It’s not easy to know what to look for when searching for investment opportunities. If you turn on the news, open a newspaper or search online, you will find hundreds of differing (and often contradictory) theories on what you should be looking for and why.
How do you know which theory to follow or whose advice to take? I’d suggest that the proof is in the pudding, the investment strategies that work are going to be used by the most successful investors.
Many world famous investors such as Warren Buffett use a ‘value’ approach. I’ll leave the treatise on value investing for another day, but this article provides some guidance on key elements to focus on first.
The characteristics of great businesses
The best kind of company to own is a great quality company that is managed well and has excellent future prospects. As Warren Buffet has said, ‘If you don’t feel comfortable owning something for 10 years, then don’t own it for 10 minutes.’ A great quality company is more likely to weather any financial storms and come out on top over any competitors.
One of the most important things to look for is ‘Return on Equity’ (ROE), a measure of the return a company makes on the equity in the business. If you are lucky, you may find a bank account that will provide you with a 5% return on your money. Some companies, however, are capable of an ROE in excess of 25%. As a guide, companies with an ROE greater than 15% are worth investigating further. Net Debt/Equity is also worthy of consideration. A company with low debt is much more likely to weather any financial storms they may face.
You also want to find a company with bright future prospects. If you can, check analyst forecasts to give you an idea of what the future may look like. Of course, forecasts are never 100% correct, but they can give you an idea of what the future may hold.
Judging whether company management has done a good job is somewhat subjective but there are a few ways, short of meeting with them personally, that you can get a feel for this. Reading any available interviews, articles or announcements can help you get a picture of how well a company has been managed.
Another way is reading the CEO’s letter from the company’s annual report for the last 10 years. You will be able to see all the promises made and whether the company was able to meet these.
Once you have found a great company, the next question is when to buy it. It’s always preferable to buy anything at a discount, especially if it is of high quality. The aim of investing is capital growth, so it can be very easy to fall into the trap of paying a lot of attention to the price of a stock. Price is important, but takes a secondary position to quality. Buying a poor quality business for a cheap price is less likely to grow the value of your portfolio in the long run.
Chris Batchelor CFA is Skaffold’s General Manager.
Chris is a specialist in equity markets and securities. He is a Chartered Financial Analyst and has 20 years’ experience in financial markets.
