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Knowledge is Power… so the saying goes. But if that is so, then academics would rule the world right? Let’s look at a wise saying from the bible:

“He who gets wisdom loves his own soul. He who cherishes understanding prospers.”
Proverbs 19:8

Knowledge itself is not power. It is the understanding that knowledge brings or the application of knowledge where power lies.

Likewise if we train ourselves to know and understand our stock investments, we can become wiser investors and get better results.

Here are a few things I’ve learned which work well for me. I’m sure it’s NOT the only way to make money but I hope it gives you that extra knowledge and wisdom that you can apply to your own investments.

BUY GOOD COMPANIES

This is like stating the obvious but believe it or not, this is not the starting point for many people! For many the rule is to buy stocks which will go up. And what will go up is what I heard while playing mahjong… Hmm I hope you don’t “play share” like this

What are good companies?

Good companies are those that consistently generate an increasing stream of cash for shareholders. Over time, the dividends keep increasing and over time your share price will go up also.

So how do you find good companies? If you have a trusted advisor then great – you’d save yourself a lot of work and effort! But personally I do it the hard way. My starting criteria:

1. Big Companies
I am kiasu (and kiasi) so I usually prefer big companies, usually with market cap of more than RM1 billion. Most large companies have many years track record which I feel provides more comfort. And you are also in the same boat with institutions and other influential shareholders. This will keep management in check.

But big in itself is not a guarantee against failure. Just look at what happened to AIG and General Motors. And even Citigroup… the bank that ruled the world 10 years ago. We need to monitor our investments from time to time and look for any signs of crack in the company. Whether management has overextended the company, or in the case of General Motors, “who moved my cheese”?

In fact just like a huge ship, the bigger you are the less agile you become.

What about Fast Growing Small Stocks?
Yep this is where you make the most money according to Peter Lynch. I do have one or two small stocks but I won’t be adding more for now. When the market recovers, it will be led by the large caps first. If I make some money on my large caps, then I start turning a few rocks on the small caps.

2. Market Share
The companies I like are usually market leaders or have huge market share in their business. Usually you can see their product or outlet in major malls/neighbourhoods.

I’m not too concerned what business they’re in unless it’s a dying business. If you’re selling fridges to Eskimos while everyone else is selling blankets, then you’ve got a problem. The main thing is that they are good in what they do. Warren Buffet says that the company should have a moat (barrier against competitors) but it’s quite hard to know this sometimes.

Why bother about market share?
Simply because market share means everyday customers. Most probably you have a business where people need to buy your stuff everyday. And if you do your business well, you will have a cash cow. Most likely you will end up with a huge market share if the barriers to entry are high.

Beware the government monopolies. These companies have huge market share but they got there largely by government backing and protection… and we all know how spoiled kids behave. Don’t ask me to mention names, you know who they are! Having said that I do admire companies in the Petronas group for their professional management and good governance.

3. Earnings & Dividends
Look at the 5 year profit track record. Or even better 10 years if they have. If Profit and Free Cash Flow have grown significantly during this period then it’s a good starting point. You will need to be slightly financial literate if you are taking the DIY approach like me. I will explain some of this financial stuff next time.

Beware of Fake Profits
What do I mean by this? It is easy for management to fudge the profit figure, eg boosting inventory value, or fake sales which go into receivables but never end up collected – sounds familiar? We will need to look at a thing called Free Cash Flow which I will explain next time.

“The word most frequently seen with earnings is surpise”
Peter Lynch

Trying to predict future earnings can be tough. I sympathise with those analysts who publish 3 year earnings forecasts. I would much rather look at how a company plans to increase its earnings and check periodically to see if the plans are working out.

4. Balance Sheet
Gearing must not be excessive – the company’s Net Debt (borrowings minus cash) should not exceed 40% of its Shareholders Funds.

Also good companies use their capital efficiently. They should be getting at least 12% return on equity. By the way, Malaysian Banks are currently quite good in this area. But they are being hammered in the market now because of the fear factor. Here’s a trustworthy saying:

“Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to missappraised.”
Warren Buffett

Stay tuned. In Part 2… the People Factor, Cheap Companies and Stock Market Timing.
To be continued…