Investors often struggle to define what makes an investment great.
Such a definition may elude even experienced investors due to the randomness in the stock market, its daily fluctuations and the fact that many investors may not document their investment theses in detail.
A cursory observation into an average investor’s portfolio may display a smattering of gems and an often larger pool of languishing stocks.
Focusing on winners
It is precisely these gems that should make you sit up, for they represent the “successful” portion of the portfolio as opposed to the “loser” stocks that may languish in obscurity for years.
The right thing to do, in portfolio management, would be to sell away the losers and substitute them for winners. But this action requires psychological determination and grit which isn’t always as easy to carry out.
I would like to help you separate the gems from the pretenders.
Companies that are worth holding for the long term can have certain characteristics that we can identify.
With that in mind, here are four aspects of great investments culled from my years of investing. It’s not an exhaustive list, but it should help you or any budding investor to be aware of what constitutes a great business.
Strong competitive moat
Companies that are able to stay one step ahead of their competitors usually have a strong competitive moat.
This unique business advantage can help them garner more customers based on brand loyalty and recognition. Other strong moat businesses are able to leverage on aspects such as network effects, low-cost advantages and high switching costs to retain customers, keeping them “sticky”.
Of course, any competitive moat can eventually be breached.
As such, investors need to be vigilant for changes in the business environment that may weaken a company’s moat. There may also be disruptive technological changes that may render moats invalid or obsolete, such as the case of Eastman Kodak when digital cameras became widely available.
Growing total addressable market
A growing business relies on its addressable market (i.e. potential client pool) to generate more revenue.
A great investment is able to tap on a growing total addressable market (TAM) in its industry that drives innovation and enables the industry to grow larger over time.
Note that even if many competitors enter the market to challenge the incumbent, this may not cause a business to falter. If the TAM is growing, the industry can accommodate more players by allowing every competitor to share in the profits.
Consistent free cash flow generation
Free cash flow (FCF) generation is an important aspect to look out for in any good investment. It’s a point worth emphasizing again.
If FCF is consistent and even growing, this bodes well for the business and signals that the company is generating ever more cash.
Extra cash can be deployed in a variety of ways to enhance value for shareholders. One is through reinvestment in the existing business to improve its return on equity. Another is the offer of higher dividends, while two other options include the execution of share buybacks or deployment of cash for mergers and acquisitions.
Candid and astute management
The final aspect of great companies is the “soft” aspect – the human and managerial aspect of a business.
Remember that all companies are, after all, run by a group of humans, and if you cannot trust the people behind the wheel to do a good job with your money, then you are better off deploying your funds elsewhere.
In my opinion, management should be both candid and astute.
Candour is important because it shows that management is willing to accept and take responsibility for errors and misjudgements, rather than sweeping them under the carpet. Everyone makes mistakes from time to time, but it takes a brave person to admit and learn from them.
For me, astuteness can be demonstrated by how the management team adapts and learns.
As business conditions are dynamic, an adaptable management team can guide the organisation through such changes and stay one step ahead. Great managers are also able to deploy capital well in order to generate superior returns for their investors.
Get Smart: Don’t forget the downsides
It’s not fair to highlight great investments without studying investments that turn out to be lemons.
While it may seem intuitive to conclude that poor investments are a direct opposite of the above, there’s definitely more to it than meets the eye. I will elaborate more in my next segment on aspects of investments that don’t do well.
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