Welcome back to this series where we feature the attributes of successful investors, as detailed by Michael Mauboussin, the Director of Research for BlueMountain Capital Management,
The first part of this series talked about being numerate and having an understanding of value.
We now continue with the next two attributes.
3. Properly assess how a business makes money
As investors, the most basic question which should be asked is – how does a company make its money?
This factor may not always be as apparent as it seems.
Some companies have complex, opaque business models and utilise arcane financial instruments.
You should be able to clearly understand how a company can sell its goods and services to generate profits and cash flows.
If this simple task cannot be easily accomplished, then it may be better to stay away or observe the company for a longer period before investing in it.
Another aspect to think about is the competitive moat of the business.
What makes it different or stand out from its competition such that it can earn a higher return on invested capital?
Does it have a stellar reputation or track record that can make customers “sticky”?
Being able to deduce this information and understanding the company’s moat will go a long way in helping you to make a wise investment choice.
4. Compare effectively
An investor should learn how to compare the gap between expectations and fundamentals.
Investors are constantly faced with different choices and have to compare to make a rational decision.
Some examples are — comparing company A against company B or comparing different asset classes such as bonds, physical property and equities.
The problem is that humans are not always good at comparing as we tend to rely on short-cuts that may not be robust.
Fundamentals relate to the company’s current financial performance.
Expectations, on the other hand, relate to the company’s future performance.
When these two aspects diverge, the investor has to be careful.
If expectations are low (i.e. investors do not expect the company to have improving fundamentals), the stock will be cheap and the investor has a good chance of achieving a margin of safety.
If the converse is true, then the investor should be wary as too much optimism may have been baked into the share price, such that any disappointment in the fundamentals may cause a sharp and permanent decline.
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Disclaimer: Royston Yang does not own any of the companies mentioned.