When you buy a stake in a firm, there's no way to truly know how the shares will perform. When I invest, I don’t think about whether a stock will rise or fall a year from now, because it’s not relevant to the task of building wealth as I see it.
What I'm interested in is acquiring as much ownership as I can in a broad collection of businesses I believe in. I look at it as making money by owning businesses—not by renting stocks. Accordingly, I spend time looking for the types of businesses I want to own, then waiting—sometimes years on end—for them to be available at a price that I think is attractive. I then buy them and sit on them.
This high-level checklist that provides a rudimentary overview of some of the things that I look for when searching for companies I want to own. Though they're not a guarantee of success—theoretically, a company could possess all of these attributes and still go bankrupt due to a low-probability event—they're a good place to begin when trying to identify the productive assets you want churning out dividends for you for years to come.
- When you buy a stake in a firm, there's no way to truly know how the shares will perform, but there are six signs that might indicate it's a good long-term investment.
- If you can easily describe how the company makes money, the company generates high return on capital, and the company's products or services are competitive, it's a good sign.
- Also, it's great if management works to keep shareholders happy, shares are priced sensibly, and the company can survive tough stretches.
You Can Easily Describe How the Company Makes Money
You might be astonished how many inexperienced investors risk their hard-earned money buying ownership in a business that they don’t understand. You should be able to explain in no more than a few sentences exactly how the company generates its profits. You should also be able to talk about the major cost inputs. For example, if you’re looking into a tire manufacturer, the cost of rubber and other materials is going to matter. If you’re looking into a freight company, the cost of fuel is going to matter.
The Company Generates High Returns on Capital
The ultimate ability of a company to generate returns for its long-term owners over many decades is going to be determined by the return on capital it produces. The best businesses produce high returns on capital without the need for a lot of, or any, borrowed money. Instead, they churn out cash that the owners can extract without harming the core enterprise.
The Company’s Products or Services Have a Durable Competitive Advantage
Most people don’t care which brand of screw they pick up at the local hardware store or which farmer grew their corn. They do care, on the other hand, whether a convenience store carries their favorite candy bar or beverage or whether a local discount merchant sells their favorite toothpaste or mouthwash.
In cases where consumers are fiercely loyal to a product or service, the manufacturer or provider can generally charge higher prices. This leads to a feedback effect where they grow larger, gain better economies of scale, and then generate even more surplus cash flow. That surplus cash flow allows them to pay for increased marketing and innovation which, in turn, drives brand loyalty even more. This is a virtuous cycle that can produce a lot of wealth for those who are patient enough to stick to their stocks for many years.
Management Works to Keep Shareholders Happy
Good companies have a history of returning surplus cash in the form of intelligently executed share repurchase plans or a dividend that grows at a rate comfortably in excess of the broader rate of inflation in the economy.
In other words, you want to go into business with executives who have your best interest at heart. You want them to nurture an environment that measures success by how the firm does for you, the owner, as well as other stakeholders such as employees.
More than a few times in my career, I’ve come across a business that had wonderful economics only to find managers were taking advantage through obscene options grants, overly generous salaries, or questionable deals with inter-related entities that were controlled by family members.
Shares are Priced Sensibly
Even the best business in the world can be a terrible investment if you pay too high a price for it. Price is arguably the most important variable in the long run because even a terrible business bought at a sufficiently cheap price can result in wealth accumulation under the right conditions. The ideal situation is to find a business that you believe in at a fair price.
The Company Can Survive Tough Stretches
Storms will arrive in the economy and the capital markets. Often, these storms will provide no warning before showing up and wreaking havoc on your financial life.
One way to mitigate this risk is to focus on investing in businesses that have the financial strength necessary to survive even the darkest days without having to issue stock at severely depressed prices—which amounts to you having to sell off your ownership in exchange for a bailout.
Sure, these businesses might grow a little slower or provide a fraction of the excitement you might get from other businesses, but you'll be grateful you put your trust in them when the maelstrom is raging around you.