1. Within the circle of competence
A circle of competence is essentially the business in which you can understand well. You should be able to understand what the company does that you’ve put your funds in. This goes much further than just describing what products or services it sells.
2. Businesses with strong competitive advantages
Businesses which can deter entry and retain the ability to earn abnormal profits are ideal. If you can raise prices and not lose customers, then you’ve got a very good business. Examples include, Coca Cola, Wrigley’s chewing gum, Gillette and WD-40 (yes, that thing!)
3. Solid business with strong fundamentals and a promising future
The past isn’t always the best predictor of the future. If a company has had magnificent fundamentals in the past, the future is what matters. So, focusing on that is what really matters. It could be the case where it continues and even improves like it has with REA, but it might not. So undertaking strong analysis is essential.
4. Low P/E coupled with high returns on equity
A low P/E may be a sign of a stock undervaluation. Barring the normal P/E discussions, a low P/E can act as a risk management tool if it’s the right company. This is because a low P/E signifies that the market isn't expecting much from the company, so if it does have a bad earnings report one season, the capital losses can be reduced. This may also work on the upside. If the low P/E company produces a strong report then the upside could be endless. Contrastingly, if the hottest high-flying growth stock produces a bad report then its price can be slogged. (But i try and be careful and not fall into value traps, especially in trying to identify if there's financial engineering present.)
A company that is trading at a low P/E that is also generating high returns on shareholder funds is no joke. This can be a powerful combination, and it is one of the reasons that hedge fund manager Joel Greenblatt was able to return 50% p.a. for 10 years (although he specialized in spin-offs and the like.)
5. Margin of safety
What is a value investing check-list without a margin of safety? Typically, the value investors most important risk mitigation tool.
This list is to be continued and i do understand that this list may seem a bit unrealistic and more suited during bear markets.
Some other philosophies that I tend to follow (but not limited to) in no particular order are:
- · Understanding that the market, at times, can be very wrong and market inefficiencies can arise leading to a stock trading at a discrepancy to firm value. Further, that the market will at some point will realise its mistake and re rate the stock.
- · Don’t try to predict market direction
- · A strong balance sheet
- · Don’t be afraid to hold cash
- · Don’t over diversify
- · Don’t try and trade frequently
- · Exercise patience and due diligence
- · Don’t follow the crowd mentality and understanding that the best investing ideas come from independent thinking
- · Invest with conviction
- · Try not to place too much emphasis on macroeconomic factors such as interest rates especially when it comes to predicting them.
- · Try and invest in stocks that have a lack of analyst coverage
- · Strong cash flow generation
- · Low P/CF, P/B, P/S (depending on the business)
- · There’s not always a risk-return trade-off
- · Try and invest in companies where you are able to have a holding period of forever or until certain circumstances change
- · Be flexible in approach as an opportunity may present itself anywhere and in any form
- · And finally, be fearful when others are greedy and be greedy when others are fearful
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