Figuring out how to choose a company to invest in is an endless pursuit for every stock investor.
Picking stocks is always a challenge, especially for new investors. Although there’s no perfect investment, there are some factors that make a company stand out.
In this article, we take a look at the characteristics of a perfect company for a long-term investor.
The Business Model
A perfect company has a business model that should be simple and understandable. It should be the kind of business that even an idiot can run because, according to Peter Lynch, sooner or later an idiot will run it.
If you don’t understand what the company does and what is its business model, you shouldn’t invest in it.
In fact, one of the best ways to manage your risk level is to obtain knowledge about the companies you invest in.
A perfect company offers products and services that people want and need. If there is no need for the company’s services, it will go out of business sooner or later.
The products should also be the kind of products that can be altered through time. Nothing lasts forever. The company should be able to alter its existing products or invent completely new ones.
A great example of this is Nokia. They evolved from making rubber boots to cutting-edge mobile phones. In the end, they were pushed out of the market by Samsung and Apple who, unlike Nokia, altered their products as demand changed.
In addition to highly sought-after and time-tested products, the company should have a scaling business model. When a company has a scaling business model, its operating costs don’t rise at the same rate that the company grows. This means that the company gains significantly more profit the more it grows.
Also, a perfect company has a high rate of return on its investments. This means that the company can invest more capital in its business with a high return rate.
Usually, it’s preferable that a growing and highly profitable company spends its excess capital on growing the business further.
Profitability
A perfect company has to be profitable in the long run. A company is only as good as its ability to make a profit.
Usually, the companies that make the best profits also operate on high margins.
What’s common for exceptionally profitable companies is that they have strong pricing power. This means that the company is able to increase its prices without losing customers.
Strong pricing power is especially important during times of high inflation when manufacturing costs are rising. If the company can’t raise its prices, its margins will diminish, profits will fall, and the stock price will most likely follow.
The best way that a company can achieve pricing power is to have a strong brand name or even better, a unique patent that gives the company a competitive advantage. When you’re the only one offering a product, you can pretty much name your price.
When comparing companies by their profitability, you should ensure they operate in the same industry. There are major differences between profit margins between different industries. For example, there’s no use comparing retail to pharmaceuticals.
If you have no companies to compare to, you can use the industry average. It’s also wise to compare a company’s current profitability to its history, see if there are changes, and find out what has happened.
Size and Market Share
The most fruitful scenario is a semi-large and growing company in a growing market. The company should be big enough to have a strong foundation, but also have a lot of growth left.
Market size should also be large because there has to be room for growth. A company can’t grow if the industry is dying. Usually, the company should stay in its field.
Expanding into completely new industries is not advisable because it carries significant risk.
The market itself must also be growing because constantly winning market share is hard in the long run.
Of course, investing in growth stocks requires a higher risk tolerance because, for a young company, there are no guarantees of favorable future performance. The stock’s current price doesn’t always reflect the real value of the company.
Management
Management should have a strong track record of allocating capital wisely. Investors sometimes underestimate the importance of management and its decisions.
Malcolm Gladwell has written an excellent book about lesser-known CEOs called The Outliers, that have allocated capital wisely and made a fortune with masterfully executed stock buybacks.
The key personnel should own a large share of the company’s stocks. If the management doesn’t own shares or owns very little, it’s wise to try and find out why. Owning a significant number of stocks is usually a very good sign.
A great CEO always speaks the truth and doesn’t sugarcoat anything. In every business, there are always bad times. There’s nothing to gain by lying to investors. Usually, it’s better to take a small hit in the short term than a large one in the long term.
Management should always favor long-term success over short-term wins. It’s not uncommon that management wants to please the stockholders by giving them quick wins at the expense of long-term success.
Financials
A perfect company has to have a strong balance sheet. When a company is over its head in debt, it’s challenging to get through hard times. Debts have to be paid no matter how the company is doing.
A weak balance sheet is especially dangerous for growth companies with a lot of debt and little profits.
It’s worth remembering that debt is priced differently for different companies. Large and stable companies usually get better terms for their loans, whereas growing and risky businesses have to pay more for their financing.
When interest rates start to rise it affects the smaller and riskier businesses more since they usually have more expensive debt. A strong balance sheet reduces both company-related risk and market risk by increasing the chances that the company survives a bear market.
Knowing how to interpret a company’s financial statements is one of the essential skills that every investor should have.
Pricing
A great company isn’t necessarily a good investment. It should also be fairly valued. It’s important to remember that the more you pay for a stock, the less returns you can expect.
If the stock is valued high compared to its current fundamentals, investors are usually expecting significant future growth. If the growth does happen, the stock price might not go up since it’s already reflected in the stock price.
On the other hand, if the growth doesn’t happen, the stock price will go down fast. That’s one of the reasons why highly priced stocks carry more risk.
The ideal situation would be to find a steadily growing company with a competitive edge at a reasonable price. The problem is that most likely you’re not the only one who has found the stock. The more interested investors there are, the faster it’s reflected in the stock’s price.
Summary
The business model of a perfect company should be simple, understandable, and easily managed.
The company should be highly profitable, run by capable management with a long-term view, and operate in a growing market. To top it all off, the perfect company should also have strong financials and be fairly priced.
As we can see, it’s quite difficult to find companies that check all the factors listed above.
To be clear, an investment can offer spectacular returns without having all the factors listed in this article. The best way is to use these factors as a yardstick for evaluating a specific company.
Acquiring knowledge about all the different factors requires a fair amount of effort. When you have an investment strategy based on stock picking, you have to put in the work.
The best part of finding these great companies is that you don’t have to find many of them. Like Peter Lynch stated in his 25 golden rules, an investor with a focused portfolio can do well with just five companies.
It’s worth noting that picking individual stocks involves more risk than investing in exchange traded funds. Beginner investors are usually better off investing in a diversified portfolio of mutual funds or passive index funds.
The stock market is a fickle place. The ability to pick stocks that deliver satisfying returns for a good price is not a no-brainer.
If you’re not sure how to choose stocks or have trouble forming your investment strategy, there are always financial advisors to consult.
