October 18, 2022

The Three Most Important Factors of Investing

There are numerous important aspects of investing. Some of these characteristics, such as experience and wisdom, may take years to develop. Perhaps one reason Warren Buffet made 95% of his wealth after the age of 65. Although investing is never easy, if I had to simplify it and share three key factors, I would say it comes down to quality, value and growth. Great investments tend to have all three components.

The first and most important attribute when investing is finding a business that is of exceptional quality. They should be a leader in their industry. They are special, unrivaled, dominant or do a number of things collectively well—or some would refer to as “wide-moat”. They have certain characteristics that make it a truly remarkable business. It is a company that has substantial and sustainable competitive advantages. In many cases, these companies have a high return on invested capital. When companies generate sizable profits, it attracts attention and competition. Only the most exceptional businesses will be able to withstand increased competition and maintain durable profitability. A ‘wide moat’ is only valuable if it’s a barrier to entry against competition. In my opinion, a very small percentage of publicly traded companies fall into this category. If not, then in a capitalist environment, organizations may have to spend too much on marketing, provide a very high level of service which could decrease margins, or reduce their price because they have too many people offering the same thing. It could be all three or one of the three. Often these companies are fully priced, but occasionally there are opportunities after a period when the stock lagged the market or during a market correction. For example, in March of 2020 when the pandemic started, most stocks were hit significantly; or during the Great Recession of 2008 – 2009. In addition to a quality business, quality management is also important. There are three types of great CEOs: visionaries, capital allocators and outstanding operators. Is management shareholder-friendly? Do they allocate capital well? Do they buy back stock at attractive valuations? Do they make outstanding strategic acquisitions?

Beware of Quality Traps: businesses that appear high quality, but their competitive advantages are eroding or don’t really exist at all.

The second most important aspect of investing is value. A great business, at an outrageous price, is not a great investment. It’s imperative to not overpay. For example, if you overpay for a business, it does not mean the business is bad, but when it comes to investing, this could make for a poor investment. If we have ever learned a lesson in value, it has been in the last year. We were in a bull market in a very ultra-low interest rate environment, resulting in so many businesses becoming over-valued. In some cases, quality companies have declined by 50% and still aren’t cheap. We like to look for a ‘Window of Opportunity’. Markets drop faster than they go up, but when they do go up, it is for a longer period of time. It goes down quickly like an elevator but takes longer to go up like an escalator. Throughout U.S. history there has been an 88% chance the market will produce positive returns after 5 years; if you hold for 10 years, it’s roughly 97%. But if you significantly overpay or buy poorer quality companies, that reduces those odds. In the public markets, there is often volatility due to fear and uncertainty. Valuation should never be ignored. There are various valuation metrics to use like Price-to-Earnings, Enterprise Value-to-EBITDA, and Enterprise Value-to-Free Cash Flow that serve as a starting point before deeper valuation analysis. Buying companies at an excellent value provides a margin of safety and could potentially increase your returns.

Beware of Value Traps: businesses that appear cheap but might have a significant multi-year declining earnings. Through the years I have made many mistakes buying positions that I thought were outstanding values because they appeared very attractive. Unfortunately, some of these turned out to be value traps; they were not of the highest quality nor were they really anything special at all.

The third most important aspect of investing is growth. A great business bought at an attractive valuation but doesn’t grow, can be an very poor investment, just like a great business with incredible growth but had been overpaid for can lead to poor returns. I have separated growth companies into two categories. One I am referring to as speculative and one I am referring to as durable. Speculative growth companies tend to be younger, not necessarily proven and often have large amounts of stock-based compensation (SBC). They tend to overspend for marketing and sales to gain market share, but this is often not sustainable. I find many of these are more like venture capital investing. Durable growth is typically seen by quality, well-managed organizations with persistent long-term revenue growth. They tend to be more proven and less risky if bought at attractive valuations. Growth is a major driver of the value of a business over time. It’s important to understand what drives the price of a stock. Over the very long-term, the stock price is entirely a reflection of earnings growth or growth in intrinsic value. However, over a 1–3-year period it is typically 1/3 the broad stock market movement, 1/3 the industry, and 1/3 the company specifically. If the company has substantial growth, high customer retention and good margins, it could be an indication of an outstanding business. If you talk to customers and you talk to employees, you can probably gather the majority of what you need to know. One of the best indicators of happy customers is happy employees, you improve the odds that shareholders will also be happy.

Beware of Growth Traps: businesses that appear to be high growth, but growth quickly decelerates after you purchase it. Over the last 5 years, I started investing in some higher growth companies. However, many companies that had quick growth during the pandemic weren’t sustainable and ended up slowing down just as quickly.

Ultimately, there are many factors, both qualitative and quantitative, that one could share on an investment checklist. Historically, as interest rates increase, markets struggle to rebound due to the significant challenges of inflation and fear of recession. In this bear market, the volatility will continue. I like to prepare for the worst and hope for the best. A friend recently sent a quote that is very appropriate, “Always be prepared to absorb a big hit, always be focused enough to create a big win, diversify enough to survive, concentrate enough to matter”. If you want to keep it simple, the most important factors to remember are quality, value and growth.

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