Suppose you decide to invest some of your money in shares of a business. Hopefully a small share of your money until you get good at it. There should be a way to assess which are reasonable investments and which are not. Here are some simple ideas that can keep you out of trouble.
You can see more of this in an article by Martin Pelletier in Financial Post HERE
Martin addresses five key factors. The fact that there are just five and they seem simple enough hides a good deal of the subtlety. It is harder than checking off the options yu want on a new car. It will take a good deal of time and some expertise to make it work. Nonetheless it is worth the trouble to think about.
The first three are fundamental value of the business, while the last two relate to the pricing supplied by the stock market.
- Strategic Positioning. How strong is their industry? Where do they fit in that? there are two approaches to this. Martin’s approach is to find businesses that are well-positioned and hard to disrupt. Other managers might look for the disruptors.
- Profitability and Margin Outlook. Profitability changes over the business life cycle. You will need to assess how the management allocates capital and uses acquisitions to grow. Most businesses become a source of cash before they expire. You must know when that begins to happen and what the business tends to do about it.
- Financial Position. Martin’s approach is to look for company’s with less debt than other managers might accept. Again there are two approaches. Some businesses with a lot of debt go broke while others thrive. It has to do with what they do with debt. There is good debt and bad debt. It depends on management and their ability to allocate capital. Debt is just one source of the money they invest.
- Near term Catalysts. Has a recent good or bad quarter affected the stock price more than it should have? Is it one off or the beginning of a new reality? This hard to analyze because you are relying on the psyche of the other earthlings in the marketplace. Never easy, but worth doing. Bargains can be found here and so can the harvesting of accumulated gains.
- Valuation. Market valuation (share price) depends on two factors. 1) What is the business worth in terms of its economic output, and 2) What do my the others think about it? Usually Mr. Market is either manic or depressed. Sometimes, for short times, he is rational. You cannot understand the madness of crowds very easily and so might adapt the approach that the market value will eventually follow business value. That might take a long time though. If you can get business value right, you can rest easy that the market will catch up.
These are all important but there are more.
- Free cash flow. The extra money the business makes that it does not need to retain its market position, grow, pay down debt and add equipment and other hard assets? If cash flow is negative, does net income per share really mean anything? Remember, cash tends to be real, income tends to be opinion.
- What does management do with free cash flow? Invest prudently, return it to shareholders, store it in a box, or waste it?
- Do you use their products and customer service or do you know people who do? Businesses who become weak at this aspect are on the downside. Better to wait.
- How clean is their accounting? Perfect is the minimum standard. Never invest in a business with dubious accounting policies or frequent restatement of earnings.
Most investment decisions are just common sense. People make it harder than it is by relying on the smoke and mirrors of analysts, TV personalities, and corporate communication directors, instead of the substance of the business and the natural and irrational pricing methods of the market.
We can do better.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772