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5 Fundamental Principles for Better Stock Analysis

Analyzing the right company to invest in is the key to long term investing success. I’ll show you the 5 key stock selection criteria I use to maximize investing success.

Hello and welcome to this week’s Lockstep Investing Newsletter.

I want to start by thanking those who received the survey for completing it. It has given great insight into what you find valuable and how we can improve.

The key takeaway is that the majority like the newsletter the way it is; however, you want more of a focus on company analysis and stock “tips”.

I have a great way to integrate this into the Investing Chronicles!

So, without more delays, let’s get into this week’s newsletter. This week, we discuss the following:

Ready?

Let’s dive in!

INVESTING CHRONICLES

Under “Investing Chronicles”, we’ll search for the highest quality companies flying below the radar of institutional investors, using my 18+ years of experience to uncover hidden gems!

Last weekend was “The Woodstock for Capitalists,” also known as “The Pilgrimage”—I’m referring to the Berkshire Hathaway Annual General Meeting, where shareholders from all over the world flock to Omaha to hear the words of wisdom from “The Oracle,” Warren Buffett.

In past meetings, Buffett commented on how his company has grown to a size that restricts his ability to find quality companies to invest in, similar to what we discussed in “Disadvantages of Institutional Investors”. However, he mentioned that he could guarantee shareholders a 50% annual return if he started fresh.

This year, a keen Berkshire shareholder asked how Buffett would make this 50% annual return if he had only $1 million to invest as of today. Buffett’s answer was simple: he would look at all the listed companies, searching for high-quality businesses that no one else is looking at.

You can watch the video here.

The timing of his comment coincided with the survey where you revealed that you want more company analysis and stock tips. Given my years hunting for and analyzing obscure businesses in Africa, I feel more than qualified to do just what Buffett suggested!

So, let’s do precisely that - Going forward I will spend my time sifting through listed US companies and dedicate the “Investing Chronicles” to discussing the process and revealing the companies I find.

I believe the benefits will be threefold:

  1. You will see the process I follow for finding and researching companies I am interested in investing in.

  2. We will learn many valuable investing lessons, which we can discuss as they unfold.

  3. We will hopefully find some amazing companies worth investing in together.

Hopefully, this sounds as exciting to you as it does to me.

Before we begin, however, I need to discuss the principles I follow when researching a company. We have touched on this in the “Checklist for Fundamental Analysis of Stocks” newsletter, but I want to give you my “Must-Haves” for any company.

Principles I Follow When Researching a Company

1. Invest Within A Circle Of Competence

Our goal as investors is to value a business, but this becomes impossible if we don’t understand the company or how it makes money. So, I gravitate towards my circle of competence, and ideally, it is a business I find exciting because it is hard to thoroughly research a business I find boring.

Businesses I do not understand and tend to avoid:

  • Mining and other commodity-type businesses

  • Pharmaceutical companies

  • Insurance companies

  • Cryptocurrencies

Of course, there will be exceptions, but I am unlikely to invest in any of the above sectors.

2. Invest in High-Quality Businesses

Determining quality can be tricky, but there are two ways to do this: quantitatively and qualitatively. I tend to use a combination of both.

i) Quantitative Measures:

First, I look for a high Return on Capital (ROC). ROC measures the return a company can expect to earn for every dollar reinvested into the business.

Next up is revenue growth. We want to see a history of revenue growth and, more importantly, the potential for that growth trajectory to continue. After all, there’s no point in investing in a company that’s stuck in neutral.

Lastly, healthy operating margins are essential. A business that can convert a large portion of revenue into operating income will outperform a company with a similar revenue profile and a lower margin – that is just simple math.

Although not set in stone, this is my qualifying criteria:

Metric

Minimum

Ideal

ROC

>20%

>30%

Revenue Growth

> 5% (=~inflation)

>10%

Operating Margin

>10%

>20%

ii) Qualitative Indicators:

Let’s discuss the softer side of assessing a business’s quality.

Not all businesses are created equal, and understanding various business models is critical to finding quality businesses. The more you know, the easier it is to distinguish between a gem and a dud. Check out my “Economic Moat Company Examples” newsletter for a deeper dive into this.

3. Invest in Healthy Businesses

How do you determine the health of a business?

i) Balance Sheet Analysis:

First, we delve into the company’s balance sheet—the financial snapshot revealing what it owns (assets) versus what it owes (liabilities).

What’s crucial here?

Well, a healthy business should own more than it owes. A business must be able to pay down its debts over time as it generates cash from its day-to-day operations, even better if it owes very little!

Together, we’ll sift through these balance sheets, learning what to look for and what are red flags.

ii) Cash Flow Statement:

As important as the balance sheet is the cash flow of the business.

You’ll be surprised how often investors ignore this, believing the cash will magically appear one day. A company’s ability to generate cash is its lifeblood. Without it, the business can’t survive, let alone thrive. We want a company that isn’t just paying its bills but also generating enough cash to fuel future growth.

4. Invest in Businesses Run by Honest People

This is probably the most challenging aspect of an analysis because it is difficult to know if someone is honest. There are things we can look for, however…

i) History of Management and Ownership:

My experience has taught me that dishonestly is a character flaw, meaning that a person will unlikely go from being a crook to a saint. Therefore, if a manager’s or owner’s history reveals skeletons in the closet, we can assume that the person continues to operate dishonestly.

ii) Management Compensation:

Show me the incentive, and I will show you the outcome

Charlie Munger

Next up, is examining how management is compensated. Is the CEO earning an exorbitant salary? Or is their compensation tied to meaningful metrics that align with shareholder interests?

According to Munger, this is the holy grail of how people are motivated, so we’re looking for leaders whose incentives are aligned with the long-term interest of the business and shareholder returns.

5. Invest In The Business Only When Decently Priced

Finally, we get to the easiest part - valuing the business.

In the newsletter about “Reducing Risk When Buying Shares in a Company” we discuss valuation in detail, introducing intrinsic value and the importance of maintaining a margin of safety. I strongly suggest reading through this if you haven’t in order to have a deeper understanding about valuing a business.

Our goal is not just to find great companies; it’s about acquiring them at a price that maximizes our potential return while minimizing our downside risk.

In Summary:

  • Principle 1: Invest Within Your Circle of Competence

  • Principle 2: Invest in High-Quality Businesses

  • Principle 3: Invest in A Healthy Company

  • Principle 4: Investing Businesses Run By Honest People

  • Principle 5: Invest In The Business Only When Decently Priced

Over time, as we work through the 5 principles, we will better understand what to look for and what to avoid. If at any point you get lost or need more information, please don’t hesitate to get in touch with me. 

Also, if there is a specific company you want me to analyze, I am more than happy to include the analysis in our newsletter.

Closing Thoughts

I hope you are as excited about the journey we are about to embark on as I am.

While I am not guaranteeing 50% returns like Buffett, I can guarantee it will be an interesting learning experience for those who enjoy investing, especially those who love learning about new businesses.

And hopefully, we will find some truly exceptional businesses that are yet to be in the mainstream’s field of vision.

RESOURCES

On our journey to uncover high-quality businesses, we will need some tools. Here, I will list the resources I am using and might be of use to you.

Universe of Stocks

Below is a link to a spreadsheet with over 7,000 companies trading on the US stock exchanges. I am going to be working through this list and updating the spreadsheet with comments as I go.

Feel free to use it as you wish or keep track of our progress:

Download spreadsheet here.

(Remember the spreadsheet will change weekly)

More resources to follow

LESSONS LEARNED

There is no faster way to learn about investing than through the Greats. Here, I share lessons from the best investors and thinkers.

When investing for yourself, it is essential to do things your way that suit your character and follow a research process that makes sense to you. So perhaps you don’t agree with my investing principles above, or maybe you want another opinion.

Enter Peter Lynch, one of the greatest investors of our time.

Peter Lynch’s Bio

Peter Lynch was the manager of Fidelity’s Magellan Fund, and he returned an impressive 29% per annum for 13 years! Under his leadership, the fund’s assets grew from $18 million to over $14 billion, making it one of the most successful mutual funds ever. So, he definitely knows what he is talking about.

In his best-seller, “One Up on Wall Street”, he shares his recipe for success and how individual investors can outperform the Wall Street experts.

One Up on Wall Street: 3 Key Takeaways

1. Invest in What You Know

Peter Lynch emphasizes the importance of leveraging your personal knowledge and experiences to identify potential investment opportunities. By investing in industries or products you’re familiar with, you can better understand a company’s prospects and make more informed investment decisions.

2. Do Your Own Research

Lynch advocates for thorough research and due diligence before making any investment. This involves analyzing a company’s financial health, understanding its business model, assessing its competitive position, and considering its growth potential.

His goal was to find businesses with high growth potential and purchase them when they are undervalued.

3. Stay Patient and Think Long-Term

One of Lynch’s core principles is the importance of patience and a long-term perspective. He advises against trying to time the market or reacting to short-term fluctuations. Instead, investors should focus on the long-term growth potential of their investments.

By holding onto high-quality stocks for extended periods, investors can benefit from the power of compounding and ride out market volatility.

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