We will soon bid farewell to the first year of the new decade.
As 2021 beckons, the hope is that it will be a year of recovery.
Amid the challenges, there’s a silver lining to all of this.
Humans have shown their tenacity by adapting to changing business conditions, and businesses have leaned heavily on technology and digitalisation to continue functioning.
Although many stocks have been badly hammered, there have been notable winners such as Top Glove Corporation Berhad (SGX: BVA) and iFAST Corporation Limited (SGX: AIY).
How should investors go about identifying a potential winning stock for 2021?
It boils down to five attributes that you should look closely at before you put your money down on a business.
Gross margin
The gross profit margin measures the pricing power a business has and is calculated as the gross profit divided by revenue.
A higher gross margin indicates the business can price its products as a high mark-up to its cost of goods.
However, a high gross margin alone should not be an indication of a strong business.
Investors also need to observe how consistent the gross margin is.
Companies in cyclical industries may display a high gross margin at the peak of its cycle, but subsequent years may see this margin fluctuating wildly as the cycle turns.
An example of a company with consistent gross margins is PepsiCo Inc (NASDAQ: PEP), a food and beverage giant with its signature Pepsi-Cola. Its gross margin has hovered between 52% to 55% over the last 10 years.
Free cash flow
Another sign of a great business is its ability to churn out copious amounts of free cash flow (FCF).
Free cash flow is what’s left when you deduct a company’s capital expenditure from its operating cash flow.
Businesses that consistently generate healthy levels of FCF are more resilient when faced with adversity.
The FCF also provides management with different options as to how to deploy the monies, be it for share buybacks, an increase in dividends, or for opportunistic acquisitions.
Competitive moat
The next attribute to look for is a company’s competitive moat.
In a nutshell, a “moat” relates to how strong a company’s competitive edge is versus its competitors.
The stronger the moat, the tougher it is for the company to lose customers or market share.
Such businesses are also more resilient during crises as the moat will offer some buffer against falling demand.
That said, investors need to assess a moat carefully in light of the disruptive nature of the pandemic.
Some business models may become obsolete as human habits and practices have been irreversibly altered.
As a result, competitive moats may also shift and either strengthen or weaken.
If a moat is assessed to be durable, the company can likely generate high returns for investors over an extended period.
Dividends
The fourth attribute that investors should look for are businesses that have a long track record of paying dividends.
As mentioned earlier, companies that can produce consistent free cash flow usually are also able to maintain dividend payments.
Besides being a generator of cash, a dividend-paying company will usually also have a strong balance sheet and a sturdy business model.
These two attributes stand the investor in good stead during challenging times as it will provide the company with a better chance of survival.
There are even companies that have increased their dividends for more than a decade and have not let crises along the way crimp their ability to raise dividends.
By observing such an impressive track record, investors can determine the secret sauce that makes the company so successful.
And if the company has what it takes to increase dividends over such a long period, there’s a high chance it will continue to do so in future.
Risks
With the first four attributes being positive aspects to watch out for, investors mustn’t neglect the negatives.
What I am referring to are the risks associated with any business that may cause it to perform poorer than expected.
These risks may not immediately manifest themselves but may remain hidden until a crisis or challenge comes along.
By thinking through different scenarios and observing how the company handled previous crises, you can obtain a better sense of how resilient the business is.
By weighing the potential risks against the anticipated rewards, you can then arrive at a better-informed investment decision.
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Disclaimer: Royston Yang owns shares in iFAST Corporation Limited.
