Have you ever wondered how successful equity investors choose their large firms? Here are some rules to follow inspired by the investment strategies of great investors such as Warren Buffett, Benjamin Graham and Peter Lynch.
Steps
Step 1. Stay within your area of expertise
You are more likely to identify winning companies in your specific field of expertise. If you work in the retail trade, you will be better qualified to decide whether to invest in companies like Walmart, Target, Best Buy, etc rather than the latest biotech firm.
Step 2. Look for EM (Economic Moat - the economic advantage a company has over competitors in its industry)
There are companies that manage to become real monopolies in their sector. Over the years, these companies have been able to build a "moat" around them to keep competition away. In practice, they enjoy a lasting competitive advantage. Here are some examples of competitive advantage:
- The Brand: Think Harley Davidson, Coca Cola or BMW. These are brands imprinted in the common memory as the best in their field. These companies can raise their prices based on their brands, resulting in higher profits.
- High transition costs: when was the last time you changed banks? Or telephone operator? Or, if you are a smoker, brand of cigarettes? Is the meaning clear to you now? Businesses that have high transition costs can rely on their customers much longer than those that don't.
- Low production costs: companies that are able to produce their products and sell them at extraordinarily lower costs than their competitors automatically attract customers - and not a few. Provided that the quality is not compromised, of course. Walmart and Dell have made this concept a science.
- The industrial secret: large pharmaceutical companies with patents, companies in possession of copyrights, drilling rights, mineral rights etc. they are practically producers or providers of exclusive services in their specific sector. Again, such firms can afford to raise prices without fear of losing their customers, which results in large profits.
- Scalability: This is a product or service that has the potential to form a network and add new users over time. Adobe has become the de facto standard of publishing, Microsoft Excel that of spreadsheets. Ebay is a great example of a user network. Each new user of the network costs the company practically nothing. The additional revenue that comes in as the network expands goes straight into the profit line.
Step 3. Check the quality of the management
How competent are the directors of the company? More importantly, how focused are they on the company, customers, investors and employees? In this age of rampant corporate greed, it is always a good idea to research the management of the company. Corporate annual reports as well as newspaper or magazine articles are good starting points for obtaining this information.
- Even a large company can be overrated. Learn to interpret financial statements and do a basic analysis to find those companies that have been fairly valued or undervalued by the market.
- The price-to-earnings ratio should be below 20. If the value is higher, then the firm may have been overvalued for its earnings. Benjamin Graham released this economic indicator after the Great Depression.
- Buy a price / book ratio below 2. The price / book ratio is the market price of a company divided by the total value of its capital. A low ratio indicates that the company's stock is cheap.
Advice
- Start thinking about the businesses you run into on a daily basis in the light of this picture.
- Visit the company's website and online finance sites that provide you with a variety of equity insights and information such as Wikinvest.com and Morningstar.
- Learn the basics of reading financial statements. Afterward, check to see how profitable the companies you are interested in are. Check their debt position. See if they are constantly growing.
Warnings
- Don't rush to buy corporate stocks unless you've done your research thoroughly.
- Stay away from stock advice. It is simply someone's great theory of how to get rich quick or a seller getting paid to inflate a stock so that the company can make money by dumping shares on unsuspecting investors. Warren Buffett says he enjoys seeing how high IQ CEOs imitate each other foolishly. Warren also says he NEVER gets good ideas from listening to others.
- While you should invest in the companies you know, don't limit yourself to just one or two industries. Also try researching companies in a variety of industries and diversifying your equity portfolio.
