth companies are high risk and can collapse if the merger were ill-thought and so the net debt rule tends to keep us away from these high-risk investments.

Debt can cripple any business if revenue starts to decline, or major credit customers stop paying (bad debtors) or money dries up. A business can help to grow by using bank loans to grow the company. Or can increase sales by offering customers long-term credit plans. But if the company becomes too indebted, can’t afford to pay the interest or default on any of the repayment terms, then the company can collapse.

3 x net debt sold be less than PBT. This allows a business to maybe have a poor financial period but able to survive any temporary blips without risk of collapse. This rule is credited to a highly successful private investor called Robbie Burns who introduced this ratio to the world in his book The Naked Trader. Net Debt is often a highlighted headline figure in financial reports so easy to find. If the company reports Net Cash then even better!

What are the issues with relying on Net Debt
I do not see any particular negatives in using net debt as a balance sheet check. Accountings may use other means for debt/profit measurements (3 x EBITDA etc) , can identify issues with debtors and creditors, but remember Grindertrading is SIMPLICITY and combine a number of simple rules we have an effective and successful strategy