In this Part 2 of the 10-step guide to stock investments, we continue with the principles and methods used by great investors past and present. Great investors achieved their success in different ways, but they share certain characteristics.
A 10-Step Guide to Stock Investments
In Part 1 we discussed the first five guidelines in a 10-step guide to stock investments and here we pick up with how to identify good businesses to buy and return on equity.
- When you buy a stock, you become the owner of the business
- Business owners should think differently
- Focus on the value of the company, not the price
- Set a long term investment horizon
- Understand the business you buy
- Identify good business to buy
- Return on Equity
- Find companies with exceptional management
- Require a Margin of Safety
- Know the difference between investing and speculation
6. Identify good business to buy
High-quality companies with increasing earnings are the place to start investing. The reason is simple; over the long term, there is a direct relationship between a business’ sustained profitability and shareholder rewards. Companies with sustained profitability share these three essential characteristics:
- Solid track record of performance
- Protective moat or franchise that helps limit competition
- Good prospects for the company
– The company has a solid track record of performance.
A consistent operating history is an essential attribute because the company has already demonstrated the ability to compete and remain successful.
Most companies will highlight their future promise and potential. However, how do you know they can deliver without a good record of performance? Past performance is a good indication. And, although it doesn’t guarantee future success, it helps.
Hockey player Wayne Gretzky made a great point when he said: “go where the puck will be, not where it is.” However, it is also assuring to know the players can get there by showing they can skate well too!
– The company has a protective moat or a franchise.
A good business doing well with an excellent record of earnings always invites the competition. So, they need a competitive advantage to remain prosperous in the face of more competition. A protective economic moat or franchise will protect it in the future similar to the way moats protected castles from invaders.
Protective moats or franchises make it difficult for competitors to copy a company’s successful product or service and take away market share. By protecting the company’s competitive and economic advantage, it helps assure good long term prospects.
Moreover, although we start looking for businesses with good past and current performance, in reality, we are investing in the business for its future. As someone once described it, “you shouldn’t try to drive looking in the rear view mirror.”
Examples of moats and franchises are a pipeline company’s right of way and utility companies’ state regulatory licenses. Widely recognized and trusted brand names like CocaCola, Apple, or Starbucks are considered franchises because of the attraction of the brand names alone. Other well-known examples are Google’s search engine dominance, eBay’s network effect, and Intel’s technology know-how and patents.
In Berkshire Hathaway’s 1991 Annual Letter Warren Buffett describes a franchise as: “An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.”
– The company has good prospects.
Companies that sell products or services with stable or growing demand and recurring sales and are often well known.
Peter Lynch points out that companies with good prospects are easy to find because they are successfully selling products and services to you, your friends, and your employer. They have products and services people want now and will likely want in the future.
A solid track record shows that a company likely has good management in place and competitive advantage. Also, a protective moat or franchise needs to remain intact to limit competition during our period of future ownership.
With these three essential business characteristics in place, it is likely the company has good long term prospects that qualify it as an investment candidate.
Both qualitative and quantitative factors make up the 10-step guide to stock investments. These three essential characteristics of a good business are qualitative in nature.
The next guideline, return on equity, is quantitative and can be used to confirm the above essential characteristics are in fact attributes of the company under consideration.
Return on Equity
Investors frequently follow a company’s earnings, sales, and price to earnings ratio (P/E) as indications of performance and value. However, a better measure is Return on Equity (ROE).
The more earnings generated for each dollar of capital invested by the equity owners the higher the return on equity. Excellent businesses run by management who are good at capital allocation generate higher earnings per dollar of equity invested. And, therefore report high returns on equity.
Reported earnings alone are not sufficient to fully evaluate company performance. That is because they do not consider shareholder dollars (owner’s investment) needed to generate that level of earnings.
Growing companies need cash to reinvest in the business and continue their growth. Alternatively, mature companies with slower growth rates can return the money to shareholders as increasing dividends or share repurchases.
As earnings increase for each dollar of shareholder’s equity, it increases the Return on Equity.
ROE = Net Income/Shareholder Equity
Companies that show high-profit margins and high returns on equity likely have a competitive edge. And, this implies a protective moat or franchises is in place.
The One Dollar Premise
So how do we know whether its best for a company to reinvest for growth or distribute cash as dividends (or share repurchases)? The answer is surprisingly simple and discussed in Warren Buffett’s 1982 Letter to Shareholders.
“Within this gigantic auction arena (the stock market), it is our job to select businesses with economic characteristics allowing each dollar of retained earnings to be translated eventually into at least a dollar of market value.”
Likewise, Robert Hagstrom’s excellent book on investing; “The Warren Buffett Way” discusses the one dollar premise. It explains that every dollar of earnings a company retains should create a minimum of one dollar increase in the market value of the company.
If management cannot generate more market value over time for investors than the earnings they retain they should return the money to shareholders as dividends (or share repurchases).
Therefore, increasing the market value of the company multiples for each equity dollar invested is a good measure of the company’s strength. It also measures managements’ ability to allocate capital, the higher the better.
But I Don’t Want to Be an Analyst!
I hear you, the point here is to understand what is essential. There are excellent resources that analyze companies qualitatively and quantitatively, including Morningstar investment research and Value Line.
They are both excellent independent resources providing analysis and valuations of companies and more than pay for their costs in my view. Although subscription based they are also available at some online resources at public libraries for their members.
Brokerage firms also provide analysis for their clients from various firms like Morningstar, Credit Suisse, and others. These are free and found in the research sections of their websites.
Other free and useful investment sites are MotleyFool, Seeking Alpha, and Bogle Heads. These are good resources with investor communities and forums to share information and helping each other become better investors.
Adding how to identify good businesses to buy and return on equity to every investment decision closer aligns us with the best investors in the world.
In Part 3 of this series, we’ll wrap up with the remaining three principles in the 10-step guide to stock investments.