Selecting Investments

One of the questions we get frequently is “How do you select investments?” In this article, I comment on 12 criteria we use to evaluate potential investments for our clients.

  1. Only Publicly Traded Securities — We want the relative security provided by the regulatory framework that publicly traded securities have to abide by.
  2. Operating in Growth Markets — It’s simply easier for a company to be successful if it operates in a market that is growing, rather than stable or declining. It means more potential customers, more opportunity, more earnings, and a higher share price.
  3. Lots of Products, Suppliers and Customers — Anytime a business relies on “just a few” (products, suppliers or customers), it’s inherently more risky. We want to see several products, several suppliers and many customers. There is no room for a “one trick pony.”
  4. Profits — The company has to be making a profit. New upstarts with good stories are plentiful, but we are not engaged in speculating.
  5. Reasonable Price — The stock price has to be below 40 times earnings per share. Investors lose when they pay too much, even for a good company. People were buying Cisco Systems for over 200 times earnings in 2000. We began buying Cisco in November ’02, at 30 times earnings.
  6. Profit Margins — The profit margin is what’s left over after all expenses have been paid. We want the profit margin to be sufficient to fund all or most of a company’s growth.
  7. Good Management — Management must have demonstrated a record of success. They must clearly articulate their business strategy, against which we can judge progress. We want to see consistency of direction and delivery on promises.
  8. Product Appeal — The company’s products must have notable appeal over competitors’ products. Some companies consistently get it more right than others.
  9. Share Buybacks — Share buybacks raise earnings per share and, all things being equal, share price. Companies issuing stock options to employees risk lowering earnings per share if they fail to repurchase shares in an amount equal to the options they give away. We have to look closely at share buybacks.
  10. Good Corporate Governance — In recent years, a couple of companies have been setting standards for good governance and rating companies against those standards. We follow the ratings by Institutional Shareholder Services and The Corporate Library. We expect management and members of the board to act in the shareholders’ best interests, without exception.
  11. Pension Liability — Some companies must contribute a large portion of their earnings to their defined benefit pension plans. These costs can become highly burdensome and detract from a company’s growth. Large “unfunded” pension liabilities are a problem.
  12. Historical Valuation Ratios — We look at the history of a stock. We compare its historical price to its historical earnings, sales, book value, and cash flow. This gives us a relevant price range for buying or selling the investment.

It’s difficult and expensive for individual investors to have the information they need to invest wisely and with confidence. We spend well over 2,000 man-hours and $50,000 per year in research costs. Markets are inherently risky, but you can mitigate much of that risk by doing your homework or using a trusted advisor.