How to Beat the Market: Part 1

This is the first part of a two-part transcript in which Fool.co.uk's David Kuo chats with Nathan Parmelee, Nate Weisshaar, James Early, and Charly Travers, otherwise known as The Motley Fool's Share Advisor team, about picking shares in the current market.

You can read the second part of the transcript here. You can listen to or download the full podcast here.

EDITOR'S NOTE: What follows is a lightly edited transcript of David Kuo's conversation with The Motley Fool's Share Advisor team.

David Kuo: This is Money Talk, the weekly investing podcast from The Motley Fool. I am David Kuo, and today I would like to look at the U.K. market over the last six months with the help of The Motley Fool UK's four stock pickers from the Share Advisor newsletter service. In the podcast, we will be revealing one of our recommendations, so listen out for when I quiz the four stock pickers on how they look for shares, and they are Nate Weisshaar, Nathan Parmelee, Charly Travers, and James Early. Welcome, all of you, to Money Talk.

All: Great, thank you, David. Glad to be here.

David: I hope people aren't going to be confused with those four voices, but I'm sure you'll get a feel of who is who in a few minutes. Now, the Share Advisor newsletter, Nathan, was started on Feb. 14 -- Valentine's Day, and on that day the FTSE 100 index stood at 5,905 points. Today the FTSE is around the same level, around 5,830 points, give or take a few points here and there. What can we say about the performance of the U.K. market over the last six months?

Nathan Parmelee: Really, in my eyes it's been similar to what we've seen in the last two years, which is plenty of volatility, driven by economic news, primarily coming out of Europe -- the euro area, I should say -- China, and the U.S. to some extent. But generally the market, even though it's had these fits of volatility, has kind of worked its way higher as earnings and results have come out, and people have focused on how companies are still growing, despite some of the economic difficulties right now.

David: So what is actually causing this, do you think?

Nathan: The economic difficulties?

David: Well, exactly, yeah.

Nathan: Really, it's just a mix of long-term planning and policies on the part of governments, and how do they want to tax and how do they want to spend, and what do they want to bring to their constituents as far as what they plan to do, and what they think they can tolerate. Really, that mix hasn't been right for the last few years, and isn't creating a lot of economic stability, but for the most part, companies have actually been able to plan out a long term future, taking this into account, and do relatively well.

David: But the fact that the U.K. index is relatively flat, do you think that investors are expecting a lot more from governments, that they think governments should try and do more to try and drive economic growth in some way?

Nathan: I think they're hoping that they will, but in some ways the governments, their hands are tied -- there's not so much that they can do, which is really why we prefer to focus on companies that we think have pricing power and competitive advantages, and can really navigate through the environment without necessarily the government lending a helping hand, more so than just keep things stable.

David: OK. The next question is for you, Nate -- over the last six months, bad news from the eurozone just continues to dog the market. These are the problems that Nathan was alluding to. So as a stock picker, how affected are you by macro-economic events, such as the eurozone?

Nate Weisshaar: Well, to a certain extent, there's no way you can avoid them, and the market will react to economic news as it does, but as a stock picker you need to cut through the noise, and look for what the underlying strengths of a company are. Nathan touched on pricing power, the ability to access markets, and grow despite what may be happening in the halls of government. So when I'm trying to pick stocks in a time like this, I try to take advantages of the fear that may creep into the market from time to time, and try and ignore the brief bursts of exuberance that pop up whenever someone from a central bank says they're going to send more money into the market. But really, the key is to find a company with the strong fundamentals that are able to continue doing what they do, regardless of what's going on around them.

David: But the thing is, you're a professional stock picker. How easy is it for the private investor to do exactly the same?

Nate: If you want to do it to the extent that I do it, it's going to take time. There's no easy way around it. There are a few hallmarks you can look for: strong cash flow generation, a strong balance sheet, the ability to pass on price increases to customers, but there is no secret to simple success in investing. It requires work, just like anything else.

David: So are you saying that companies can operate in isolation to what is going on with regards to the macro-economic events that are happening around?

Nate: Not complete isolation. They obviously have to deal with inflation, as far as price increases for the products they buy, in order to create something to sell onto you, but there is a level of isolation protection, if you're a company with strong intellectual property, or a company that has a brand that resonates with consumers, regardless of what's happening, say, to Coca-Cola, or, well, it's not quite a brand, but British American Tobacco. Consumers are still going to buy those goods; companies need the technology, the Microsofts and the Apples of the world, I guess. Companies don't need Apple, but...

David: Yeah, but the point I'm trying to make here, Nate, is this: If you have a company like Procter & Gamble, and you have a company like Unilever (LSE: ULVR.L  ) , Procter & Gamble said they were affected by what was going in the world, and yet Unilever, for some reason, hasn't been similarly affected. So how do you differentiate between these two different companies? I mean, is it a gift that you have, to be able to sidestep one, and pick the other one instead?

Nate: It's not so much a gift -- as with everything, luck is involved, but you can read through what management's telling you through the annual reports, or various interviews, and you look at how they are viewing the company, and the world around them. Unilever's CEO, Polman, has come out in the past year or so, and expressed a strong emphasis on the long term. His plans are involving multi-year periods. He's not concerned about quarterly updates with analysts, and he comes out and expresses that clearly, and the companies that take that longer point of view, and try and pull themselves above the noise that comes in economic downturns, is a company that is more likely to make the decisions, invest in the right places, and do the things necessary to succeed, regardless of what's going on around them.

David: So what you're saying is, it is quite important to read the annual accounts and read what the chief executive has to say about the business, and how he's actually planning to drive that business?

Nate: Knowing what the plans are going forward is always important.

David: OK. The next question's for you, Charly -- six of the 12 recommendations that we have in the Share Advisor news service have done well, a couple that are in the doldrums. Now, how do you think the Share Advisor news service has been able to pick good shares, given that we are told that the global economy is in the doldrums?

Charly Travers: Well, David, about six months ago, I made a pact with the Devil, and I'll say he's held up his end of the bargain just fine. But no, seriously -- we aren't really looking, and I want to stress this, for short-term results at The Motley Fool, and we're happy to have him, but what we're really interested in is long term outperformance over many years -- five, 10-year periods -- we are long-term investors here. I think right now we've started a good foundation for that. What the process that we're looking at is, what Nathan has already touched on, is looking for well-managed businesses, companies that have a strong balance sheet, and the cash flow to invest in growth, and the focus of the questions so far have been on some of the tough times around the world. But a good managed business that has a lot of cash can play offence in these times, and really take advantage of weakness in their competitors, and build out their lead. These are some of the things, at least, that I've been looking for when I'm making my own recommendations.

David: OK, well that's wonderful. Now James, an integral part of the Share Advisor service that we have is to let people know what are buys, what are sells, and what are holds. Can you explain to listeners what these recommendations actually mean, if they come onto the service?

James Early: Sure, David. On a superficial level, or a surface level, they are, as you'd expect, a buy means we think that's a share you can buy; a hold is something, don't buy, don't sell, but just hold it for now; and a sell is something, if you own, it's good to exit out of it, in our opinion. Now, I'd like to emphasize two points, David: the first is that a sell is something that we would issue, if we really think the thesis is broken. That would be the primary reason we would suggest you sell a share -- something just didn't go according to plan, and you always have to be ready to do that in investing. The buy versus hold distinction is something that usually comes down more to valuation; in other words, you could have a wonderful share, a wonderful company with wonderful business results, wonderful margins -- all that sort of stuff, but the price is just a bit too high, or maybe it's way too high. In that case, we might just move it to a hold, meaning, just sit on it, no need to sell, but just don't add any more money to it. The second thing I'd like to say, David, is that at Share Advisor, we don't just give a blanket recommendation. Our guidance is very clear, but we also give nuance. In other words, each investor is a little bit different. A buy for me might be a hold for you, or for somebody else, depending on risk tolerance. So with the context around our decisions, our members are better informed to do what's best for their own portfolios.

David: OK, and Nathan, now, as you know, every month we sit down, the five of us sit down, and we have a chat about shares. Why do you think that collective decision-making is better than just one person sitting in front of a computer screen, just screening out the various shares that they want to buy and sell?

Nathan: I think it's really because we all have different backgrounds, and by that I mean, we have different educational backgrounds, we've had different work experiences in the past, and even with The Motley Fool, we've focused on different industries at different times. So if one of us comes up with an idea, and we bring it to the group to discuss, we can get all that input and all that background and all that history lots of times, that can help us think in more detail about an idea. Then sometimes, in other cases, it's just that one of us has already looked at a company that's related; let's say, if we used Unilever for an example, one of us has looked at P&G, or looked at Reckitt Benckiser, and we've looked at the companies that may be supplying these companies, or their biggest customers, and just by having that extra input and what's been in there in the news, and what the trends have been, it allows us to further develop an idea more quickly, and then decide if we think it's the right time to act on it or not.

David: How do you feel as an analyst, when you've done a lot of work on a particular company, you bring it into a meeting, and then it gets ripped apart by the other analysts? I mean, how do you feel as a person?

Nathan: Sometimes it's very disappointing, I'll be honest, because you put a lot of effort and time into it, but it's really not about the personal aspect. What I really like about that is, I would much rather be ripped apart by these three gentlemen on a closed conference call, or including you, David, and some others, than I would put an idea out in front of people, have people potentially invest and lose money, because of an oversight or something like that. I just think it's much better that we talk and we discuss these things in advance.

Charly: Well, I rather enjoy knocking your ideas around a bit, for what it's worth.

David: OK, now, the next one is for you, Nate. We're talking about the various things that we look at when we bring these companies forward at a meeting. Now, what are the various things that you consider, in order of importance?

Nate: Well, first is picking a company that won't get torn apart by Charly. Second, when I'm looking at companies, it really kind of depends ... with Share Advisor, we've got two types of recommendations: we've got our ice shares and we've our fire shares, and I have a different set of governing criteria when I look at either one, but the core, for me, for any company, is cash flow, and how well they generate cash flow, turning sales into actual cash. Secondly, I like to look at the balance sheet strength. This ties very closely to cash flow, but a lot of people don't like to see debt on a balance sheet at all, and I think that rules out a lot of good companies that are taking advantage of the current financing situation. Interest rates are at an all-time low, but it's very important to make sure that the company has the cash flows to back up any debt that they're taking on. So step one is to make sure the company's got solid cash flows; step two is, how well they manage the assets and liabilities of the company; and then three is the growth opportunities the company faces, and that becomes more important if I'm looking at fire shares than it is with ice shares, but we would like to see both types of companies growing, just to different degrees.

David: So where does the share price graph come in that ranking, Nate?

Nate: It's somewhere on that list, I suppose.

David: Right down at the bottom somewhere?

Nate: Somewhere.

David: OK. The next one is for you, Charly. Now, the four of you switch regularly between fire and ice shares. Fire shares are predominantly growth shares, while ice shares are predominantly dividend payers. Now, how easy, Charly, is it for you to switch between hunting for fire shares and ice shares?

Charly: For me, David, it's actually quite easy. I use the same process for both types of companies, and let me explain why -- I'm mostly looking for profitable businesses, and a company that is earning a profit has a number of choices as to what it can do with that money. It can retain the earnings and just let it sit in its bank; it can make an acquisition; it can invest in the growth of its business, whether it's new manufacturing plants or branding; or they can use some of that money to pay a dividend. The ice shares that pay a dividend have looked at all of those options, and decided that the best returns for their shareholders are going to come from giving them some of that money, and you'll get a yield of three, four, five percent. But on the fire side, that is a business that has said, we have enough opportunities to deploy this money more effectively, and we think shareholders will get a better return if we build new retail stores, or manufacturing facilities, or invest on our own R&D, for example, like a drug company would do that. So really, from that framework, it's just looking at how a company is spending its money, and seeing if it makes sense. The fire shares, because they do tend to be smaller businesses, come with more risk and uncertainty than a stable, mature business like one of our ice shares that has decided to pay a dividend, but otherwise there's not a big distinction, at least in my mind.

David: Well James, as an income specialist, do you think that ice shares are always at a disadvantage to the fire shares, in terms of the performance on our newsletter service?

James: Absolutely not, David, and I should say, this question is a bit like asking a duck if water is a good idea. I am very, very biased toward ice shares. But I'll say two things: if you want to end up with a lot of money for your retirement, as a lot of people probably listening probably do, you've got to do two things -- you've got to make a lot of money, and you've got to try not to lose a lot of money. Now, either type of share can certainly lose you money. I've lost people money in one of my ice shares that I recommended, but in general, overall, ice shares are supposed to be more stable. Maybe they don't give you quite as much capital appreciation, but they give you good risk-adjusted returns. In other words, they give you a lot of return per unit of risk that you're taking, and that's very important. Plus, I know you're a secret, or not so secret, dividend fan, David, so it is quite nice to get those checks. You can spend the cash, you can reinvest it -- it's good to have that option.

David: But doesn't it take a lot longer for that value, or rather, for that performance to come through, when you're looking at an ice share, as opposed to a growth share?

James: Not necessarily, David. That is a common belief, but I've read a lot of the academic research on this, and ice shares, the steady, boring companies, tend to be more often undervalued than fire shares. In other words, you've got a lot of money out there chasing the next glamorous stock, the exciting, sexy story, and they tend to ignore the boring, unloved, infrastructure or logistical plays, but to me, it's fertile ground for profitable investing.

That was the first part of a two-part transcript in which Fool.co.uk's David Kuo chats with Nathan Parmelee, Nate Weisshaar, James Early, and Charly Travers, otherwise known as The Motley Fool's Share Advisor team, about picking shares in the current market.

In the second part of the transcript, the team discusses one of their picks from the Share Advisor newsletter service. Just click here to continue reading.

David Kuo challenged his Motley Fool analysts to pinpoint the attractive sectors of 2012 -- and they delivered! Discover the industries they selected in this new Motley Fool guide -- "Top Sectors for 2012" -- while it's still free!

Further investment opportunities with David Kuo:

Nathan owns shares in Coca-Cola. David owns shares in British American Tobacco and Unilever. The Motley Fool owns shares of Apple, Microsoft, and Coca-Cola. Motley Fool newsletter services have recommended buying shares of Apple, Procter & Gamble, Unilever, Coca-Cola, and Microsoft. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. Motley Fool newsletter services have recommended creating a synthetic covered call position in Microsoft. The Motley Fool has a disclosure policy.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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