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3 things I always check before buying an ASX share: expert

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The Motley Fool chats with fund managers so that you can get an insight into how the professionals think. In this edition, Monash Investors portfolio manager Sebastian Correia shows the criteria that he puts ASX shares through when deciding whether to buy.

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The Motley Fool: What are the 2 best stock buys right now?

Sebastian Correia: I’m going to have to disappoint you a little bit because I had a good think about this, and it’s really very hard to answer the question appropriately without knowing the reader’s risk tolerance, investment horizon, and ESG requirements.

So what I thought instead, I might give you 3 characteristics that I personally look for in a company as economies start to or continue to experience inflationary pressures and heightened geopolitical risk at the moment. Something that I use as a very good starting point to assess companies, and hopefully readers will find it useful. 

I should say it’s not an exhaustive list. For example, management quality and experience is very important but, unfortunately, not every investor has access to management like we do. 

Nevertheless, out of the 3 things that I think are absolutely critical when assessing a company at the moment, the first one is pricing power.

So the company has to be able to effectively pass on price increases to its customers. It’s critical in our inflationary environment obviously to protect margins. But also, the knock-on effect is, down the track, it provides the company with a stronger competitive position to actually take advantage of those that don’t have that ability to pass on their price increases. Statistically, and there’s been a lot of studies on this, margin resilience has been a pretty good barometer of business survivability in the past.

It’s also quite important for valuation because when margins compress, generally the market price or the stock will decline to adjust for the contraction in the valuation multiple. So by being quite prudent on companies you invest in, if they have pricing power, you actually protect yourself from two elements, not just the valuation multiple that it trades at, but also the underlying earnings that it could achieve in an inflationary environment.

Number two, free cash. It has to be free cash-flow positive, or at least operating cash-flow positive, and preferably net cash. If not net cash, very low debt on the balance sheet. This one is pretty self-explanatory, but it’s very important. So easy to miss because it seems obvious. 

I’m sure if interest rates rise, the more cash the company generates, the better-placed management will be to make optimal capital decisions. For example, paying down debt as interest rates rise or bolstering up the balance sheet to make acquisitions that turn up as an opportunity.

Then last but not least, number three, for us anyway, because we like to make investments in companies that are going to go through some sort of step change in earnings that will allow us to anticipate a repricing by market. The company has to have some sort of tailwind behind it. 

It’s very difficult to swim against the tide. Just ask Kodak, for example. It has to be leveraged to some sort of tailwind to allow it to not just get lost in a broader sell-off from a sector or thematic purpose, particularly in the ever-increasing influence of passive, bespoke investment vehicles like ETFs, thematic ETFs. 

So those are the three. I look at those 3 every day when I’m looking at a company and, hopefully, it will be useful to the readers.

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