A consistent theme emerges when you read the best investment books. While each has their own unique strategy, the main points start to overlap. You get a picture of what the great investors look for in a company. And it’s an easy place to start when doing your own research and learning about stocks.
Consistently Strong Management
Most of the talk about stock selection involves balance sheets and income statements. The people behind the company are too often overlooked as secondary. Yet, they are necessary for long-term success.
Take sports, a team with the best players still needs someone to lead them, build a game plan, and manage the players. The best teams, the ones that consistently win year after year, have the best coaches. The same philosophy works for companies. Find the best coaches in the corporate world and you’ll find the best companies.
In a Berkshire letter to shareholders, Buffett talks about how Coca-Cola had a business plan for the next 100 years. This was in 1896! Ever since then investors have speculated the end to Coca-Cola’s growth. The success of Coca-Cola is due to its management’s ability to stick with the core business model – selling the commodity of soft drinks.
Watch out for management and companies that stray to far from their primary business. They tend to stumble. You don’t want to be on a ship headed off course or sinking.
A tip: A good time to buy is after management gets its act together and rights the ship. Peter Lynch was a master at finding these turn around stories.
Seriously, do you want to own the best companies, providing the best products or services or some third-rate competitor that can barely keep its head above water?
Value investors refers to this as a moat. It offers protection from economic changes. The basic things to look for are:
- Pricing power
- High (and growing) market share
- High barrier to entry
- Limited government regulation and interference
Generally these companies are the leaders of their industry and might as well be a monopoly.
Every dollar a company makes has a specific use. A portion goes to taxes, some pays the expenses, payroll, and building and equipment upkeep. What’s left is used to grow the business. It could be for research and development, expansion, growing a sales force, or buying competitors. Which goes back to a strong management staying focused on the primary business.
The best companies use those dollars very efficiently. Buffett talks about how every dollar of earnings reinvested back into the company should be returned to shareholders in the form of capital gains. If a company can’t do that efficiently, any amount above and beyond that should be returned through a dividend. The alternative is through share buybacks, which isn’t the most efficient way of returning capital to shareholders.
The company with the most efficient use of each dollar will get a better return on equity. The higher the ROE, the faster the company (and your money) grows year after year.
This is the hard part. You can find dozens of companies that meet all the above criteria. But if you pay more than the company is worth, you’ll never see the returns you expect. So you have to find stocks that are undervalued.
You do this for two reasons: it increases your returns and protects your money. Even if the company doesn’t live up to your expectations you have a built-in margin of safety that protects you from excess losses. Graham discusses this often.
You’ll need patience to wait for the right price, even if it never comes. The discipline to pass on a stock that fits all these requirements is just as important as that needed to sell a stock that no longer meets them. And this is what sets the great investors apart from the rest. Which is the biggest lesson we can take away from all this.