Whenever you buy a stock, there’s a certain amount of risk involved. At the time you make your investment, there's no way to tell — with any precision — whether it will be a winner or loser. But by investing in companies that have attributes of good business, you can stack the deck in your favor.
There are a large number of attributes, each with significance to a different area of the company’s business, but they can point to a well-managed company.
It’s unlikely you’ll find all of these traits in one company, but you should look for companies with as many good business attributes as possible.
High Barriers to Entry to Limit Competition
High barriers to entry create a wall around an industry that make it difficult for new competitors to enter. It effectively gives existing competitors something close to a monopoly on business. The barriers can include high initial investment, stiff regulatory restrictions, or unique product lines.
While none of these obstacles are completely insurmountable to a newcomer, the fact they exist will keep the majority competitors away while increasing the chance of the company's success.
Brand Name Recognition
Brand names not only create loyalty and indicate a history of success, they also stand as evidence of the company’s ability to market products effectively.
Since marketing is a major element of business success, this advantage should never be taken lightly by investors.
High Return on Invested Capital
Also known simply as return on capital, this is calculated as net income minus dividends divided by total capital. Invested capital is a major indication of how well a company invests to produce revenue, or more particularly from an investor standpoint, how well it is doing it.
You can determine this by comparing the percentage return on capital to that of the company’s major competitors. If the company has a higher return on capital than it’s competitors, it is doing a better job of managing its money.
High Free Cash Flow (FCF)
Generally considered as free cash flow yield, FCF is calculated by dividing a company’s free cash flow per share by its current market price per share. The higher the yield, the more desirable the stock is. It means you are generating a higher rate of income for a smaller amount of money invested.
And once again, whether a free cash flow yield is high or low, depends upon how well the company stacks up against competitors in this category.
A Loyal Customer Base
A loyal customer base means that a company does not have to work as hard to get new business, and the existing customer base is sufficiently satisfied with the products of the company to be repeat customers.
It is far easier and less expensive to market to existing customers than it is to get new ones.
Reasonable Growth Opportunities
The company you are considering investing in should have reasonable opportunities for future growth. Looking at the company itself, what's the track record of growth been in the past five years?
If the company is growing steadily, there’s a strong likelihood it will continue to do so in future. But that also has to be matched up against new product lines that are pending, as well as the growth in existing product lines.
Also, pay particular attention to the industry the company operates within. At any given time, industries are expanding while others are contracting. Naturally, companies operating in expanding industries offer greater growth potential.
A Strong Management Team
How do you know if the company has a strong management team? If the management team has been in place for several years, and the company has a successful track record, that can be evidence in itself. But if new management is involved, you’ll need to look closely at the histories and track records of the people who are taking over.
You want to know that they had been responsible for success in previous positions. You’ll also want to know if they have any direct experience running that kind of business.
Just because an executive had a successful track record at a pharmaceutical company, doesn’t mean that he will also be successful running an auto-parts supply business.
How tight is the pricing situation in the company’s industry? If there are a lot of competitors, the company may have very little flexibility here.
But if the company has a unique product, one has been well received by the general market, it will likely have more pricing power than its competitors.
This will raise the prospect of higher future earnings. A lack of pricing power will largely force a company to increase earnings by cutting expenses (and there’s only so far you can go with that strategy).
A Strong Balance Sheet
Many investors tend to over-focus on a company’s income statement — after all, earnings drive stock prices. But the balance sheet can be a sign of things to come. Even if the company has strong growth, a weak balance sheet could be an indication that the company is not properly investing its income.
By contrast, a strong balance sheet can give a company the wherewithal its competitors lack. It can ride out weak economic periods, and even a mistake here and there, without destroying the company or it’s stock price.
Low Capital Expenditure Requirements
Low capital expenditure requirements means a company does not have to invest heavily in plants, equipment or other major assets.
Even if the company has an excellent recent earnings history, it can get into trouble if it needs to redirect a significant amount of revenue into capital assets. This could be the result of a deteriorating physical asset-base that needs to be replaced quickly in order for the company to remain competitive.
Some industries are naturally more capital intensive than others. An example is utility companies, which are entirely dependent upon heavy investment in plants and equipment in order to provide their products and services. Heavy capital expenditures could be an X-factor from an investor standpoint.
High-Return Reinvestment Opportunities
Much of this will be determined by the industry a company is involved in. In a fast growth industry, high return investment opportunities are all over.
While companies are feeding a hungry market, they often do so profitably at very little cost. This is a critical factor because it is an indication of a company’s ability to grow without investing large amounts of capital.
By contrast, in mature or declining industries, high-return investments are practically nonexistent. The low-hanging fruit has already been picked, and increasing cash flows often requires a substantial investment.
A Favorable Position on Commodity Inputs
Some companies are able to acquire commodity inputs at relatively low cost. They do this either, because they have control (direct or indirect) over the suppliers, or because there is an abundance of suppliers all competing to sell their products to a relatively small number of companies.
If a company has a favorable position on commodity inputs, they will have greater price flexibility. Price will be determined primarily by the company and its competitors, rather than the cost of raw materials from suppliers.
Once again, it is unlikely you will find everyone one of these attributes of good business in a single company, but you should want to know that it has as many as possible.
What attributes do you think are most important when investing in a company?