Track Record
While there are numerous examples of companies performing relatively poorly for a number of years before turning things around, the odds are very much stacked against them. For example, a business that has been loss-making in recent years is likely to continue to make a loss moving forward – unless it is a cyclical company that has just experienced a recession.
As such, the track record of a company really matters and, although it will not be perfectly replicated in future, it provides an excellent guide as to what could be in store for the business over the medium to long term. Therefore, it can be prudent to stick with companies that have at least shown a degree of impressive performance in the last five years.
Valuation
Although a great company will usually deliver strong share price growth whatever price you pay for it, a generous margin of safety will help to stack the risk/reward ratio in your favour. For example, oil stocks at the present time offer very wide margins of safety because investors are uncertain about the future direction of the oil price, and have factored in further falls in its price level. As a result, the downside risk to oil stocks is somewhat limited, since it would not be a major surprise for the price of oil to fall back to below $50 per barrel. Similarly, the upside potential is greater due to a wider margin of safety, since share prices appear to be trading at below their intrinsic values.
Buying shares in good quality companies when they are cheap has the potential to maximise your returns and also limit the risk of loss. As such, focusing on value is a prudent step to take before buying shares in any company.
Competitive Advantage
Before adding a company’s shares to your portfolio, ask yourself what its competitive advantage is. For example, perhaps it has considerable brand loyalty, a lower cost base than its rivals, considerable geographic diversity or a management team that is better than those of its rivals. Although it sounds rather simplistic, identifying what is good about the company you propose to buy a slice of helps you to be honest with yourself about its strengths and weaknesses. In other words, if you are struggling to simply state why company X is a better business than its peers, then it may be time to look elsewhere for your next star investment.
Forecasts
While forecasts are rarely accurate, they provide an indication of the performance that the market is currently expecting from a company. This can be useful in determining if its current valuation is too low or too high, while also providing an indication of how volatile its share price could turn out to be.
For example, a company that has extremely high growth forecasts could see its shares hit much harder by a downgrade to guidance than a company which has only moderate earnings growth expectations. Furthermore, a company that lacks strong growth prospects is unlikely to be the subject of an upward rerating in terms of its valuation by the market, since investors reward earnings growth more than anything else in normal market conditions.
Debt Levels
While we as investors have become somewhat blasé about debt levels, for long term investors they remain a crucial consideration. Certainly, debt servicing costs are low now, but they are unlikely to still be in five or ten years’ time, with highly indebted companies set to see the ‘interest paid’ line on their income statement increase multiple times, thereby reducing their net profit considerably and, in some cases, pushing them into loss and towards the territory of ‘unviable business’.
In fact, history tells us that the pain of a recession is often felt many years later, when interest rate rises kill off the companies that were being propped up by a loose monetary policy. Avoid such problems and your portfolio returns will be given a major boost.
