Monday, June 1, 2015

6 Critical Criteria for Investing

Nothing more worries individual investors than not knowing what to look for, and choosing the wrong companies to buy. How do I know when a stock is cheap? How do I tell if it will go up over time? 

But that doesn't work for me. I'm much more interested in what a stock will do tomorrow than in what it did yesterday-- and I don't believe I can learn much about tomorrow based on yesterday. Which means I have to find other ways to value the companies I buy. I need to look at non-financial criteria. I've written about this before. But because it gets so much investor attention and because it seems so difficult to people starting out, I'm going to revisit it here.

Most money managers try to steer an investment portfolio by looking in the rear-view mirror

1. First up, I want a great brand, and often a change agent. By that I mean I want a company people have heard of, and one which is dominant in an industry. Examples include Netflix and Apple. Sure, some people gotta hate because these companies steamroll the competition (respectively: cable TV/Blockbuster/neighborhood video rentals, and Microsoft-Dell-Gateway-Sony-Nokia-Blackberry ...) but that's what makes them such compelling investments. These companies are so strong they redefine the way business is done in their category. It is no longer possible to have a realistic discussion about the state of retail without mentioning Amazon, or about television without Netflix. They change everything and as consumers we can either get on board or get left behind. 

2. Second, I like to see a wide moat. Simply put, this is the distance between the business in question and the nearest competitor, which usually indicates the difficulty of the competitor catching up in the next few years. A good example is Starbucks. On the surface Starbucks sells a commodity-- coffee. But what makes them so valuable is they do it with panache: across a massive swath of the globe, at tremendous profit (remember when we thought $3 for a cup of coffee was crazy?) and they do it in their ubiquitous neighborhoody, comfortable, jazz-infused stores. Sure another business can mimic what they do-- and thousands have-- but Starbucks has such a massive head start and with worldwide brand recognition and a well-established level of quality product and service that no one can realistically catch them for years to come. 

Another great example of a wide moat is Visa. Almost regardless of where you travel, time of day, language spoken, or currency used, they take Visa. Even MasterCard can't catch up. And newer methods of payment-- ApplePay, PayPal-- are just alternative ways for most people of using their Visa card (both systems tie into an existing card account), and in any case are many years away from the level of saturation Visa has worldwide. 

Amazon's AWS data center 

3. Next, I'm looking for a business which is in strong growth mode. This one is obvious: a company whose sales are expanding rapidly year over year as they add new stores, or put out new products or services, or buy up their competitors (or kill them). It is nearly impossible to value these businesses financially based upon their past performance because in a lot of cases they're growing too fast for last year's numbers to mean much. For example, a division of Amazon called Amazon Web Services, or AWS, offers cloud computing services to other businesses (Netflix among them). AWS is only a few years old but it's currently growing at something like 80% per year. In time it could be worth more than the company's "traditional" ecommerce business. A number of other, more established technology companies have even abandoned the cloud services industry in the face of Amazon's juggernaut (Hewlett-Packard did that just that last week). Partially as a result, Amazon's stock valuation has increased over 100% in 2015 alone. That's a ride I want to be on. 

4. After that, I want a business with low debt. Typically, manufacturers have higher fixed costs for heavy equipment and materials, so they must borrow more for those items and maintain higher debt levels on their corporate books. By contrast, software companies and online services generally have much less need for serious capital (their highest costs are often their people) so they tend to carry less debt. Generally speaking, a company with relatively little debt has a lower bar to clear to make a profit, and therefore has a much wider operating margin to work with. As a side benefit, businesses carrying little debt can usually better weather difficult economic climates or other sales downturns. 

Long Term Debt is a line item on any public company's Balance Sheet. This can easily be found on Yahoo! Finance by entering the company's name in the Quote Lookup field. Ideally (but not exclusively), Long Term Debt should total 25% or less of the company's annual revenues, which is available in the same location on Yahoo!, but on the company's Income Statement. 

Under Armour Founder-CEO Kevin Plank
5. The next has to do with the company's executive leadership. I want smart, transparent, confident leaders who are less interested in Wall Street analysts' quarterly expectations and more interested in long-term growth, product quality and customer service. You can read interviews, listen to conference calls with press, watch them on YouTube: are the executives of your business providing clear direct answers to questions posed? Are they worried about share prices or customer satisfaction? What do they say about competitors, about new technology, about growth plans? Do they come across as a little phony, a little slimy or more genuine and trustworthy? Do you believe them? Like them? 

Financial research and the news are added to my existing customer experience, and together they serve to enrich and deepen my knowledge

The most famous example of straight-talking, trustworthy leadership is Berkshire Hathaway's billionaire leader Warren Buffett. In his annual letters to shareholders, Mr. Buffett comes across as down-to-earth, honest, folksy and even funny. Whatever the business he's describing he tells is like it is, explaining how it works and why it's important as he goes along. Reading his letters is some of the best business education you can find, not to mention a model for others and entertaining to boot. 

6. Finally, I prefer businesses with which I have first hand customer experience. I've found it invaluable: how better to judge a business's performance than by being a consumer of their products and services over time? 

This one is a slightly higher hurdle because most of do business with only a handful of public companies  relative to the thousands worldwide in which we could invest. But in truth there is no shortage of investment opportunities just among those: manufacturers of toothpaste and paper towels, clothing and shoes, electronics and furniture, housing and automobiles, sporting goods and appliances. Makers of entertainment products like books, magazines, music, movies, television, video games. Service companies like utilities and cellular, cable and internet, shopping clubs and online retailers, banks and even brokerages. 

For example, I prefer Under Armour's athletic clothing to Nike's both for fit and durability, and have since I stumbled onto it about 10 years ago. I'm a huge fan of Amazon's Prime service, which is preferable for me rather than shopping around for vacuum filters that fit, or having the right gas grill shipped to my door. Despite living in Seattle my coffee snobbery has never advanced past Starbucks' fresh roasted espresso beans. I generally enjoy Disney's Marvel superhero movies. I've mentioned Netflix and Visa. Also there's LinkedIn and Twitter, IMAX and Zillow, all of which have come up with a great new business concept or revolutionized an everyday process like career networking or house shopping or movie-going.

By being a customer/user (even an unpaying one), I better understand the value proposition these businesses offer and I've already got a finger on their pulse. I notice when quality slides or new services are added, and this information informs my investment decisions. Financial research and the news I read are additional to my existing, ongoing customer experience. Together they work to enrich and deepen my knowledge.

This list of criteria has provided me close to 80% of what I need to know prior to investment-- but you likely will not find all 6 in one company very often. It happens, but those are rare. Look to get several in one stock. I've listed several of them here, but there are probably a couple of hundred if you look hard enough. This method is largely unscientific and non-financial, and therefore is an unconventional way of assessing a stock-- but then being somewhat contrarian is my nature. Some pro stock-pickers and market timers might poke fun at you; they certainly have at me. Generally speaking, however, my returns crush theirs... though I don't think they believe my numbers. A high-class problem if there ever was one. 
Drifting to Fifty | Random unrelated nugget of the week
If you reset your car's side mirrors from reflecting your own rear fenders to reflecting that empty zone between the edge of your peripheral vision and the edge of what you can see in the rear-view mirror, then you will eliminate blind spots. 

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