Last Updated September 11, 2013
If you’re looking to invest in successful businesses that are relatively large and safe, perhaps with a preference for market leaders and household names, then you’re not alone. But despite the popularity of this approach, there is often a surprising lack of planning in the way that many investors go about the business of picking stocks.
If you want to invest well then here are 10 important questions you should ask about your next investment candidate.
1. Does it add to the industrial diversity of your existing portfolio?
Different industries are affected by the economic cycle in different ways. When some do well, others do badly and when some are in favour with investors, others are out of favour.
Making sure your portfolio is well diversified across different industries is a powerful way to use market volatility, economic and industrial cycles to your advantage. It can open up opportunities to sell companies that are in booming industries (with booming share prices) and to put the profits into industries which are in a temporary slump.
2. Does it add to the geographic diversity of your portfolio?
Many UK investor’s portfolios have a high exposure to the UK economy. That’s understandable, but is perhaps not such a good idea if your job and the rest of your economic welfare are also largely affected by events in the UK.
A more international portfolio is likely to cope with UK economic problems better than a UK-only portfolio.
There are two main ways to increase geographic diversity. The first is to look for companies that operate almost exclusively abroad, either in a single country or relatively localised region somewhere outside the UK. The second is to look for companies that are truly international, selling their products and services into many different countries all across the globe.
3. Is the company operationally diverse?
Operational diversity can mean different things, but in this I’m talking about companies that are excessively dependent on a small group of people or companies.
An example of this could be a small DVD distributor which has a contract to supply a major supermarket. That contract could make up perhaps 80% of the company’s revenue. If the supermarket decides to switch to a competitor the distributor will effectively be dead in the water.
4. Is the company in the leading group within its industry?
Large, market leading companies are actually a big turn-off for some investors. They believe that large companies are unlikely to grow fast enough to make them attractive investments.
Of course that depends on what you think is “fast enough”. But as the world is still developing, many market leading companies have the power and reach to maintain their leading positions as the global economy grows.
In most industries there is a group of perhaps three to six companies that dominate market share.
5. Does the company have a history of economic success?
As a shareholder I measure a company’s success by the long-term growth of per share revenue, earnings and dividends. If a company can consistently grow all three then I think most investors would be happy.
Companies that are not profitable, or have shrinking revenues and earnings which are unlikely to return to historic levels, are definitely not what I would call successful.
6. Does the company have any low cost and durable competitive advantages?
Both Warren Buffett and Morningstar are two of the main proponents of a competitive advantage based approach to investment analysis. Competitive advantages, especially low cost and durable advantages, are a great help to any company that has them. Some of the main advantages to look out for are:
• Intangible assets – including things like brand names with loyalty and pricing power, patents and barriers to entry, e.g. operating in a regulated industry
• Switching costs – this is where the hassle of switching to a new supplier outweighs the benefit, for example changing your current account to a new bank
• Network effect –where the product gets more attractive as more people use it. Facebook is a prime example of this
• Cost advantages – this can come from things like cheaper processes, better locations or greater scale.
7. Has the company operated in a single industry for many years?
Some companies are able to expand successfully into all sorts of areas in which they have little expertise, but these may be the exception.
Companies which over-diversify into new areas often have problems a few years down the line. In many cases they end up selling their failing business units at a loss. Sometimes they go bust under a debt mountain built up during the acquisition phase.
Of course, single-industry businesses can fail too, but they can make for a simpler, more focussed business, and one which is easier for investors to analyse.
8. Does the company face any large and obvious threats to its existence today?
As a value investor I’m used to the idea that I will often be investing in companies that are having tough times. But if the investment is to do well it is essential that the company can pull through and prosper in the future.
Sometimes a bad news story appears to be overdone. The collapse of Tesco’s share price this year is an example where I think the market was overly pessimistic. In the long-run it still seems likely that Tesco will grow and there is still little risk of it going bust.
On the other hand Luminar, the UK’s largest nightclub operator, faced a wall of debt and vanishing cash flows as the recession dragged on. The result was a total wipe-out for shareholders.
When you’re looking to threats to a company, excessive debt and lack of cash flow are a good place to start.
9. Is there any chance that the company’s products or services will become obsolete in the near future?
A company can be well run with high profit margins and low debts, but if its products are soon to become obsolete then nothing else matters. This can happen regardless of how the company tries to turn things around.
The invention of downloadable digital music has transformed how music fans get access to the music and companies like HMV have struggled, often in vain. Another example from a different industry which is also affected by digital information is Yellow Pages.
10. Would you feel comfortable if you could not sell the shares for 5 years?
It’s well-known that share price movements in the short-term are effectively random. This means that it does not matter how great the company is, or how well it performs. Over periods of a few months to a few years, you really have no way of knowing whether the shares will go up or down.
Warren Buffett came to the same conclusion many years ago. His answer was to concentrate on buying companies that were virtually certain to grow their revenues, earnings and dividends in the long-term. This means that eventually the share price is also virtually certain to rise too.
If you buy shares in a company with a 5% yield and it quadruples the dividend over the next decade, then there is effectively no chance that the share price won’t also rise considerably over the same period.
At the very least, an equity investment should be seen as something like medium-term bond. The money goes in with no expectation that it will be returned for at least 5 years. If you’re not comfortable with that timeframe, then perhaps the stock market is not for you.
However, if you are comfortable with taking a long-term view then you already have a massive advantage over most other investors.