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Volatility and uncertainty seem to have become a near-permanent feature of global financial markets. Yet, in the midst of this environment, numerous fine companies continue to emerge in Australia, offering investors great potential. Top Stocks 2018 showcases many such companies.

They are often smaller to medium-sized corporations. Some will be unfamiliar to investors. But all meet the stringent Top Stocks criteria, including solid profits and moderate debt levels.

This is the 24th annual edition of Top Stocks, and guiding investors towards value stocks has been one of the paramount aims of the book from the very first edition. Indeed, one of the rationales for the book has always been to highlight the truth that Australia boasts many excellent companies that enjoy high profits — and growing profits — regardless of the direction of the markets. Despite the title, Top Stocks is actually a book about companies.

Right from the start it has been an attempt to help investors find the best public companies in Australia, using strict criteria. These criteria are explained fully later. But, in essence, all companies in the book must have been publicly listed for at least five years and must have been making a profit and paying a dividend for each of those five years. They must also meet tough benchmarks of profitability and debt levels. It is completely objective. My own personal views count for nothing. In addition, share prices have never been relevant.

Of the 91 companies in Top Stocks 2018 — one more than in last year's edition — fully 70 reported a higher after-tax profit in the latest financial year (June 2017 for most of them), including 45 that achieved double-digit profit growth, and five reporting a triple-digit increase. In addition, 66 achieved higher earnings per share and 63 paid a higher dividend.

And though, as I wrote above, share prices are not relevant for selection to Top Stocks, 76 of the 91 companies in the book have provided investor returns — share price appreciation plus dividends — of an average of at least 10 per cent per year over five years. In fact, 40 of these 76 companies have given an annual average return of at least 20 per cent.

And eight of them — Altium, Aristocrat Leisure, Blue Sky Alternative Investments, Capilano Honey, Corporate Travel Management, Magellan Financial Group, MNF Group and Pro Medicus — have provided an annual average return over five years of more than 50 per cent.

High-tech stocks

Probably the biggest trend in Top Stocks in recent years has been the rise and rise of high-tech stocks. This is significant. The Information Technology sector represents only around 1 per cent of market capitalisation in Australia (compared to more than 30 per cent in the US). Yet fully 12 of the 91 companies in the current edition of Top Stocks are in the Information Technology sector, the same number as last year.

They are generally small companies — though large enough to be in the All Ordinaries Index of Australia's 500 largest stocks — and it can sometimes be difficult for outsiders to understand just how they make their money. Thus, many investors avoid them.

But technology has infiltrated virtually every facet of our lives, and the best of these companies are set to grow. It is worth taking the time to learn more about them.

Increasingly they are selling what has come to be known as software as a service. This means they will often charge an initial fee and then a subscription, so they have a high degree of recurring revenue. It gives a degree of consistency and predictability to their earnings. They can also generate high profits from a relatively small increase in sales, given that they are dealing especially in software.

Profit growth (and share price acceleration) for many of these companies has been outstanding. They are often on high price/earnings ratios, but that reflects the market's belief that high levels of growth will continue. They should be on the radar of all serious investors.

Top Stocks 2018: information technology companies

  Year-on-year after-tax profit growth (%) Dividend yield (%) Five-year share price return (% p.a.)
Altium 22.0 2.3 71.6 7.7 2.9 15.6
Codan 106.3 3.2 14.4
Data#3 11.2 4.9 17.4
DWS 5.2 6.9 5.8
GBST Holdings −24.6 3.1 20.6
Hansen Technologies −8.4 1.8 34.3
Infomedia 15.8 3.8 30.1
Integrated Research 15.5 1.9 30.0
IRESS 7.3 3.6 15.5
Objective 55.8 1.8 38.5
TechnologyOne 15.5 1.5 33.0

High dividend yields

With interest rates remaining low, many investors have been seeking stocks offering high dividend yields. These are still a worthy target, as they should offer a degree of protection if the market is falling.

Four years ago, in Top Stocks 2014, with investors looking for smaller companies with high dividend yields, I published a list of smaller companies from the book — a market capitalisation of below $450 million — with a dividend yield of at least 5 per cent.

There were 22 such companies in Top Stocks 2014. In Top Stocks 2015 there were 15, with 16 in Top Stocks 2016 and 11 last year.

Unfortunately, this year the number has fallen sharply to just six. In the table that follows (overleaf), I have added three more from the book with a yield of more than 4 per cent.

Dividend yield: small companies

  Dividend yield (%)
Vita Group 11.3
Mortgage Choice 7.2
DWS 6.9
MyState 5.8
Cedar Woods 5.6
Wellcom Group 5.5
Data#3 4.9
Sunland Group 4.3
GR Engineering 4.0

Exchange traded funds

Disquiet is growing in America about the impact that exchange traded funds (ETFs) are having on the market, and concerns are spreading to Australia as well. Astute investors ought to be aware of the issue, and should consider what impact it could have on their shareholdings.

ETFs in Australia are low-fee funds that can be bought and sold on the ASX, just like a share in a company. Most are passive investments, in that they simply track an index, such as the S&P/ASX 200 Index, or an asset, such as gold. The price of the ETF will generally move in line with the index or the asset.

In America, partly in reaction to the underperformance of many active fund managers since the global financial crisis of 2007 and 2008, investors have increasingly been turning to ETFs, with a huge inflow of new money.

If a company is part of an index that is covered by a popular ETF, then that company's shares have almost certainly enjoyed some strong appreciation. It has not especially mattered whether it has been a good company or a bad company, whether overpriced or underpriced.

But what will happen when the market turns and shares start heading down? Many investors will sell their ETFs. And those same companies that have been seeing their share price appreciate may experience a fall.

Again, it will not matter whether they are good companies or bad companies. They could all fall together if they are part of an index that is covered by a popular ETF.

That, at least, is the theory. No one knows exactly what will happen, as this is new territory for investors. But it has led to newspaper headlines during 2017 such as this in the Australian Financial Review: ‘Are ETF inflows a bubble in the making?' And in The Australian: ‘ETFs turn stockmarket into the ultimate Ponzi scheme'.

The latter article, published in September 2017 by financial journalist Alan Kohler, predicts EFTs will most likely figure prominently in the next stockmarket crash. The reason being:

… the flow of funds into exchange-traded funds has been so colossal and indiscriminate, and they now represent such a big proportion of investment in equities, that the money coming out when markets reverse will be large, swift and just as undiscerning as it was on the way in.

In 2016 the financial press carried stories suggesting that one of Australia's pre-eminent active fund managers, Platinum Asset Management, could suffer because of the growth of passive investing, and in particular the large inflow of money into ETFs.

In response, Platinum chairman Michael Cole, in August 2017 at the release of the company's June 2017 financial results, made some interesting comments:

In the United States, indexed or passive equity strategies now account for approximately 40 per cent of funds under management (FUM).

By contrast, in Australia passive equity investment strategies only account for 20 per cent of all FUM. Since January 2016, net inflows to active managers for both local and global strategies ($914 million) continue to exceed net flows to passive strategies ($804 million).

He added:

Active investment management still continues to be valued by Australian institutional and retail investors but it would be remiss to ignore the strong overseas trend towards passive equity management.

Who is Top Stocks written for?

Top Stocks is written for all those investors wishing to exercise a degree of control over their portfolios. It is for those just starting out as well as for those with plenty of experience but who still feel the need for some guidance through the thickets of around 2200 listed stocks.

It is not a how-to book. It does not give step-by-step instructions to ‘winning' in the stock market. Rather, it is an independent and objective evaluation of leading companies, based on rigid criteria, with the intention of yielding a large selection of stocks that can become the starting point for investors wishing to do their own research.

A large amount of information is presented on each company, and another key feature of the book is that the data is presented in a common format, to allow readers to make easy comparisons between companies.

It is necessarily a conservative book. All stocks must have been listed for five years even to be considered for inclusion. It is especially suited to those seeking out value stocks for longer-term investment.

Yet, perhaps ironically, the book is also being used by short-term traders seeking a goodly selection of financially sound and reliable companies whose shares they can trade.

In addition, there are many regular readers, who buy the book each year, and to them in particular I express my thanks.

What are the entry criteria?

The criteria for inclusion in Top Stocks are strict:

It is surely a tribute to the strength and resilience of Australian corporations that, once again, despite the volatility of recent years, so many companies have qualified for the book.

Changes to this edition

A total of 19 companies from Top Stocks 2017 have been omitted from this new edition.

Three companies were acquired during the year:

One was removed from the All Ordinaries Index:

With interest rates remaining low some corporations expanded their borrowings, and six companies from Top Stocks 2017 saw their debt-to-equity ratio rise above the 70 per cent limit for this book:

The remaining nine excluded companies had return-on-equity ratios that fell below the required 10 per cent:

There are 20 new companies in this book (although 12 of them have appeared in earlier editions of the book but were not in Top Stocks 2017).

It is worth noting that one of the new companies is Wesfarmers, which last appeared in Top Stocks 2007. It is one of Australia's largest corporations and the shares are widely held. I have sometimes received queries from readers enquiring — a little snidely, I thought — how a book that calls itself Top Stocks could omit such an illustrious company.

The reason is that Wesfarmers acquired an enormous amount of goodwill from the takeovers of Bunnings and Coles Myer. For accounting purposes, this goodwill is classified as an asset, which means that, on its balance sheet, the company enjoys a very high amount of shareholders' equity (which is its assets minus its liabilities).

Consequently, its return on equity — which is the after-tax profit as a percentage of the shareholders' equity figure — has, until this year, fallen below the 10 per cent benchmark for inclusion in the book.

To illustrate, in its June 2017 accounts Wesfarmers reported goodwill of $14.36 billion and other intangible assets of $4.58 billion.

Most companies do not report a separate figure for goodwill, but include it under their intangible assets figure. So, for comparison, Woolworths, in its June 2017 accounts, listed intangible assets — including goodwill — of a total of $6.53 billion. BHP listed intangible assets of US$3.97 billion. Commonwealth Bank listed a figure of $10.02 billion. Telstra reported $9.56 billion. Rio Tinto, which does separate goodwill and intangible assets in its accounts, reported US$1 billion for goodwill in June 2017, with intangible assets of US$2.99 billion.

The new companies in this book are:

*Companies that have not appeared in any previous edition of Top Stocks.

Companies in every edition of Top Stocks

This is the 24th edition of Top Stocks. Just three companies have appeared in each one of those editions:

Once again it is my hope that Top Stocks will serve you well.

Martin Roth


September 2017