I would not buy shares of G8 Education Ltd (ASX: GEM), Slater & Gordon Limited (ASX: SGH) and Challenger Ltd (ASX: CGF).
That's not to say they will make bad investments or are bad companies…
Filtered Tastes Better
Last year, I spent time interviewing Australia's — perhaps some of the world's — best sharemarket investors as a research analyst.
We got the skinny on their investing process, how they recruit analysts and what they look for in companies.
One of the things that struck me was how much emphasis professional investors place upon negative filters.
What is a negative filter?
Also called 'stock screens', a filter uses some rules of thumb, derived from experience, or a set of factors that come from empirical research, to weed out or identify investments.
For example, you might go into your brokerage account and search for companies to buy. But to do so, you might exclude companies with dividend yields under 3% and a price-earnings ratio over 10x. Your brokerage account will list all the shares that meet your negative filter.
Why use a negative filter?
On many levels, it makes sense to use a negative filter.
There are over 2,000 companies listed on the Australian stock exchange. And, let's be honest, many of them will be hopeless investments and simply not worth your time.
Finally, it makes sense to use some type of filter because you are only one person – how can you possibly research all of the shares on the ASX?
3 ways to filter companies
Ordinarily, I don't use my brokerage account to filter shares. I find new ideas through associates or reading online. Then, I use some rules of thumb. Here are three of them, with three companies to match.
External influences.
When a company relies heavily on external influences to be a profitable investment I am reluctant to buy shares. For example, G8 Education is a child care provider. Child care is an intensely expensive exercise for families and a political 'issue' at the best of times. That in itself is not a problem. But aside from location, the centres themselves have a weak competitive advantage. For example, if prices get high enough, parents will look elsewhere or a new centre pop up to meet demand.
That's easier said than done and many parents will just cop higher prices.
Nonetheless, I would rather not have to worry about regulation, commodity prices, acquisitions or any external influence for my investment to grow.
Poor economics.
If a company has to invest a lot of money upfront and its profits are not reliable, I get concerned. Slater & Gordon used unusual accounting tricks to make its business appear more profitable than it was.
There are no hard and fast rules for this. But, you should want to target companies with wide profit margins. For example, you can divide net profit by revenue, EBIT (earnings before interest and tax) by sales and free cash flow by sales.
Also, you should always look at the company's accounting policies (found in the Annual Report, just after the four financial statements).
Once you've done this, compare your findings to what is written in a competitor's annual report.
Staying in my wheelhouse.
Every share or stock on the ASX is a slice of a business. When you buy a share, you are becoming a part-owner of that business/company.
Whenever you invest, make sure you know what the company is doing. How is it making money? How does it plan to make more money?
Let's take Challenger…
Challenger sells annuities. Check.
Annuities are used to provide a secure income for retirees by taking their cash and taking on their investment risk. Check.
How are annuities made secure? Umm.
What happens if their actuaries make a mistake? Double-umm.
This is not to say Challenger is a bad business. But I simply avoid companies I wouldn't be capable of running myself.
Foolish Takeaway
Identifying investments you shouldn't make is much easier than identifying those you should make. And rightly so, because you don't need to own all 2,000 shares on the ASX.
For the record, I have owned each of the companies above. Although two of the three were profitable for me, I realise now that they were bad investments.
