Monday, March 21, 2016

Winners Wanted

In my last post, I discussed the market 'doldrums' and how I'm preparing during this achingly slow period to ready myself for some buying in the next few months. But what does that mean in real terms? What exactly should I be looking for? I'll need a checklist of attributes I want my businesses to have as well as resources with which to research the companies in question.

First, I'll need a place to start. For that, I often turn to The Motley Fool's free podcasts, of which my favorites are Rule Breaker Investing and MarketFoolery. Respective hosts David Gardner and Chris Hill break down simple stock selection methodology and their favorite companies in brief understandable segments, providing a perfect jumping-off point for beginning investors looking to get the basics, as well as for the more experienced who want fresh ideas.

Next: data and other information. I've said previously that my favorite starting point is Yahoo!Finance. Online today you can't find a more comprehensive, up-to-date, easier-to-navigate stockpile of free public company info. You'll discover recent financial statements, basic criterial calculations, insider (executive) histories and stock positions, and a broad-reaching searchable database of articles on every American public company, plus hundreds of internationals.

(A portion of what follows was originally published last summer. It's been edited and updated.)

Hopefully by now a few specific businesses look promising. When I'm thinking of investing my hard-earned money to buy into one of these businesses, I want to be able to
  • Describe in one sentence exactly what the company does
  • Identify the CEO by name, and whether she or he is a founder of the business
  • Identify primary marketplace competitors 
  • Recall how the stock has done over the past 12 months

The next step is to start examining specific criteria— contrary to a lot of what we read, I generally find it more helpful to search qualitatively than quantitatively— that will help me decide if this company is one I want to own. Here's what I look for:

1. Sustainable Advantage, or 'Wide moat'. What kind of a gap exists between the business I'm looking at and other players on that field? For example, Amazon has a huge moat against every other internet retailer— even every bricks and mortar retailer— due to its sheer scale, which lends it buying power, shipping efficiencies, and brand recognition. Which means in every theoretical matchup between Amazon and Walmart, or Chinese e-tailer Alibaba, Amazon is the odds-on winner. The moat generally makes it a safer investment. 

But a competitive advantage could be anything difficult to replicate, whether another company is currently competing or just thinking of getting into that market. Proprietary technology for example— or actual patents— can keep competition at bay for years. Think of what happened to the Sony Walkman line when Apple introduced the iPod. Plain old momentum, too, provides a hell of an advantage: look at the the uphill battle faced by anyone— including deep-pocketed Amazon— who tries to challenge Netflix in streaming TV.
Under Armour's Kevin Plank

2: Smart, transparent leadership. I also want to learn about the executive team. Every company's 10K (annual report, written by the execs) is available for free, and many execs routinely make themselves available for interviews with the financial press. Are they smart? Does what they say make sense? Do they seem genuine, or phony? Are they likable, or trustworthy? Confident? Slimy? Egotistical? Do they talk about their customers and their employees— or just about their board members and stock price? I'm looking for how they think, whether they duck hard questions or obfuscate their answers. I want to get to know them because ultimately they run the businesses I'm buying into, so largely they will decide the success of my investments.

3: Low debt. I generally don't like businesses which are capital-intensive: they require a lot of expensive equipment or facilities which drag on their cash reserves and profitability. As an example let's look at airlines. An airline has extremely high fixed costs for equipment, fuel contracts, parts, logistics systems, and lots of trained personnel and retirement/pension expense. An airline has to take on huge debt to finance these costs, and the payments on that debt take a fat chunk out of profits. Because airlines sell a commodity (a seat on this plane is largely no better than a seat on that plane) they face brutal price competition, and when the economy dips, customers travel less, and the airlines and their stocks frequently take a pounding.

So I look for the line item Long Term Debt on any business's most recent balance sheet, and what I want to see is total debt around 25% or less of the company's annual revenues (this information is on the Balance Sheet of any public company and is easy to find). I want to know is how much the company is borrowing compared to how much they're selling, so I can get a napkin-sketch idea how much the debt payments (usually 5-10% per year) drag on profitability. 

It's everywhere
4: Be a customer. Many investors are interested only in what they can learn from financial statements, leadership 'guidance', or from technical analysis of charts and graphs. All of which is useful. But unlike them, I believe the customer experience is perhaps the most fundamental measure of a company's values and future opportunity. I'm pretty normal. So when my customer experience is substantially flawed (bad restaurant service, a crappy or crashing website, cheap fabrics, a lousy return policy) I am unlikely to come away feeling good about the company's prospects; that company's values would seem misaligned with mine. But when the customer experience is stellar, I imagine other customers will be as delighted as I was. I start to see possible future trajectories for that business, and I get interested in owning a piece. So whenever possible I prefer to buy companies I do business with directly (Amazon, Netflix, Apple, Starbucks, Chipotle, Twitter) or whose products I've used extensively (Under Armour, Visa, Disney, Imax). While I can research the financials and leadership and competition and operational efficiency, only being a customer gives me the ability to properly judge its products or its value proposition to other customers. Without that piece I have a lot less to go on.

The original 1997 logo
5. Climbing stock price. We've all heard 'buy low, sell high,' so it's counter-intuitive that you'd want to buy a business whose price is climbing. The truth is that buying low often means buying a company which has lost value and might never regain it. There are usually very good reasons why a stock gets hammered down, and the market is brutally efficient. The odds that you'll buy a company whose price is unjustly low— one which has been oversold by unnecessarily fearful investors, so its price is currently below its 'real' value— are slim. Instead, look for businesses with rising prices: these are companies the market has decided are winners, and in the words of David Gardner, "Winners tend to keep on winning." It's more difficult to go wrong with fast-growing businesses, for which revenues are increasing year-on-year and profitability is improving with them.

6. A great brand. This qualitative assessment is more art than science, and it requires me to look around at my community, at the news, current music, at my family, at teenagers in our circle, at colleagues, friends and neighbors. Is this brand popping up more? Are celebrities photographed using their products? Do my kids want me to buy something they make, or does it seem like their prices are rising a little faster than competitors? Am I noticing their stuff product-placed on TV? Does the company ever come up in general conversation? These are all signs that the business in question is hot or heating up, that it's coming of age. Good signs. 

The important thing to bear in mind through this process is that I'm not simply buying something which represents the future success (or failure) of a company. It's not a bet. I'm becoming an owner of this business. Which means the business itself should be fun, exciting, and compelling for me. Otherwise I'll tire of it in a couple of years when it hits a rough patch, and that will make me want to sell. But real investing gains come only over the long term. So buy smart.

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