Stockmarket Masterkeys

I’d had enough of other people managing my money. I wanted to set up a portfolio of stocks I had researched and was confident about. Apart from the satisfaction (and gains) it would give when things went well, doing it myself would save the steady drain of fees to a fund manager; that money would stay where it belonged, and be built up by compound interest.
That was the plan. I now needed a way to speedily assess the track records of a range of companies so I could put my money into a diversified basket of sound stocks with the stamina to provide sound long-term performance. And, of course, I wanted my money to work hard without for me, without sustained vigilance on my part. Utopia? Nirvana? Maybe not, but at least I was trying to give myself a chance to control an aspect of my life vital to my long-term comfort.

Without the benefit of previous annual reports to study, I reasoned the quick way to determine a company’s track record is to examine two sets of figures: "contributed equity" and "retained earnings". These are in a company’s "statement of financial position” under “total equity” (which, by definition, is equal to "net assets”, calculated by deducting liabilities from assets).
Simply stated, the higher the "retained earnings" relative to the "contributed equity", the better a company’s record in making profit; this is not counting dividends because, obviously, they have left the balance sheet.

All of this assumes that part of earnings has gone to dividends, thus unlocking franking credits, and, of course, retained earnings can go to share buy-backs. There is no easy way to figure out the latter because Australian accounting standards don't have a provision to show this figure separately.

However, there are companies that do, and see that Woodside Petroleum reports a separate figure for treasury (buy-back) shares. (This practice of showing treasury shares separately, which is fairly standard in the US, can be very helpful in the study of a balance sheet.

The difficult way to get a meaningful picture of the relationship of retained earnings to contributed equity is to study annual reports going back 10 years or so and then do calculations and ratio analysis. An easier option is to buy a handbook on companies’ past performances, but still there are various ratios and figures to consume, which can be daunting, even to a serious investor.

Beware of companies that retain earnings (thus not paying dividends) yet fail to produce an adequate return on them. The rule to follow is that every dollar of retained earnings must produce at least one more dollar. Property trusts are required to distribute profits to unit-holders, so those that are listed have almost no retained earnings on their books. This is not to say that investing in listed property trusts is bad.

If you think you have done a good job in the selection of your portfolio in the first place, you should really never need to sell your shares and churn the portfolio unnecessarily, and this will save you a lot of money in brokerage costs and, more importantly, capital gains tax.

If, like me, you are an individual direct share investor, review your portfolio and count the number of companies with retained earnings; then count how many have retained earnings that match contributed equity; and, finally, count those whose retained earnings exceed contributed equity. Now check when the companies whose retained earnings exceed contributed equity were formed (which can be longer than since they listed) to find out how long they have taken to reach this desired status (obviously, the quicker the better). The results might surprise you.

Some may argue that looking only for good track records is a bit like driving a car by looking in the rear-view mirror. That is, in a way true, because the future, though it may look like more of the same, is always different. One can resort to crystal balls, or analysts’ reports, but these tend to make astrologers look good. Remember, in stockmarket investing, there is no one formula that will make you money or guarantee that you will keep your money. But the importance of track record must no be overlooked.
At the very least, it is a good starting point. To finish in front, you first have to finish '” and that's my point. If you find this approach appealing, you should still resist putting all your eggs in one basket, even when you are prepared to fuss over them like a broody hen.

Another word of caution in your search for these elusive companies. Some do not present contributed equity and retained earnings correctly in the sense that these terms mean. They are getting away with it because Australian accounting standards do not have strict guidelines on how the figures should be shown.

They can show total equity and pro-rata it in any proportion they choose, so do not blindly follow the numbers and assume they are what they should be.