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SELECTING COMPANIES  

HOW TO SELECT GOOD COMPANIES IN WHICH TO INVEST  

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This page and linked ones cover how to select good companies in which to invest and the content is based on articles first published in the ShareSoc Informer newsletters.


Some investors take the view (and I am inclined to this stance), that so long as you buy shares in good companies, then you can ignore the swings in the economy and the gyrations of the stock market. No need to follow other investors as they take a different view of the future and change the discount factors they unconsciously apply to future profits. If the business is soundly based, it will continue to generate profits which it will pay out to you in dividends or return to you in other ways.


In extremis, this is reflected in a “buy and hold for ever” strategy where you can simply forget about monitoring your portfolio because you have constructed the perfect compendium of companies and changing it will just incur transaction costs. Not that I would go so far as to support that approach I hasten to add.


Was it not that famous investor Warren Buffett who said  that his favourite holding period for stocks was “forever”? But clearly he does sell some stocks and buy others over time. However many successful investors seem to stay pretty fully invested in the market, i.e. they don’t try to make money from market timing or dodge in and out of companies. Even though some investments don’t show a short term return, they often hold them for long periods until the market, or some trade buyer, recognises the merits of the company.


Is It a Good Company or Not?

So anyone trying to emulate those paragons of investment wisdom such as Buffett have to decide when they look at a company whether in essence it is likely to generate the long term return on capital that is going to make it a successful investment. For those new to the investment game, the current value of a share is probably based on the future expectations of the cash flows from the company (i.e. cash paid out as dividends or reinvested to expand the assets). So return on capital is clearly an important factor, and the sole question is how to achieve it.


How Are Good Companies Created?

Anyone who has ever launched a new company, or is managing an existing one, must at some point reflect on this question. Needless to say, there is an enormous literature on this subject, and you can spend two years doing an MBA course if you really want to learn what the experts say on this matter. Yes this article is going to attempt to condense the wisdom of ages, and the mantra of many experts, into a few basic things to look at when reviewing companies for investment purposes. You may want to consider this more a “checklist” to review when researching companies.


If you want a bit more detail, please read “In Search of Excellence” and “Competitive Strategy” in our recommended reading list (see Reading List). Or read part 2 of Philip Fisher’s “Common Stocks & Uncommon Profits” for a less academic approach also listed there.


Excess Profits that are Maintainable

The key to any really successful business is whether it can achieve a superior return on capital (at least in comparison with the run of the market or against you putting money on deposit at no risk). Obviously those returns must be “risk adjusted” so that they do not depend on some reckless strategy that might win or lose a fortune. Indeed one of the characteristics of good management is that they are typically paranoid to control risk, even in business areas where some risks cannot be avoided (something that the management of BP might have paid more attention to in the past).


But if a business is consistently getting a superior return, then other people will attempt to move into the same market. In other words, excess profits can quickly be eroded by competitors or new entrants.


No Barriers to Entry

A simple example. You are selling potatoes at £1 per kilo as a distributor because you have historically good sources of supply and contracts to buy them from major supermarkets. That gives you a handsome profit margin. But there is nothing whatsoever to stop other potato distributors pinching your customers, doing deals with your suppliers and undercutting your business on price if they choose to do so. In essence your market has no barriers to entry and you have probably no control whatsoever on the actual prices you can obtain for your goods.


Powerful Suppliers or Customers

Another obvious problem with the above scenario is that a few major supermarkets dominate the potato retailing business, so you will be dealing with customers who are much bigger than you and are likely to have their interests at heart rather than your own. Not only that, but if they see you making good profits, they may simply try to cut you out and deal directly with the farmers who produce the goods.


At least in this case, the suppliers may operate in a fragmented market with good price competition, but that is not always the case of course.


The other problems with selling potatoes are they are subject to the vagaries of the weather like any agricultural product, and in addition are easily replaceable by alternative products if they become too expensive. In other words, if you raise prices the retail customers might simply switch to other products such as pasta on their plates.


Would you start up a new potato distribution company, or invest in an existing one? Surely the only way this could be justified is if the business had some special characteristic that ensured it could compete successfully and build a protectable space around its market against new competitors. For example, economies of scale, vertical integration, government imposed monopoly, intellectual property or whatever. In reality, there are probably few such avenues for potato distributors.


Intellectual Property

Many successful companies are based on intellectual property such as inventions, copyrights (e.g. in software), trade secrets and trade marks (Coca-Cola is a good example). The real money spinners in the modern world have been companies such as Microsoft, Apple and Google who have relied on “proprietary” technology which has given them a semi monopolistic position in many markets. For example,   Microsoft is way ahead of anyone else in the market for personal computer operating systems and even when faced with competitors who gave away their product at no charge (e.g. Linux and other “open systems”) they have maintained their dominance and increased their profits!


So when looking at a business as an investment proposition, look at the barriers to entry, look at the supplier and customer relationships (preferably diverse), look at the intellectual property, and examine if there is any control over the prices at which they buy and sell.


Excellence Helps

Some businesses succeed though despite not having the natural advantages of a proprietary position (or a monopoly granted by Government or other regulatory bodies).


For example, they can become a dominant market force, and protect their position, simply by becoming the largest and lowest cost supplier in an industry. Or they can sell their indistinguishable product at superior prices by clever marketing or strong branding (beer and spirit producers tend to follow that path).


Good Management Helps

Superior management can of course help a great deal. Are the managers experienced in the sector in which they operate, and do they have a track record of outstanding performance? A good question to ask when looking at the kind of early stage companies that list on AIM. But  don’t expect good managers to turn around basically unsound businesses (those operating in poor business segments with no protectable niche). As the sage of Omaha said “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact”.


But look at companies like Lincat (recently taken over at a good premium). This was a very boring “metal bashing” business producing professional kitchen equipment. Barriers to entry not apparent, and surely vulnerable to cheaper overseas producers? So how did they achieve their results—almost certainly from good management, and staying close to their customers.


Indeed if you are investing in an early stage business as a venture capital investor or business angel, the strength of the management team is all important. Obviously the larger the business grows, the less it tends to depend on one or two individuals partly because businesses develop a “culture” over time that reinforces good practice. Good management can improve an existing business, but cannot turn a sow’s ear into a silk purse.


Financial Structure

A characteristic of a good business is a sound financial structure. Not excessively indebted (which increases the risks), with decent gross and net margins (so even in a recession, some profits may be maintained), and not operationally geared.


What’s an operationally geared business? One that has high fixed costs that do not vary with volumes. For example, those with large capital assets such as expensive machines that need to be fully occupied (airlines or steelmakers for example). Come a recession, such businesses drop their prices so as to maintain volume, and it ends up as a mutual throat cutting exercise for industry participants.


Take a recent example of a company that went into administration—Loseley’s an ice cream maker. Apart from operating in a very competitive sector with a few “Gorillas” in the market, they had high fixed costs, low profit margins and on top of that a wildly seasonal demand that was unpredictable because it was subject to the weather. Nobody would go into producing ice cream if they understood the economics, but I suspect too many people have read the story of Ben & Jerry and how they grew such a business from scratch (it’s an inspirational management story but probably not repeatable).


Growing or Declining Markets

You need to invest in businesses that are operating in growing markets. Any fool can make money in a booming sector, but it takes a genius to make a success of a business in a declining sector.


Avoid Fashion and Obsolescence

If you back a company whose products are fashionable, it may show good short term growth but come unstuck later. Likewise avoid technology companies with one product idea that can instantly be made obsolete by a competitor launching a new alternative. So “one product” companies are always questionable.


Avoid Regulatory Risk

Likewise avoid companies that are subject to regulation and Government interference. The internet gaming sector is a good example. The US market was closed without any notice (even market experts did not expect the legislation to pass) and there are still on-going law suits and criminal prosecutions.


Learn About Companies

Make sure you understand how a company operates, and what is its special expertise or grip on the market. Do study the company’s web site and read its Annual Report to ensure you know the basic background, but if you can get some industry comment from a third party, so much the better. Often you can do your own research—for example, if it’s a retailing company visit one or two of their shops and buy something (as I did recently with Greggs). Is it a good experience? Are you satisfied with what you bought?


One way to learn about a company is to become a shareholder and follow it for a while—for example attend the AGM and talk to the management. There is often much you can  learn that may not have been apparent at first glance, so investing over a period of time and in stages rather than plunging in with a large stake is likely to be the best option.


Indeed some of my least successful investments have been those where I put too much money into a business, before I realised that the underlying characteristics were poor!


Don’t Buy Unproven Business Models

In conclusion, one golden rule is do not buy unprofitable companies (or at least those with profits not certain to arise in the near future). The proof of whether a viable business model exists is when profits are present. Otherwise you are simply gambling. So no “concept” companies please, no gold mines that may have a hole in the ground but are not producing and no “shells” where the management may find a business in due course. The South Sea Company (c. 1711) combined the lure of gold with an unviable business plan, leading to one of the greatest “bubbles” of all time.


Perhaps these comments will dismay those readers who like to invest in oil or mineral explorers, or in the latest technological wonder, but you need to judge the risks very carefully. Everything has a price of course, so sometimes the risk may be justified, but often there is a wide psychological trap that it is just too easy to fall into, i.e. the lure of untold wealth at little cost. Having once invested in a dot.com business that decided to buy a gold mine when its first venture proved unprofitable, I know well the kind of people who back these kind of companies, and those who are foolish enough to run them! See Unprofitable Companies for more on this topic.


Cash Flow

A key financial factor to look at is cash flow. One can never be sure that the reported profits are real as they can be subject to accounting manipulations or presentational polishing, but cash in the bank is usually indisputable.


An easy check is to compare the “cash flow from operations on the cash flow statement to reported profits. If the profits do not turn into cash, there may be something questionable. Businesses go bust because they run out of cash, not profits.


Return on Capital

Never forget to review the return on capital employed (the profits as a percentage of net assets ). This is one of the most important measures I use to judge the quality of the business model and of the management. Anyone can develop a business and grow sales rapidly given a sufficient equity injection, but whether it will ever produce a better return than putting your money on deposit in a bank is the key question.

Good businesses consistently show a high return on capital (i.e. more than 20%), and this is what will drive the business forward and enable it to pay those dividends you are so keen upon.


Mergers & Acquisitions

Be wary of companies that grow via mergers and acquisitions. It is a difficult trick to pull off and most such corporate activity seems to benefit the managers rather than shareholders.


Financial Analysis

More information on financial analysis of companies is present on this page: Fundamental Analysis. Another useful article is on avoiding dud companies (i.e. those poor quality companies that tend to go bust) is here: Avoiding_Duds


AIM Companies

AIM companies are particularly problematic because of they often have short track records, some have poor corporate governance and are very mixed in quality. It is important to be selective when investing in AIM companies. ShareSoc has devised a “Scorecard” system to enable you to rate those companies which is described on this page: Scorecard


Summary

I hope that in this brief article I have shown you some of the things to look out for when reviewing companies. But there is no substitute for knowledge and experience, which is why investment is more of an art than a science. There is no magic formula you can follow to identify good companies.

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