investment grade companies - what are they?

This thread has been started to continue the debate that arose from the thread "sharemarket is not a wealth creation vehicle" on what constitutes "investment grade" companies, as well as the identification of some companies that satisfy the criteria for "investment grade".

I would like to preface this piece with the following:

- What follows is my opinion and, by definition, it is an outworking of my experiences, perceptions, research and intellectual limitation. It is therefore not intended to be used as the basis of investment advice.
- Any "list" of investment grade companies will never be a fail-safe, magic pudding for wealth creation. For starters, the list will always be fluid to some extent, with changing circumstances and changing management strategies causing companies to enter and exit the list (although this should really be at the margin, for example, ABC Learning Centres was once a very good business, certainly one I would have considered investment grade, until the stragety became one of global empire building, which involved gorging on undeigestible chcunks of debt. An example of a stock entering the investment grade category from being a dubious business is Orica, where a decade-long reinvention to the company from a highly-leveraged commodity chemicals business, to a focused, free cash-generative supplier of value-added chemicals with far more predictable and stable earnings, to fast-growing customer segments)
- Nothing in the arcane art and/or science of securities analysis can ever be set in stone, nor be 100% correct; at best, what we should be doing, if we want to be prudent, risk-conscious investors, is to skew the wealth-creation odds very much more in our favour than they already are in generic equity investing terms.
- I fully expect some HC participants to disagree with some of the stocks on the list; soem might argue (rightfully) that I have omitted some companies. I stresss that this is not intended to be the definitive list of all great investment ideas.

With the preamble out of the way, let's begin.

WHAT ARE THE CRITERIA THAT DEFINE INVESTMENT GRADE BUSINESSES?

Four factors need to be satisfied:
1. DEBT FILTER
2. ROBUST BUSINESS MODEL
3. ACCOUNTING QUALITY
4. MANAGEMENT ALIGNEMNT

1. DEBT FILTER:
I hate corporate indebtedness. It removes management options and strategic flexibility. I don't invest in businesses where NIBD > 2x EBITDA, or EBITDA/Net Interest <6 times (unless for extremely good reason).
I define an investment as something that puts money into my pocket, not take it out, so when companies need to come to me to repair the balance sheet because they are beholden to the whims of their bankers, then that I don't consider to be investment grade.

2. BUSINESS MODEL:
* I don't care for new concept companies, biotechs, financial engineers, explorers.
* Investment grade companies must be durable, highly cash generative (FCF must be > 3 or 4 times stay-in-business capex) with track record of free cash flow performance during economic/business downturns.
* The company's executives must be able to be the architects of my company's destiny (i.e., differentiated, unique, difficult-to-replicate products and services with the attendant pricing power).
* Customer granularity - no one customer shoud represent more than 5% of total revenues, and the top 5 customers should be less than 15% of total revenues.
* Supplier Independence - the company must have many alternative suppliers for it inputs, and must not be subjected to pricing pressure from suppliers (vice versa, in fact)
* Technological obsolescence threat - the company's products or services must not be subject to demand shocks due to tectonic shifts in the business/economic landscape.
* Regulatory threats - the company's products and services mmust be immune from regulatory pressure/threat
* Surplus organic capital generation - Investment grade companies are ones that generate capital far in excess of their internal growth funding requirements, i.e., they are scalable businesses that are able to drive up margins as revenue grows by the fractionalising of fixed cost overheads. I am not a fan of growth by acquisition. My experience has led me to coin the "5-4-1 Rule of Acquisition Growth": for every ten acquisitions that are made by corporations, 5 will destroy shareholder value, 4 will be borderline, and only one will be unequivocally shareholder value accretive.
* Transparent business model - If I don't understand EXACTLY how a company derives its revenues and profits, i.e., if I don't understand the business, I don't invest. Period.

3. ACCOUNTING QUALITY:
* I perform numerous reconciliations and cross-checks of reported Income Statement items with the cash flow statements and balance sheets.
* I conduct a range of diagnostics to discern how aggressive accounting practices are, how much accounting alchemy is taking place and hence how much prudential buffering is contained in financial statements. I have always been horrified to see how many investors take the notions of "Net Profit After Tax" or "EPS" at face value, without understanding that they are merely accounting constructs, and really are just approximations of a company's financial performance. But what people don't understand is that they are full of various assumptions on the part of the company's board of directors, its audit committee and its auditors, and like any assumptions, however well-intended, they contain natural biases and subjective interpretation of accounting standards.
* Before investing in a company I will read, from cover to cover, at least the past 5 Annual Reports, looking for warning signs or areas of comfort. Its amazing how much one can improve one's understanding of a company by trawling through the notes to the accounts, however boring that might sound. Many things provide excellent proxy clues to, such as:
- Related party transactions,
- Contingent liabilities,
- Structure and tenure of borrowings,
- Depreciation policies,
- The nature of, and changes in, intangible assets,
- The nature of, and changes in, provisioning levels,
- Changes in the elements of working capital,
- Performance (profit or losses recorded) on asset sales,
- Bad debt write-offs versus provisioning for bad debts,
- Other income

3. MANAGEMENT COMPETENCE, INTEGRITY AND ALIGNMENT:
* I look for honest, competent, engaged boards and management, who have interests that are aligned with my own.
* I look for exceptional governance practices, such as board independence, appropriate composition of nomination committees, experience set and skills distribution of board members, composition of various board sub-committees.
* I study remuneration practices, and compare these with alignment to shareholder value creation, seeking to ensure that executives my companies are not scoring fat cat salaries simply for rocking up for work, but are incentivised financially to increase the value of the business.

At the risk of sounding glib and pretentious, investing successfully is not difficult. The formula, I believe, is quite simple:
There are 2,000-odd shares listed on the Australian Stock Exchange. My view is that only about 80 to 100 of these are of investment grade quality and, of these in turn, just a handful are undervalued enough to buy at any given time (depending on where we are in the economic/equity market cycle).

My investment process involves the identification of the 90 or so "investment grade" stocks, establish through financial modelling the valuations at which they are cheap enough to buy and then to just sit and wait patiently for the event(s) that will drive these investment grade stocks to these sorts of valuations.

So here are my 90-odd list of INVESTMENT GRADE stocks (I stress once again, this is not intended to be THE definitive, nor prescriptive, list):

LARGE CAPS:
AGK
AMP/AXA
ANN
ANZ
ASX
BHP
CBA
CCL
COH
CPU
FGL
ILU
JBH
JHX
LEI
MTS
MYR
NAB
ORG
QBE
RIO
RMD
SEK
SHL
TEN
TLS
WAN
WBC
WDC
WES
WOR
WOW

SMALL CAPS
AAU
ABC
AEO
APN
ARP
ASZ
AUB
BKL
CDD
COF
COU
CPB
DLX
CRZ
DTL
FWD
GUD
GWA
HIL
IFL
IRE
IVC
MCP
MND
PBG
PTM
REH
RKN
SAI
SDG
SFH
SGN
SKE
SLM
SMX
SPT
SUL
TGA
TRG
TWO
WHG

MICROCAPS
ABOUT 15 to 20 (AWS, BSA, KOV, NCI, and others which I reserve my right to not disclose)


In closing, I stress again, this is not the definitive listing, and in the interests of becoming a better long-term, fundamental investor, I would welcome aletrnative input/debate/criticism.

All in the name of prudent, risk-aware investing.

Cam