In a previous blog post describing my investment philosophy I explained that I try to invest in companies of highest quality. But how to measure the quality of a company? There are many ways of course, such as looking at the strength of the balance sheet, competitive advantage or track record of management. There are also various equity research institutions which provide metrics and rankings to measure the quality of different companies.
However, I came up with another interesting data point to look at. I have a margin account with my stock broker, Nordnet, where I hold Finnish stocks. This means that they will lend me money to buy shares, and any shares I own will be used as collateral for the loan. The stock broker has internal metrics for calculating how safe the stock of each company is, and the value for collateral is different for each company. For example, if the company is considered really safe and stable, the bank may accept 80% of the value of the position as collateral. If the company is really risky, they may accept only 30%. They will tweak these values if there are significant changes in a company, but they appear to be relatively stable.
Why is this such an interesting metric to look at? The business model of a stock broker is to earn commissions on trades and sell other services for fees. Generally they do not want to speculate which stocks go up or down, in other words they do not want to take on risk if they can avoid it. The collateral value gives us some idea of what they think a stock is worth in a worst-case scenario. This means they are putting their money where their mouth is, or in other words, risking their own money in proportion to this figure that they state. Meanwhile they will hype and advertise the IPOs of hottest tech stocks all day long but they will not lend money against their shares. Interesting isn’t it? Lets look at Rovio, for example, which went public about 3 months ago. The broker is accepting only 20% of the value of Rovio shares as collateral, which means that in a worst-case scenario the broker thinks the fundamental value of Rovio is only 20% of what it is currently trading at.
But enough about Rovio, lets get to the quality names that this blog post is about. All the links for the companies lead to the Investor Relations sections of their website.
Grade A (collateral value 85%)
These companies, according to the broker, are the safest and highest quality listings traded in Helsinki. If one were to build a portfolio consisting of just these stocks, I expect that investor to sleep well at night. There are two telecomm stocks (Telia and Elisa), so maybe owning both is not necessary. Kesko is a stable consumer goods company, one of two large companies that sell food and other necessary items in our duopoly. I think not many will disagree with my opinion that Kone and Wärtsilä are the highest quality industrial stocks we have in Finland. Sampo is our leading financial services company and Fortum is an electric utility which is not going anywhere. The only company in this list that has been struggling lately is Telia, but their share price seems to have bottomed between 3.5 and 4 euros.
Grade B (collateral value 80%)
This second group is very interesting. These companies are still of very high quality, but not quite as rock-solid as the first group in the opinion of my stock broker. Each of these companies has some specific risks which I suspect landed them in the second group. For example, Nokian Tyres has some exposure to Russia which has risks. Metso is heavily exposed to the mining sector and their share price got crushed along with the share prices of mining companies at the start of 2016. Neste has strong dependency for government subsidies in biofuels. Orion is vulnerable to expiring drug patents. Nordea is undergoing a large upgrade of their tech/software infrastructure. And being the largest bank in Scandinavia has lots of regulatory risks as well. Tieto is the largest software company in Finland, but software is an area that is easily disrupted and Tieto is very dependent on government/municipality contracts. Overall I would stay these are very good companies to own, but one should be aware of some company-specific risks.
Grade C (collateral value 75%)
Companies that belong to the third group are, according to my stock broker, slightly more risky than the first two groups. If I try to look for a common thread among these names, I think their competitive advantage is weaker than any companies in the first two groups which means they are more susceptible to disruption by competitors. They seem to lack a “moat” as Warren Buffett calls it. I don’t personally own any companies from this group. Going back to my investment philosophy, I said I wanted to own the highest quality companies, and those are found in the first two groups.
I found this method of ranking stocks particularly interesting because I had already formed some opinion about the quality of different companies through research and other methods, and I found there was a very strong correlation with how my stock broker ranked these companies. This strong correlation definitely surprised me. Of course, one should not buy stocks based on this list alone, but it does serve as an interesting data point to consider.
But lets say, for the sake of argument, that one would construct a portfolio using this list as a guide. A rough rule of thumb would be to own all the companies from group A, half of the companies from group B and maybe one or two from group C. This would result in a fairly safe and defensive portfolio, perfect for an investor who is interested in protecting the invested capital and not chasing quick profits.
Oh, you might be wondering where is Nokia? They did not make the list as my stock broker would rank them in group D that I did not include here. Apparently they see Nokia as a fairly high risk business. It is currently my only position that is not included in this post.