Picking good companies and avoiding bad ones (Part 1)
Chapter 13 (part 1) of "Getting a Better Class of Enemy", my investment book
I'm writing an investment book called "Getting a Better Class of Enemy - Money, Markets and Manias". As I write the chapters, they will be made available to paid subscribers to OfWealth. Previous chapters, along with the Preface and Chapter Plan, can be found by clicking on this link.
The reason for the title is that, as your wealth grows, there are a lot of potential "enemies" that will try to take it away from you. These are explained in Chapter 1.
"Money can't buy you friends, but you do get a better class of enemy."
Spike Milligan, Irish-English author and comedian (1918-2002)
Phew. This chapter has been a labour of love. It became much more involved than I expected. But I hope the result is worth it. (And apologies for the radio silence while I wrestled with it.)
There are plenty of different ways to make money in stock markets. But one of the more reliable ones is to stick with good companies, don't overpay, and then let time and compounding work their magic.
But the big question is how to decide what makes a truly "good" company.
To be honest, I thought originally that this would be a fairly easy chapter to write. But the more I dug into it, the more things I realised should be taken into account. In fact, I think I could write a whole book on this single topic.
So what follows is my attempt to condense the most important points into something digestible in one chapter. I'll admit it took a lot of re-writes until I'd boiled it down. I've cut out nearly as much as I've included.
But it's still quite long, so I've split it into two parts. You can find both parts here. I think I'll probably divide it into two separate chapters once the book is complete.
Writing this chapter has helped me to refine my own thinking, and even led to some tweaks in my own portfolio. I plan to place more emphasis in future on "good and cheap", rather than just "dirt cheap enough that it doesn't matter" (although I'll still do both).
This illustrates a couple of reasons why investing is so interesting. There's always something new to learn. And there's always room for improvement in your own approach, whatever your level of past experience.
As always, feedback from readers is encouraged.
Please send emails to ofwealth@substack.com
Chapter 13 (Part 1):
Picking good companies and avoiding bad ones
"If we avoid the losers, the winners take care of themselves."
Oaktree Capital Management company motto (source: Howard Marks).
"There's more than one way to skin a cat", as the old - and rather graphic - saying goes.
This is certainly true when it comes to seeking profits from stock markets.
Some people like to try their hand at short-term trading. Chapter 7 explained why this is unlikely to be a successful strategy for long, especially for private investors.
Another way is to seek deeply beaten-down value stocks, of companies that are experiencing temporary difficulties, and hold into them until prices recover. Although I often invest in such situations with part of my portfolio, they do have various drawbacks.
In particular, once they've paid off, then the time comes to sell - which is usually after two or three years, in my experience. This means that new ideas must be found for the released capital.
Hence, relying solely on that strategy requires a constant flow of new targets, and that takes a lot of work. Which is made even harder because such situations are often complex to analyse.
Given such challenges, a better approach for most investors is simply to find good companies in the first place.
These are the kinds of stocks that can be held for many years, and even for decades in some cases. There's plenty of work involved in identifying them. But the workload should be lighter in the end, because usually you can hold them for a long time.
What's more, the longer that you stay invested in a good company, the more that you learn about it and what really matters for the business. You become more expert, and the incremental workload involved is pretty light.
Over time, an investor should aim to build up a list of several dozen good companies. The idea is to own some of the stocks, but keep others on a watchlist until the stock prices are attractive. You can check in on them from time to time, and occasionally buy something if the price looks attractive.
It's important to remember that the stocks of great companies aren't always good investments. This situation occurs when they are in high favour in the market and the stock price has been bid too high.
Building a list of dozens of good companies may seem like a daunting task at first, and it could take years to achieve. But you can start with a handful of companies and build from there.
If you can invest in around fifteen stocks of good companies at a given time - sometimes more, sometimes perhaps a few less - then that will form a fantastic basis for any investment portfolio.
It will have a very high probability of attractively profitable long-term success, provided you are patient. Of course, it's also important to stay diversified at all times, across sectors and geographies (meaning where the companies do business, more than where they are headquartered).
All stocks eventually reach bargain levels, even those of the very best companies in the world. For example, this tends to occur during periodic stock market crashes. That's when everything is dragged down at once, as investors panic and sell indiscriminately. If you've done the preparation in advance, such moments are fabulous opportunities to buy stocks of the best companies at bargain prices.
In this chapter the focus is on what makes an underlying company "good" (or "bad"), and not on whether the stock is cheap or expensive. Valuation techniques - from the very simple to more complex concepts - will be covered in the next chapter.
So what are the various elements that go together to make a "good" company?
The characteristics of a "good" company
No company is perfect. If such a thing existed, then investors wouldn't need to diversify. Even the best companies can go bad, perhaps due to serious management incompetence.
Hence a diversified portfolio of good company stocks, held patiently, is about as close to investment perfection as any private investor can hope to achieve.
Each company will rank well on some measures and less well on others. The investor's aim is to find businesses that rank well in a large number of areas.
To clarify one area of potential confusion, in the investing world there's a concept known as "quality" companies, or "quality investing". This usually involves companies with big, stable businesses, often in the consumer staples industries (food, drinks, household products, personal care products, and so forth).
But what's usually grouped into the "quality" category is only a subset of what I consider to be good companies, as I'll define them below. In fact, some supposedly high quality companies are anything but, once you get into the details.
I've seen plenty of such companies turned into investment dogs over time, often due to mismanagement. One recurring cause is large, "transformational" corporate acquisitions, often at high prices and financed with debt. They are certainly transformational, just not in a good way.
Some factors that make for good companies are specific to a particular business. But the general things to look for mainly fall into the following categories:
Stage within the company lifecycle, and future life expectancy
Nature and scope of the business
Regulatory and political exposure
Competitive advantage and whether it's sustainable ("moat")
Quality of management and other governance issues
Style of corporate communications
Financial strength and capital structure
Capital allocation policies and track record
Financial performance and accounting ratios
Let's take a look at each category.