Simple techniques to add to your homework routine when studying stocks.

“Buy companies with good products, services, and good management and the investment returns will come.”

This is a story that you have heard over and over from the most impeccable sources. As with other investment stories, this one resonates because it is both intuitive and reasonable.

But, what is a good company?

The Problem

It is difficult to get consensus on what makes for a good company since there are so many dimensions on which you can measure excellence.

There are some who believe that good companies have managers who can fry (manipulate) the share price of the company for the shareholders to make money numerous times in a year. They think the CEO must have a high profile and be a talking head in the press.

Some think that good companies must often carry out corporate exercises such as bonus issues, share split and “free” warrant to “reward” their shareholders. We have read about this numerous times where shareholders attend the AGM to demand for that.

And why not? This is what shareholders want – the management “fries” the share and always give freebies, the share price will always go up, and they as shareholders will make tons of money, so it seems.

Of course, you cannot forget that there are many investors who think that a good company must have higher profit this quarter than the last and next, and the next better than the next, etc. One quarter of reduced profit will be disqualified as a good company and the share must be sold.

Really? Are they talking about stock trading and speculation, or investing for growing long-term wealth?

We cannot ignore that there are also many who think that a good company must be owned by fund managers, EPF, analyzed and written by investment bankers and professional analysts, owned, and constantly promoted by big and high-profile super investors, etc.

There are also investors, me included, who think that a company which gives good and rising dividends are good companies.

So, what really is a good company?

Characteristics of a Good Company

A good company must have a good and durable business, better if it has a moat, and a long runway for future growth. It is a well-run company with credible management and good corporate governance, no unfair related party transactions, independent board of directors. The management must focus on constantly improving and growing the business. It frequently listens and responds to their shareholders’ best interests.

A business must make profit. That is a no-brainer. A good business should make good profit with high profit margins. Not only accounting profit, but the business must also on average have good cash inflows over the years. The more cash it earns, and higher than the accounting profit, the better, of course.

Generally, a fast-growing business is better. That is how company can earn more and more money, the faster the better, and shareholders can multiply their wealth faster.

However, it must be noted that not all growth is good. A fast-growing business is only good if the business earns a return higher than its cost of capitals. Otherwise, the growth destroys shareholder values, and the company will grow itself to bankruptcy.

It is good if the company can utilize other people’s money, issuing bonds or borrowing from banks to carry out and grow its business, but make sure the company does not borrow too much, or is too highly geared that it cannot still survive in time of economic and financial crisis.

Quantitatively, here are some simple metrics summarizing whether a company is a good company.

  • Growth
  • Profit margin
  • Cash flows
  • Debt/Equity ratio
  • Return on equity

The above metrics can be easily extracted from the three financial statements of the company, the Income Statement, Balance Sheet, and Cash Flows Statement. All investors need to do is to carry out some simple addition, subtraction, division, and multiplication to obtain those numbers.

Simple Valuations

However, research has shown that investing in good companies is not necessary a winning strategy. This is because the market has built into it these expectations.

The biggest danger is that the firm will lose its lustre over time and that the premium paid will dissipate. It is only when markets underestimate the value of firm quality, or there is panic selling in the market, that this strategy stands a chance of making excess returns.

There is a strong tendency on the part of companies to move toward the average over time, or mean reversion. So even though a company may be a good company, we try not to pay lofty prices.

How can an investor check if he is not over-paying for the stock? Again, do some simple maths to find out the price of stock versus the value of the company.

A couple of simple, quick, and dirty to use metrics such as price-to-earnings ratio and dividend yield will do.

  • Price-to-earnings ratio, PE = Price/Earnings per share, EPS
  • Dividend yield = Dividend / Price

Go for Value Investing

What I have described above, looking at quality and making some simple valuations is what value investing is about, buying good companies at reasonable prices. It is logical and plausible. It has been proven successful in providing extra-ordinary returns for investors over the long-term, myself included.

The beauty is it is not difficult to do. The metrics can be easily extracted and computed from the three important financial statements, income statement, balance sheet and the cash flow statement.

It is just a matter of whether you are willing to spend some time and effort to do some homework before investing?

 

How was your experience in identifying quality stocks?

 

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