Just like pilots have a checklist before takeoff we believe its important to check off the following investment characteristics.
1. Invest in the leading companies, is it a company you can’t live without?
A general rule for investors is to buy into the leading companies. Just as consumers buy products from brand names they trust, investors should buy shares in companies with the leading brands whose products and services they use and understand. It’s always a good thing to produce a product your customers can’t live without.
2. Management should be owner oriented. Do they own a substantial amount of shares, did they found the company?
Great managers act like long term owners of a business, not like caretakers. Owner oriented management will invest for the longer term focusing on what is best for the customer and not just short term profits. We like to see significant management share ownership as this aligns management with shareholders. For founders especially its their life its not a job.
3. Is the company/industry growth oriented (The toothbrush test)?
Just like Google we try to employ their toothbrush test in that we prefer to invest in markets that are large enough and meaningful enough to be used by nearly everyone twice a day. Companies that grow their business and increase earnings above the market should do well over the longer term as share prices tend to follow what a company earns. After all if profits are not increasing then why should the share price increase.
4. Is it a quality company? Leading companies tend to have above average returns on equity.
Consistent high returns on equity suggest that the company has some competitive advantage (which may or may not be sustainable) that allows it to earn above average returns. Just as important is the company’s reinvestment rate, as if it can reinvest and compound its profits it can significantly increase future earnings.
5. Cash is king follow the cash.
Cash flows consistently greater than profits are a typical indicator of a cash generative business. These businesses are so good that they do not need to go to the banks for money. Even better unlike earnings cash is a hard number to manipulate, as any good accountant will tell you cash is fact and profit is an opinion. Leverage is also a factor it’s harder for companies to go bankrupt if they have no debt.