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If you really want to "beat the market", most professionals and academics can't help you, and that leaves only one real alternative: You must do it yourself.
-Joel Greenblatt-
Cultivating the right mindsets will bring about awareness and acceptance of the stock market that is a complicated space. It takes a tremendous amount of work and time to get comfortable and adapt yourself to it.
There are eleven sectors with more than 58,000 publicly traded companies worldwide. I don’t know about you but to me, covering each and every one of them seems to be an impossible task to pull off.
Therefore, I have come up with a list of questions that I always ask myself before making any decisions. Don’t take it as a complete checklist for investing in the stock market. As my strategy is constantly evolving with the learning process, things will change.
Here it is.
Circle of competence – Where to look?
First and foremost, what am I interested in? Or more importantly, what do I know?
This is arguably the most subjective aspect of investing: being aware of what you know and what you don’t know.
Let’s take a moment and think of your local cafe. I think most of us have a basic understanding of how to set up a coffee shop: You rent out a space, buy a coffee machine, spend some money on fitouts and then hire employees to run the place.
From there, it is a matter of efficiently operating the shop, getting enough traffic through the door and setting up the right prices in order to generate a profit on the drinks and food you serve— of course after taking operating expenses and taxes into consideration.
Though the kind of coffee, targeted customers and price points will vary by shop, they all have to follow the same economic formula.
With that knowledge, some understanding of basic accounting and a little bit of study would enable one to evaluate and invest in any number of cafes/coffee shops and coffee chains (As much as I don’t like the coffee, I think Starbucks has a great business model and is a money-making monster). It’s not all that complicated.
However, can most of us say we understand the workings of a biotech drug company or a waste management business at the same level? Perhaps not. I am sure I can’t.
This brings me to the concept of the “circle of competence” (CoC). Developed by Warren Buffett and Charlie Munger, CoC is a mental model that involves developing knowledge of areas of expertise that an individual has a deep understanding of or experience in. It helps you identify your strengths and weaknesses, and gain a better understanding of yourself for the sake of capitalising on potential investment options and avoiding losses.
What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
Warren Buffett, 1996 Letter to Shareholder
Without an accurate understanding of ourselves, we are doomed to fall prey to the traps of readily available opportunities in the investment world and will likely languish under our false delusion: we know how things are the way they are.
Understand and know the game you play.
If you do, investing is the best business you can be in. I can look at a thousand different companies and I don’t have to be right on or make money out of every one of them. So I can just pick the businesses that I know well and invest in them.
The trickiest part is just to sit there and watch one after another go by and wait for the right one to scream at you. People are going to say, somewhere along the lines of, “You’re an idiot if you miss this trend” or “XYZ is going to be the next Apple or Microsoft”.
Ignore them.
I learned this the hard way and that there’s a temptation for people, myself included, to act far too frequently and recklessly in stocks. The fear of missing out (FOMO) is inherently dangerous. But I do now know what I call my ‘circle of competence’ so I stay within that circle and don’t worry about things that are outside that circle. Defining what your game is – where you’re going to have an edge – is enormously important.
I still remember looking at Clinuvel Pharmaceuticals (ASX: CUV) in mid-2022, when it was trading at $14/share. Everything that I want to see in a business, Clinuvel has them all. I saw some giant institutional investors holding the name so I decided to do further research. About five minutes in, I lost interest because I could not understand anything.
“CUV's lead compound is SCENESSE (afamelanotide), a drug targeting erythropoietic protoporphyria (EPP)”. What?! I couldn’t even pronounce those words correctly. I figured it was way out of my league so I stopped.
It is now running in the neighbourhood of $23. Do I regret not buying the company? Nope! Maybe I will go back and have another crack at it but as far as I am concerned, I will need to work a lot harder to have a good feeling about this business than any others in my portfolio.
It would not be the best use of my time. I’d rather be vaguely right than precisely wrong. Any business I invest in must be either in my CoC or I must be capable of understanding it.
There is no other way.
High-quality businesses - What to see?
Now that I know where to look - stay away from uncharted territories and focus on what I know and can understand, the next step is to figure out what to see - what kind of business I want to own.
The answer is simple: exceptional businesses - the ones that have durable competitive advantages protect themselves from competitors the way a moat protects a castle (which are what Buffet refers to as “economic moats”).
In the search for an exceptional business with durable competitive advantages, I always start with the company’s income and cash flow statements which reveal what you need to know about its operations within a set period of time.
There are a few metrics that I look at:
Gross profit margins: which give us a good sense of how much a company makes off of total revenue (in percentage) after subtracting the cost of goods sold (COGS). Companies that have excellent long-term economics working in their favour tend to consistently have higher gross profit margins than those that don’t. What allows them to enjoy this is their competitive advantage - the power that lets these companies set the prices for the goods and services they sell well above COGS.
As a general rule of thumb, I always look for companies with gross profit margins of or better than 40%. Of course, it varies across different industries and sectors but the idea is the higher the figure, the more likely that the company has an economic moat that shields it from competition and price wars.
If any company shows up on your radar has relatively low gross profit margins compared to its peers, it means that it is suffering from bad underlying economics and probably is operating in a fiercely competitive industry.
I’d personally like to stay away from it.
Net income margins: which is whatever is left after all the expenses and taxes are taken into account and goes to the business and its shareholders’ pockets. I would always look out for an upward trend in the net earnings over a long period of time. In another word, I am much more interested if a company can prove to have a predictable source of income and consistently show that it is capable of earning more than what it did the previous years.
An excellent business will more than likely report a higher percentage of net income to total revenues than competitors in the same industry. Given the choice of a company that earns $2 million on $10 million in total revenue, or a company that earns $5 million on $40 million in total revenue, I would choose to own the former any day. This is because it earns 20% on its revenues, a much higher return than the other company that can only take home 12.5%.
I always keep my eyes out for businesses that show a net income history of more than 15% of the total revenue because, again, I think there is a good chance that those companies are benefiting from some sort of competitive advantage.
Earnings per share: if you take net income and divide it by the total number of shares outstanding in a given period, you will get the earnings per share number (EPS).
While the figure does not mean much in one particular year, EPS for a five- or ten-year period can tell you whether or not the company has great long-term underlying economics working in its favour. It does not have to be smooth as I don’t expect anything to go as planned all the time. What I am after is an upward trend in EPS.
Below is just a quick comparison between Apple Inc. (NASDAQ: AAPL) and Ford Motor Company (NYSE: F)
You can see that while AAPL (in blue) has been increasing its EPS year after year, Ford (in white) is somewhat struggling to stay profitable, let alone keeping up with the iPhone-making giant.
I understand that the two companies are in two totally different industries. And comparing them with each other seems quite unfair. However, this is to prove the point that consistent earnings are usually a good indicator of a company that is selling a well-balanced mixture of products and services that don’t require much of unnecessary changes.
An upward trend in earnings also means that a) the company has pricing power (in the case of AAPL, it lies within its brand name and the cost of switching to another ecosystem) which means it can charge whatever the price for its products it feels like and b) the economics are strong enough to allow the company to focus more of its resources on growth strategies such as increasing market share or making acquisitions, which in return, generate more sales and profits.
Whereas with Ford, the automaker has to constantly spend a tremendous amount of capital on research and development; advertising; and building and equipment in order to release new products just to keep up with other companies in the automotive industry - the one that is extremely competitive and cyclical in nature.
It is these characteristics that cause Ford’s erratic earnings and as a result create the illusion of buying opportunities for investors - that often lead to nowhere.
Free cash flow - a number that should not be neglected.
Cash is king as people always say.
Sometimes, for some businesses, the majority of their sales are on credit. This leaves them running the risk of having customers default on their debts. As a consequence, a company can still be profitable on paper but does not have a lot of cash coming in, which is never a good sign.
A positive free cash flow is a must-have. It indicates that a company is generating enough cash to satisfy its debt and other obligations, including dividend distributions to shareholders.
In order to work out the number, you subtract capital expenditures (representing the cash outflow toward purchases of property, plant and equipment) and other ongoing expenses a company incurs to keep itself running from the cash inflows from operating activities.
Generally speaking, the higher the figure, the more attractive a company is as an investment. If you are still reading up to this point, you know exactly what I would love to see: an upward trend.
In addition, to better assess and determine the quality of businesses, I pay very close attention to the Return on Capital (ROC). Or sometimes, it can be referred to as Return on Invested Capital (ROIC).
There are two ways a company can raise capital: either through debt or equity. Like everything else in life, it is not free. It comes with a cost (cost of capital or cost of borrowing money), which is the amount of return that creditors and investors expect to get back when they lend you money.
From a business perspective, you would want to use this amount of capital to make money, preferably at a rate of return that is higher than the cost of capital. For example, if your cost of borrowing is 5%, in order to create more value for the company as well as investors and shareholders, you would have to make at least 6% in return. Generating anything less than 5% is destroying the value of the money invested in the business.
This is where ROC comes in and makes its voice heard. It tells you a good sense of how well a company is using its resources and capital to generate profits. And if a company can consistently deliver high ROC, you bet that it has a good story to tell.
Let’s have another look at Apple and see what I mean.
As illustrated in the chart above, Apple has been delivering exceptional performances year after year at making money from the amount of capital under its control. There is an upward trend in its ROC. Starting from an already high of 21.8% in 2017, Apple managed to triple the return, bringing it up to 65.2% in 2022. It basically means that for every dollar of capital invested, Apple made 60 cents in earnings before interest and tax (EBIT).
That is a pretty damn good number. Mouth-watering if you ask me.
(to be continued)
Thanks for reading!
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