4 Things to Look for in an Investment

Some Important Qualities a Good Investment Should Possess

What Investors Should Be Looking for in an Investment
When looking for good investments to add to your portfolio, there are a few characteristics that should stand out and make certain candidates rise to the top of the list. Jose Luis Pelaez Inc / Getty Images

If you're finding this article, it means you are likely in the beginning stages of putting together your investment portfolio with the goals of becoming financially independent. This is a major step to building your wealth, and for that, I'd like to congratulate you! New and amateur investors alike are often interested in purchasing a company's stock but are not sure if will be a good asset in their portfolio.

These four characteristics should serve as helpful guidelines in your search for a good investment, illuminating the better candidates while sorting out those that may not be appropriate for you.

1. What Is the Price of the Entire Company Based on What You're Paying for a Share?

When doing research, it is important that you look at more than just the current share price - you need to look at the price of the entire company. The "cost" of acquiring the entire corporation is called market capitalization, or market cap for short, and is frequently referred to by financial professionals (if you add in the debt on top of it, it is known as enterprise value). In short, the market cap is the price of all outstanding shares of common stock multiplied by the quoted price per share at any given moment in time. A business with one million shares outstanding and a stock price of $75 per share would have a market cap of $75 million (1,000,000 shares outstanding X $75 per share price = $75,000,000 market capitalization).

This market capitalization test can help keep you from overpaying for a stock. Consider the case of eBay and General Motors during the heyday of the Internet era. At one point during the boom, eBay had the same market cap as the entire General Motors Corporation. To put that into perspective, in fiscal 2000, General Motors made $3.96 billion dollars in profit, while eBay made only $48.3 million (not including stock option expense!).

Yet were you to buy either one, you would have had to pay the same amount. It is almost unbelievable that any sane investor would pay the same price for both companies but the general public was seduced by visions of quick profits and easy cash.  (This isn't even a particularly good illustration, either, given that General Motors is representative of the worse sort of cyclical business and perpetually headed for trouble.)

Another useful tool to help gauge the relative cost of a stock is the price to earnings ratio (or p/e ratio for short). It provides a valuable standard of comparison for alternative investment opportunities.

2. Is the Company Buying Back Its Own Stock and Reducing the Outstanding Share Count Regularly Over Time?

One of the most important keys to investing is that overall corporate growth is not as important as per-share growth. A company could have the same profit, sales, and revenue for five consecutive years, but create large returns for investors by reducing the total number of outstanding shares.

To put it into simpler terms, think of your investment like a large pizza. Each slice represents one share of stock. Would you rather have part of a pizza that was cut into twelve slices or one that was cut into eight slices?

The pizza that was only cut into eight parts will have bigger slices with more cheese and toppings.

The same principle is true in business. A shareholder should desire a management team that has an active policy of reducing the number of outstanding shares if alternative uses of capital are not as attractive, thus making each investor's stake in the company bigger. When the corporate "pie" is cut into fewer pieces, each share represents a greater percentage of ownership in the profits and assets of the business. Tragically, many management teams focus on domain building rather than increasing the wealth of shareholders.

3. What Are Your Reasons for Investing in the Company?

Before you add a company's share of stock in your investment portfolio, it would be wise to ask yourself why you are interested in investing in that particular business.

It is dangerous to fall in love with a corporation and buy it solely because you feel fondly for its products or people. After all, the best company in the world is a lousy investment if you pay too much for it.

Make sure the fundamentals of the company (current price, profits, good management, etc.), which can be found in their corporate filings like the annual report, 10K, and 10Q, are the only reason you are investing. Anything else is based on your emotions; this leads to speculation rather than intelligent investing. You have to remove your feelings from the equation and select your investments based on the cold, hard data. This requires patience and the willingness to walk away from a potential stock position if it does not appear to be fairly valued or undervalued.

4. Are You Willing to Own the Stock for 10, 15, or 25+ Years?

If you aren't willing to buy shares in a company and forget about them for the next ten years (five years at the absolute minimum), you really have no business owning those shares at all. The simple but painful truth of this is evident on Wall Street every day. Professional money managers attempt to beat the Dow Jones Industrial Average, which is a collection of 30 largely unmanaged stocks, but year after year, a not insignificant percentage fail to do this. It seems impossible that a portfolio managed by the best minds in finance can't beat an unmanaged portfolio of long-term stocks held indefinitely, but it happens (partly due to the incentive structure created by investors themselves, who reward frenetic activity and flashy strategy names - portfolio managers who tried to behave rationally might have a harder time attracting assets).

The guaranteed way to success has historically been to select a great company, pay as little as possible for the initial stake, begin a dollar cost averaging program, reinvest the dividends and leave the position alone for several decades.