Investing in shares can be daunting for new — or even experienced — investors. There are thousands of companies to choose from (the S&P/ASX 200 (ASX: XJO (Index: ^AXJO) excludes 90% of the companies on our exchange and there are tens of thousands more, worldwide), an endless stream of metrics, and as many tips and opinions floating around as there are stars in the sky.
Here's a tip you can take to the bank: You can improve your returns and quickly decide whether a stock is right for you by filtering shares through your own personal investing checklist. Here are the seven filters I run a company and its shares through the first time I analyse them.
1. What are the company's competitive advantages, and how durable are they?
Competitive advantages are the lifeblood of growth. They give companies pricing power and make for high returns on invested capital. There are different types of competitive advantages that a business might possess, but some of the most valuable you should look out for are network effects like SEEK Limited's (ASX: SEK), prized brands like Coca-Cola's, high switching costs like those of Commonwealth Bank (ASX: CBA), and high barriers to entry at-large because they keep competition at bay. Even better, we Fools love when those advantages have staying power. A pharmaceutical company's blockbuster drug will eventually lose its patent, for example, but Coke's brand has timeless appeal. The bigger the competitive advantage and the longer its staying power, the more valuable the business and shares.
2. Why is this stock interesting now?
Fools can afford to be choosy: Markets are volatile, and thousands of stocks can be bought at any moment of the trading day. What makes this stock interesting today? Maybe it has been whacked, maybe an activist investor just got involved, or maybe the company just pole-vaulted expectations. A stock can be interesting for a thousand reasons, but we should at least be able to zoom in on why now might be our window.
3. What is our variant perception?
In other words, what do I see that the market doesn't? This is the question that separates the shepherds from the sheep (also opposable thumbs, but you get the point). Maybe you think an Apple (Nasdaq: AAPL) TV will be a smash hit or that Mr. Market underestimates the lifetime value of Coke's brands and distribution. Fools invest only if we have a clear, articulate description of what we think the market has wrong about a stock. Without a variant perception, you are just following the flock.
4. Can the business earn high rates of returns on the marginal dollar it reinvests?
High returns on capital are great, but growth hits the brakes once companies run out of great reinvestment opportunities. The real shoot-the-moon opportunities we stumble across are those that can improve the overall economics of the business with each additional dollar invested. Typically, these are network-centric businesses — and why my U.S.-based newsletter service, Inside Value, has a scorecard packed with networks like eBay, Visa, and Amazon.com.
5. Do we trust management with shareholders' cash?
Copious cash flow is great, but only in the hands of a management team that can allocate it well. I'm not wild about management teams who use share repurchases as a sponge to sop up dilution from employee share options or chase growth via splashy acquisitions. Fools should also give the funding of dividends a close look. All too often management teams at cash-strapped companies will quietly take on debt or, worse, raise equity to fund dividend payments that the existing company's cash flow won't cover. A company that funds dividends by issuing new shares is like a CEO pick-pocketing you and then magnanimously returning the wallet to you. Funding the dividend through debt increases, meanwhile, only amplifies the company's cash crunch and increases the likelihood the dividend – and maybe even the company – could someday go bust. Be very wary of management teams with spotty track records of capital allocation.
6. Do management's incentives align with minority shareholders?
We like when CEOs have skin in the game. For example, Amazon's Jeff Bezos and Berkshire Hathaway's Warren Buffett both have the vast majority of their personal wealth tied up in their company's stock. When CEOs don't have a large personal stake in the business, though, we're still comfortable so long as their compensation is geared toward creating long-term value, not empire building. My favourite metrics for managers to chase are growth in book value per share and improvements in returns on invested capital.
7. Are the shares attractively priced?
It's better to own a great business at a fair price than a fair business at a great price. Still, no business is a buy at any price. You can turbo-charge your results and reduce your risk by buying shares of quality companies when they're out of favour. Look for low price-to-earnings (P/E) or price-to-book (P/B) ratios against a company's history and its competitors for clues to whether you're getting a good deal.
What's next?
Try running your largest holding through these filters and see what you find. Don't worry if the shares didn't "score" well on all fronts – only a handful of business score highly on each question. Next, take my questions and tweak or build on them in a way that fits your style, approach, and risk profile. No matter how you change them, though, be sure to stay focused on fundamentals and the long-term. In other words, stay Foolish.
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The Motley Fool's purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Motley Fool investment analyst Joe Magyer owns shares of Amazon.com, Berkshire Hathaway, Coca-Cola, eBay, and Visa.
