Study these cases if you are tempted to invest

Equity investors tend to fall into two broad categories — growth and value.

The former pursue companies that offer strong profit momentum which can attract high stock market valuations but are often accompanied by low or zero dividends.

Value investors, in contrast, focus on relatively solid dividends as the primary source of returns and they try to couple that with companies that have conservative but progressive strategies.

Over the past fortnight the value camp have been taught an important lesson by two very large European companies, RSA and KPN.

RSA is a giant insurance company that has been touted for some time by certain brokers as an attractive dividend-paying equity. KPN is the Dutch telecoms group that is akin to Eircom but in a much larger market. It, too, has been pushed at investors as an attractive dividend generator. Both have delivered news that torpedoed the “value” thesis promoted by their fan club.

RSA cut its dividend when announcing 2012 results and this sent its shares down 14% on the day and reduced its dividend by 33%. KPN announced a rights issues which caused its share to fall even harder by 36%. A rights issue requires an investor to fork out more cash if he/she wants to retain their share.

If you are tempted to develop your pension, investment or savings portfolio along a value theme, then a good study of these two announcements is worthwhile.

Telltale signs of risk existed in both companies. RSA’s earnings per share (a measure of profit) was just barely above its annual dividend per share so it was dicing with the possibility of eating into profits to protect its dividend payout. KPN has a history of launching rights issues when its cashflow comes under pressure and that should always be in investor’s minds when they contemplate such a stock.

The converse of these points applies equally when sizing up companies to invest in. My ideal company has a very strong balance sheet which I look for via low gearing, net debt to EBITDA (a proxy for profit) that is two times or lower and as many assets as possible that are tangible rather than goodwill. Then, examine the cashflow statement to see if your company actually produces proper money at the end of each year that can reduce debt, fund dividends and increase shareholder value. The profit and loss account can often publish a profit but this may be embellished by one-off disposal proceeds that flatter the numbers.

The last piece of machinery to take apart is the profit and loss account. Companies that have consistently solid operating margins are a good start but it is the headroom of earnings per share compared to dividend per share that usually catches my eye. If the earnings per share is comfortably larger than last year’s dividend per share, then I’m reasonably relaxed that the dividend ends up in my current account.

Putting all these together, you get a company that pays a steady dividend while managing a conservative balance sheet that can be accessed to fund expansion without asking equity investors for more money or over relying on bank debt.

If you can pick up one of these with a dividend yield of, say, 4%, then you have an asset that beats the socks off deposit accounts and most quality bonds.

Moreover, if the company’s management team positions the business as a leading player in its chosen markets, and displays ambition to pursue solid but conservative growth while protecting investors, then it belongs in your long-term portfolio.

Both RSA and KPN failed on a number of these criteria and it was easy to spot those before their recent announcements.