5 steps to finding the next great investment

Reported by Motley Fool Staff
Sunday, March 11, 2012
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A little while ago, The Motley Fool’s CEO and co-founder, Tom Gardner, made a video series on how to pick great companies. His investing style is to search out — and buy shares in — great, growing businesses as the company rolls out its expansion plans. In his own words, he seeks businesses that can potentially deliver 10 and 20-fold share price increases over a reasonable period such as a decade.

Tom distills his strategy for finding the special qualities that make these businesses super-performers into five steps — the five Ps.

People

Although recognising that quantitative aspects of company analysis are important, Tom reveals that he spends more than half his research time analysing qualitative factors. What sets a business above its competition is the quality of its people, he reckons.

Tom is looking for companies with great business leaders. He wants the main decision maker, usually the CEO, to have:

  • passion for the business,
  • loyalty,
  • commitment to a long tenure, and
  • financial interests aligned with shareholders.

Once he’s examined the CEO, Tom looks for similar qualities in the rest of the company’s management team and investigates how this filters down into the vision, mission, values and culture of the rest of the organisation.

The idea is that passionate, committed leaders and management teams can find avenues for business growth that don’t show up in the figures.

Tom recommends Googling the names of key company people and following up the leads to get a ‘feel’ for their achievements and integrity. It’s amazing how much you can find out quickly, he reckons.

Profit

Tom’s interested in businesses that are good but capable of getting even better, so a record of profitable trading is important. He looks for consistent earnings, backed up with solid cash flow to prove that the earnings are real and not just the result of accounting manoeuvres.

The dream company for Tom would have accelerating profit growth, thus proving that the qualitative factors are having a real effect on the figures. He also insists on the company’s return measuring at least 10% against equity and ideally higher.

Potential

Great businesses can grow fast and then saturate their markets, so it’s important to determine what opportunity remains. Tom uses bowls as a metaphor, saying that the company needs either to have plenty of room in its bowl of opportunity, or be capable of targeting new and bigger bowls of market opportunity, just as Apple (Nasdaq: AAPL) did with each new product launch.

Position

A company’s position in the market can have dramatic effects on its future operations. If it enjoys a competitive advantage — something that protects current and future cash flows — it may prosper. If it doesn’t, it’s likely to decline.

Tom identifies three types of common competitive advantage as:

  • a less expensive product,
  • a better product, and
  • customer convenience.

A company achieving all three often trounces the competition. However, achieving any one could give the company an edge.

He also identifies three threats to competitive advantage that could cause businesses to decline:

  • external threat,
  • transformational disruption, and
  • poor management.

Think of the decline of the traditional newspaper and recorded music businesses, the shift from high street to internet sales and the rise of smartphones at the expense of older styles of mobile device.

Purpose

Purpose in a company is something you know when you see, or feel, reckons Tom. It’s a general enthusiasm expressed by customer and employee alike. He reckons telltale signs that a company has purpose are:

  • there’s a need for the product,
  • customers are being delighted,
  • customers are better off through buying the product,
  • the world is a better place for the product, and
  • a general enthusiasm surrounds the business.

Last word

I reckon it’s a good idea to put energy into identifying great businesses for investment, but it’s worth bearing in mind that even a great business can make a poor investment if you pay too much for the shares. So the final step should always be ‘valuation’, to ensure that you pay a price that makes sense of an investment.

If you are looking for ASX investing ideas, look no further than “The Motley Fool’s Top Stock for 2012.” In this free report, Investment Analyst Dean Morel names his top pick for 2012…and beyond. Click here now to find out the name of this small but growing telecommunications company. But hurry – the report is free for only a limited period of time.

The Motley Fool’s purpose is to educate, amuse and enrich investors.This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

19/04/2014 21:58Sydney, Australia. 19 April,2014
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