With all the recent turmoil in the financial markets, some investors are now comparing achieving market-beating returns to buying a National Lottery ticket. There is no denying that luck plays a role in an investing journey. However, investors like Warren Buffett are living proof that consistently beating the market is possible in the long run.
It’s true that share prices can be highly volatile and unpredictable in the near term. However, stocks ultimately represent businesses. And focusing on the underlying quality of operations can provide a powerful insight into the long-term potential of an investment.
While it can take a long time for an investment thesis to play out, a carefully researched position has far greater odds of building wealth than buying a National Lottery ticket. So how does Buffett do it?
What is a high-quality stock?
It’s easy enough to say invest in good businesses. But what exactly makes them “good”? This is the challenge every buy-and-hold investor has to overcome. And to make things more complicated, every company, even similar ones, are fundamentally different in some way, making it impossible to develop a universal standard to classify organisations.
However, there are some factors investors can check that can quickly eliminate duds from consideration.
1. The fundamentals
Starting with the financial statements, these can provide a lot of insight, including:
- The general health of the businesses
- Its operational efficiency
- The quality of cash flows
- And whether or not it’s actually growing
Reading and understanding what the numbers mean is a critical skill for long-term investors. And it becomes crucial for estimating the fair value of a business – something that Buffett is famous for. After all, even if an investor finds the world’s greatest company, buying shares at the wrong price can still result in an underperforming investment.
2. The competitive edge
Of course, it’s not just about the numbers. Buffett has repeatedly pointed out that he looks for qualitative factors such as competitive advantages. For any enterprise to grow and capture market share, it needs to have a business model that rival firms can’t easily disrupt.
These advantages can come in many forms. And some examples include:
- A brand with a reputation for quality can usually charge premium prices even with cheaper alternatives available to customers
- A firm’s products or service becomes so heavily integrated into its customers’ operational pipeline that it becomes economically unviable to switch
- A unique operating approach that leads to higher productivity at lower cost and can’t be replicated by competitors
3. The management
Even a terrific product or service will fail to generate meaningful returns if a company’s leadership is incompetent. That’s why having skilful management at the helm can make a world of difference. And investigating their backgrounds, experience, and achievements allows investors like Buffett to verify they’re the right people for the top jobs.
The bottom line
These factors are only the tip of the iceberg when it comes to stock picking. But they can act as a powerful filter to eliminate many bad investments from consideration. Becoming an investor as successful as Buffett is no easy task but, given the potential rewards, it’s a worthwhile pursuit. At least, that’s what I think.
