What makes a company a “value” investment?
Following Warren Buffett there are various financial and qualitative characteristics a company must have to qualify as a “value” investment. These include:
1. An enduring competitive advantage
The first question to ask about a company is : “What is its enduring competitive advantage?” The business world is divided into a small number of businesses with strong competitive franchises, and a huge number of mediocre businesses that are not worth owning.
Sources of competitive advantage include patents, brand loyalty, low cost industry leader, location, and market dominance.
2. A high return on capital employed
Long term you will only do as well as the business does, so invest in businesses that earn a high return on their capital.
Banks earn around 15% per annum on their capital, however traditional manufacturing businesses can earn as low as 7%-8%. Internet and technology businesses can earn huge returns on their capital.
3. Honest and able managers
You look for three qualities in management: integrity, intelligence and energy.
Businesses and countries succeed because of one person who leads the way. True corporate leaders all share a relentless drive to bring their vision to life. Seven days a week, twenty four hours a day, a leader never stops working to enlist board members, management, employees, distributors, clients, investors, the public, and the government in their vision.
Reading the Chairman’s and CEO’s letters in the company’s annual report will tell you a lot about them. A good Chairman and CEO will want to tell shareholders about the company and its prospects in their own words. You can soon tell those who use PR speak.
4. Sound finances
Only invest in companies that have sound financial structures.
Generally major blue chip companies will be well financed (that’s one of the reasons they’re called blue chip!)
However, the finances of any company need to be continually analysed and monitored. This requires an understanding of accounting, which is the language of business.
The golden rule is the less debt a company has the better.
5. An attractive price
A great business with all the above qualities but bought at too high a price, is not going to be a great investment. So you need to value the business, to ensure you are paying only a reasonable price for it.
The true, real or intrinsic value of an investment is defined as “the discounted present value of all the cash that can be taken out of a business during its remaining life”.