When buying a house, we consider price, location, nearby amenities and how accessible it is using public and private transport. We’re just as meticulous when it comes to a car – we look at how much it costs, petrol consumption, driver and parking assist, engine, and car make. We put so much effort into buying a house or a car because such a decision will cost us hundreds of thousands of dollars. It is not a choice to be made lightly, just by tossing a coin or snapping our fingers.
Likewise, when we invest, we want to be careful and thorough. But with so many choices out there, how does one decide what kind of stocks are the best? How does one determine if a company is of high quality? Here are five fundamental aspects of a company that you should consider before investing in them.
1. What is the company’s business model?
A company creates something of value and then sells it to others for profit. That “something” can be a physical product, like mobile phones, or a service, including health care. When we buy a stock of a company, we want to know about its core business, like how it earns its money and how it uses its strengths to continue growing its business.
One way to grow and increase market share is through mergers and acquisitions (M&As), where larger businesses with spending power buy out smaller companies, especially companies that are direct competitors or have complementary services.
These days, however, M&As have taken on a twist, especially with internet-based companies. Large companies are buying over smaller companies, many of which have yet to make money but are considered to have social value because of their popularity. Sometimes this strategy works, but other times, these large companies run the risk of being unable to convert that popularity into profits.
If a company’s business is more about buying the next big thing rather than creating the next big thing, then that is a company you should avoid.
Fundamental 1: You should invest in a company that is not overly reliant on acquisitions to sustain growth and has a distinct value proposition that gives it pricing power. Basically, you should feel comfortable locking the stock in a box and not touching it for five years, or worry about its impact on your portfolio.
2. How is the company’s industry doing as a whole?
A company may be thriving, but you should also consider whether the industry it is in, is also doing well. Take banks, for example. We all use some kind of banking service on a daily basis – whether it’s a savings account, credit cards or loans. In Singapore, we have a diverse banking industry. There are three major local banks as well as several foreign banks. The industry helps meet banking and financing needs of people and companies, so it is an industry that we can expect to be around for many years to come.
Another aspect to look at is how easy it is for a new company to enter the industry. Remember the bubble tea craze? Almost everyone and their aunties were opening bubble tea shops to cash in on the craze. Because it was so easy to join the F&B industry, it was soon oversaturated and eventually very few of those bubble tea shops survived. Banks aren’t bubble tea shops – you can’t just start a bank when you feel like it and enter the market. You should invest in industries that are stable over the long term.
Fundamental 2: It’s not just about choosing a company to invest in, but also an industry to invest in. The rate of the industry’s growth should be consistent, and the industry should have strong foreseeable future prospects. A high level of capital expenditure means it will have a stronger competitive advantage over other industries.
3. What is the company’s management like?
A company’s management is often what makes or breaks a company. Look at how it deals with the public, with the press, with customers and employees. After all, if you’re investing in a company, you’re investing in the people.
There are some questions you need to ask: Does the management have the necessary experience to run a company of that size? Does it have the vision and the knowledge to grow the company? Does the company have a proper succession plan? Or will it falter and crumble should it lose its founder and CEO?
Fundamental 3: Trust in the management of the company is crucial if you’re going to make the decision to invest in it. Even though a company may have a great product, poor management can often lead to its downfall.
4. How do you gauge a company’s financial health?
There’s a lot more to running a business than just proving that you can make money. For example, a company could be making a profit, but if it’s earning less than in previous years, then it needs to be looked at more closely. On the other hand, if there’s a sudden spike in profits, that may not necessarily be good news either – it could mean that the company’s on the decline and desperately selling off assets to stay afloat.
There are other aspects of a balance sheet to consider. For example, the price-to-book ratio (or P/B ratio) can be used as an indicator of whether a company’s stock price is overvalued or undervalued. Again, you can’t just take this ratio at face value. Just because a stock price is undervalued doesn’t mean that you’ve found the golden goose.
Fundamental 4: A company’s balance sheet can reveal a lot about its financial health, and whether it is hiding the truth about how it spends its money during good and bad times. A good company is able to sustain itself even when times are bad.
5. Is the company committed to you, the shareholder?
When you buy shares of a listed company, you become an owner of that company, or a shareholder. Chances are that you’re unlikely to have a say in the day-to-day operations of that company. But because you’ve invested money in the company, it is accountable to you on how your money is used.
For example, if you are investing for the long term, you expect the owners of the company to also be active managers. However, the company may have entrusted management to outsiders, who may try to maximise their wealth at the expense of owners, creating a conflict of interest.
Fundamental 5: A good company should have a strong ‘best practice’ in governance, such as a board of directors to oversee the management team on behalf of you, the shareholder. This board should be independent and not possess any executive function, in order to ensure there is no conflict of interest. Measures of executive performance should also be aligned with the interests of long-term shareholders.
So I should apply these 5 fundamentals to every company I hope to invest in? That seems troublesome.
Since it is your money at stake, you should make the effort to do proper research into the company you’re planning to invest in. However, not everyone has the time and the in-depth understanding to do that for every company. That’s where an investment management firm comes in. Aberdeen Asset Management is one of these firms which rigorously employ all five fundamentals to assess companies to include in their funds.
So, if you don’t have the patience to assess the companies that deserves your money, or you want to diversify your portfolio to more than just a few stocks but can’t manage all that on your own, that doesn’t mean your investment journey stops. Consider letting an investment management firm do the legwork for you.
Do you agree with these 5 fundamentals of investment? Are there other fundamentals you look for?
A MoneySmart Investment article in collaboration with Aberdeen Asset Management.