How many investors out there have a company that they're embarrassed to admit that they hold? Everyone's had at least one. Warren Buffett's biggest embarrassment was Berkshire Hathaway, the failing textile mill he bought in a fit of anger after a buyback offer was below what had previously been agreed on.
(If he'd followed his own advice, listened to Phil Fisher, and "not quibbled over eighths and quarters" he wouldn't have bought it, but that's a story for another time…)
So how can you build a portfolio that you're proud of? Most investors can live with mistakes, especially valuation ones if the underlying business is high quality. It's the 'gonna' stocks that burn a lot of money and go nowhere that embarrass investors. That's your first rule:
- Don't buy businesses with minimal sales that are burning cash
If I'd applied this blanket rule I wouldn't have bought Newzulu Ltd (ASX: NWZ) or Reffind Ltd (ASX: RFN). If you buy a business with minimal sales that is losing millions of dollars per year, typically there's only one way your investment will head – south.
Of course, there are plenty of profitable businesses that might not be ideal to own. I know a guy that bought Rio Tinto Limited (ASX: RIO) above $100 per share. He was embarrassed when the cycle has turned and shares fell to $50-ish. Myer Holdings Ltd (ASX: MYR) is another company that's been tough to hold, since it's down 72% over the past 10 years. The lesson here is:
- Don't buy businesses without a competitive edge
Companies like Rio simply take whatever price they can get on the open market. Myer is vulnerable to all kinds of competition both from other stores, online, and cheap imports. Instead look to own companies with a dominant market position like Carsales.Com Ltd (ASX: CAR) and REA Group Limited (ASX: REA).
Of course, some companies like Woolworths Limited (ASX: WOW) have a strong competitive position, with their buying power and wide network of stores close to customers. A competitive edge doesn't always deliver great investment returns, what you also need is:
- Buy businesses with a well-thought-out story
Now the word 'story' can carry negative connotations, and all some companies seem to do is tell stories. What I mean is that investors should buy a company with a detailed strategy of how they are going to grow profits.
Greencross Limited (ASX: GXL) is going to grow profits by adding new stores and by adding vets and groomers to its existing stores, i.e., effectively adding new businesses within existing stores. It has data that suggests this is a sound and cost-effective strategy for growing. CSL Limited (ASX: CSL) is growing its profits by investing in new treatments which it is bringing to market, as well as by reinvesting its profits in share buybacks, which deliver higher earnings per share.
