Revisit: Buying into the right business

When we buy stocks, we are actually buying into those businesses. So when you own the shares of example company A, you are actually buying into a small portion of company A's business. That is stocks in a nutshell.

Of course you would want to make sure that company A is doing very well with your money running its businesses and wish it has the potential to grow stronger - such that it's earning will increase and demands for its stock will go up, in turn leading to increase in its share price. Stock market is a weighing machine in the long run.

Here are some very useful notes sourced from http://wiki.masterlifefaster.com/Home/investing which is modified from Buffettology:



How to identify a great business

1. Does the business have brand-name products or services that give it a monopoly in the market?
2. Does the business have a multi-year track record of consistently growing earnings?
3. Does the business have low amounts of debt?
4. Has the business consistently earned a high rate of return on shareholders’ equity? This measure is known as Return on Equity (ROE). It gives you an idea of how efficiently the management team generates earnings with the company’s assets. Over the last 40 years, American companies have achieved an average ROE of 12 percent. Anything over 12 percent is above average.
5. Is the business able to maintain current operations with minimal investment (low capex)? The ideal business rarely has to replace factories and equipment, and requires minimal investment in research and development to stay competitive. Think airlines, think pharma companies.
6. Is the business free to adjust prices to inflation? If the prices of raw materials go up, the business can increase the price of its products and services with no drop in demand.
7. External factor - is the outlook for the industry of the company bright? (See Kodak, Nokia examples.)

Excellent product-based companies usually share the following characteristics:

• The product wears out fast or is used up quickly. (High turnover)
• The product has brand-name appeal. (Brand is an intangible asset of a company)
• Merchants must carry the product to stay in business.

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Business Moat put simply...

A company which fulfils the above would be considered one with great business moat. It is surely no easy feat plowing through the balance sheets, cash flow sheets, figuring out bombastic figures (with unfamiliar terminologies attached) and calculating ratios. Thus, using the above questions to identify a good business would make things much easier and less time consuming.

I would consider number 6 most important followed by number 1 and 2. For point number 6, it often applies to businesses with superior products under patent, established business network or complex infrastructures that competitors find hard to mimic. Therefore they have the pricing advantage of increasing their service / product prices without losing (too many of) their current customers.

For point 1 and 2, think Coca-cola think McDonald's. However, do bear in mind that even giants with good track records could fall when technology in the world revolutionised (like mentioned in point 7 above for industry outlook).
俗话说‘识时务者为俊杰’。

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Come to think of it, I really should start attending AGMs of the companies which I have bought into.

To correctly value a company, we should not only look at its past results but also the future earning potentials and future business risks / plans that it has. :)


Read also: 

The Dividend Trap
Indicators and Intrinsic Value - no magic formula?