In yesterday’s Daily Reckoning, I showed you how spreading your investments across the right type of assets is vital. But this doesn’t mean that any old mix of stocks will create a winning portfolio.
Today, I’ll show you why only the best businesses out there deserve your hard earned money.
Before ever being considered for any of the Guild’s portfolios, every potential investment has to meet our strict list of eight criteria. No exceptions.
Here’s what they are…
#1. It must be a cash rich business.
A business’s finances are not so different from your own. You probably earn a certain amount of money each month from your job, and maybe some from investments.
Out of your income, you have to pay your expenses. The more cash left over, the better your financial position.
Businesses are no different. Before investing, you have to look for companies with a strong cash position — those left with high levels of cash after paying their expenses.
Companies with high cash flow ratios also tend to pay dividends. US discount retailer Wal-Mart, for example, has raised its dividend payments every year for 41 years. It not only paid — but increased — dividends through recessions, government shutdowns, wars, real estate busts and even during the GFC.
Now imagine you had a few companies like that tucked away, working for you in the background for your retirement. This is the power of a cash rich business. And is the kind of business we look for at the Guild.
#2. A great business will survive and prosper through any threats and challenges.
These can come in many different forms — new competitors in the market, technologies making operations or products obsolete, shifts in the economy, or changes to legislation…to name a few.
History is full of companies who were at the top of their game but failed to adapt to changing environments. You do not want those in your portfolio.
Take Blackberry, also known as RIM, for example. Not all that long ago, throughout the corporate world, any smartphone was known as a ‘Blackberry’. But in time the compelling features of personal iPhones and Android devices were recognised by employees. Soon after, corporate IT departments made the switch to the new technologies.
Blackberry failed to adapt. Its first modern touchscreen phone wasn’t released until 2010 — three years after the iPhone came on the market. By then it had a huge deficit to make up. And it failed to do so.
It teaches us a valuable lesson…
Invest only in businesses that recognise the threats and challenges they face. Businesses with realistic and achievable plans in place, who respond and adapt.
#3. Before investing any of your money, always look for a quality management team.
While Blackberry floundered, Apple soared. Above all, it was Apple’s leadership that made it such a dominant force in the mobile phone market.
In the 1980s, under the management of co-founder Steve Jobs, Apple established itself as a dominant competitor in the personal computer market. Jobs left the business in 1985, but after a bleak outlook in 1997, Apple brought him back to lead the company.
Jobs applied his exceptional leadership skills to remind Apple to focus on its strengths — providing simplified, user-friendly products. It wasn’t long before the company returned to greatness, an industry leader in the mobile phone market, at Blackberry’s expense. Its shareholders did quite nicely too.
Only look at businesses with experienced management teams with a proven track record.
As an investor, you are trusting these people with your money. They must display quality decision making and leadership.
#4. Make sure the business you’re investing in has low or declining debt.
Of course, in business, a little debt isn’t always a bad thing. Sometimes loans are needed for growth, just like borrowing money to renovate your home. You’re taking on more debt, but you’re raising the value of your property — assuming you chose the right renovation projects.
But even if you’ve raised the value of your home, if you can’t meet the repayments, you’ll soon find yourself on mum’s couch.
It’s no different in business. While businesses with no, or low, debt are preferable, many businesses need to borrow money at times for new projects and expansions. But they must invest wisely, without taking on more than they can handle.
They should have a proven track record of doing so before you consider buying shares and lending them your money.
#5. Industry dominators with competitive advantages.
If you’re flying to Sydney, you’ll pass through Sydney Airport. It’s also a mandatory hub for many international travellers flying to and from other parts of Australia. That’s why 22 million people fly in and out of Sydney Airport each year. With just one major airport, you don’t have any choice.
This gives Sydney Airport a competitive advantage. They have a monopoly. And with the massive expense involved in building airports, it’s very difficult for competitors to enter the market.
You want to invest in companies that dominate their industry or offer a unique competitive advantage. You want to find the businesses that dominate with innovative products.
Invest in companies with established, well-respected brands that are likely have opportunities to grow their share of the market.
#6. A good business at the right price
Whether you’re buying a new house or investing in stocks, you don’t want to overpay. No one wants to find out they could have bought the same house in the next street for half the price.
And you don’t want to find out the stocks you bought have dropped because you paid too much, or because they were no good to start with.
So how do you judge whether you’re paying too much or not? You can compare the share price — what investors believe the company is worth — to the ‘intrinsic value’ of the business. The intrinsic value is the value of the business based on the assets the company owns and the income it expects to generate.
If the share price is below the intrinsic value, you’re getting the business for less than the sum of its parts.
To go back to the new house example, it’s like paying $500,000 when there are buyers who will pay you $600,000 for it.
Now other factors need to be taken into consideration. It’s important to consider whether the stock is expensive compared to others with similar operations and to other investments available.
#7. A growing business
Deere & Co., one of the world’s largest agricultural machinery manufacturers. They have a 200 year track record of earnings growth, multiplying shareholders’ wealth by the thousands. And according to Deere’s Max Guinn, they have yet to celebrate the huge opportunities ahead. ‘You can celebrate accomplishments, but after a while, you need to start celebrating the speed at which you’re traveling, instead of the destination you’ve reached.’
By 2050, the world’s population is expected to grow to nine billion people. This is up from seven billion today.
Agricultural output will have to double in that time to meet rising demand for food, fuel, and fibre. And as the percentage of the population living in cities rises from the current 50% to 70%, the demand for mechanised farming will grow, and with it, the success of Deere & Co.
Before investing in a business, make sure it has demonstrated reliable earnings growth. The amount of earnings created for each share should be stable, if not rising.
Invest in companies that are becoming more efficient, have a solid growth plan, and evidence that it is being implemented.
#8. If the business has passed all these tests, make sure it is profitable.
Don’t be fooled into believing that the only way to win in the stock market is by investing in speculative start-up businesses.
Of course, we hear all about the one-in-a-million who skyrocket. But the losers are forgotten all too quickly. No one likes to dwell on all those who’ve lost their hard earned capital on risky gambles that didn’t pay off.
But there is no need to take unnecessary risks in the hunt for superior returns.
If you had invested in BHP 20 years ago, you would have made 374% returns by now. And you could have made this investment with peace of mind — BHP already had a history of profits going back 130 years.
There’s no need to take unnecessary risks on companies without a history of profits.
Invest in opportunities today that look like BHP did 20 years ago — with excellent track records and a bright future.
Now, please don’t take any of the companies I mentioned today as stock tips. They may meet some of the requirements but may not tick all the boxes. And I don’t want you to invest in anything less than the best businesses out there.
Here at the Guild we’ve been busy finding businesses that meet ALL these requirement. I think you’ll like what we’ve found. Stay tuned…
Investment Director, Albert Park Investors Guild