Investors face tough decisions when it comes to finding investable companies. Analysing the huge amount of data available out there is crucial when trying to find investment ideas that is suitable for ones portfolios. This can be an arduous process.
So, how should individual investors interested in purchasing stocks find investment ideas? What investment criteria should they be using when shortlisting a list of potential companies?
Therefore, developing a simple set of investment criteria to follow can make the shortlisting process a much simpler task. In today’s article we will be sharing on 3 key investment criteria Buffett uses when it comes to stock selection.
Understanding the Business
I like businesses that I can understand. Let’s start with that. That narrows it down by 90%. There are all types of things I don’t understand, but fortunately, there is enough I do understand. You have this big wide world out there and almost every company is publicly owned. So you have all American business practically available to you. So it makes sense to go with things you can understand.
Source: Lecture at the University of Florida Business School
Ultimately, when investing in stocks, we are not just buying a piece of paper but a part ownership in the business. Hence, having some understanding of the business is crucial.
Think about it. Would you go into a business that you have no understanding of? The same logic should apply when it is investing in stocks as well.
Understanding of Oneself
First, you need two piles. You have to segregate businesses you can understand and reasonably predict from those you don’t understand and can’t reasonably predict. An example is chewing gum versus software. You also have to recognize what you can and cannot know. Put everything you can’t understand or that is difficult to predict in one pile. That is the too-hard pile. Once you know the other pile, then it’s important to read a lot, learn about the industries, get background information, etc. on the companies in those piles. Read a lot of 10Ks and Qs, etc. Read about the competitors. I don’t want to know the price of the stock prior to my analysis. I want to do the work and estimate a value for the stock and then compare that to the current offering price. If I know the price in advance it may influence my analysis. We’re getting ready to make a $5 billion investment and this was the process I used.
Source: University of Kansas, MBA Student Meeting
Simplicity is Beauty
We get paid not for jumping over 7-foot bars but for finding 1-foot bars that we can step over.
Source: Berkshire Hathaway Annual Meeting 2003 Tilson Notes
Investment ideas comes in all shapes and sizes. Furthermore, with investing you need not swing at every pitch. You have the choice. Choosing between 2 investment ideas, where Idea A’s probability of working out is 90% vs. while Idea B’s probability of working out is 10%. It is only natural that we would go for the Idea A. However, very often I do still see investors investing in Idea B.
There are many investment ideas in the retail industry that are currently very cheap, such as Sears Holdings, Macy’s, GameStop etc. While they are indeed undervalued, however, the probability of the company turning around is very limited.
Hence, we need not swing at every pitch. Waiting for the ones that are just 1-foot bars is definitely much better investments than having to jump over 7-foot bars.
While these guideposts are helpful, it just helps one narrow down the list of investable ideas. One would still have to conduct their own investment analysis – reading the Annual Report of the companies, understanding the earnings and cashflow of the companies or even analysing the long term viability of the business.