Originally posted on ASX website (Source: Here)
By Romano Sala Tenna
We learn by our mistakes – and here’s what they’ve taught us when investing.
Oscar Wilde once wrote, “Experience is simply the name we give our mistakes”. Based on that definition, I am a very experienced investor.
So, what have I learnt from 22 years of investing? In this article, I set out the five most critical traits to look for in a good company.
1. Trustworthy, shareholder focused, competent management
Ultimately, inside a company there are innumerable decisions that arise each day. How management respond to each of those decisions will, when collated over a period, determine the ultimate success or failure of your investment.
The dilemma here, however, is that management is also arguably the most difficult attribute to assess. There are no formulas or ratios. Face-to-face meetings are good but in the short term, management can fake integrity, vision and competency. And like a racehorse (Black Caviar exempt) even past form is only a partial guide to future success.
What have our mistakes taught us on this point? Our learnings are twofold:
- Do not be over-enamoured with management after one, two or even three meetings. It takes a good number of meetings over a period to truly determine if management is trustworthy, shareholder focused and competent. Be patient and test company performance against management guidance.
- Wherever possible, meet staff and assess the corporate culture. You can fake management, but it’s a lot harder to fake corporate culture.
2. A robust business model with a sustainable competitive advantage
While this is widely reported as the holy grail of investing, what’s not reported is that a sustainable moat in its true form is a) a truly rare commodity; and b) unlikely to be as sustainable over the long term.
Capitalism and the entrepreneurial spirit are wonderful at finding ways through, under or around supposed barriers to entry. However, barriers do exist in the form of legislation, patents, intellectual property, economies of scale, brand pole position, geographical and physical constraints, infrastructure constraints, corporate culture, cost of capital, and more.
The long-term returns are likely to be well above benchmark and it is likely to be an investment you can ride for many years into the future. But if you are fortunate to identify a company with a true sustainable competitive advantage, then first rigorously test your thesis (as it may not be what it appears) and second, remember that it does have a use-by date. This is not a licence to set and forget.
3. Valuation
Paying too much for a good company is a common sin of our time. Equally, the notorious “value trap” has been responsible for the destruction of significant wealth – especially when we consider the opportunity or holding cost.
To overcome both of these issues we focus on the price-to-earnings growth (PEG) ratio, which is simply the PE ratio divided by earnings per share growth. When we started using this ratio more than 15 years ago it was on the fringes. Today, the PEG ratio is well entrenched in mainstream analysis.
4. Positive macro/sector tailwinds
I’m sure you do not need to hear another story about rising tides versus swimming against the current. This trait should be self-evident to all investors.
Macro factors such as step-change technology, population and industrialisation demographics, sector growth and phases within the economic cycle, can provide a free kick and overcome a multitude of investment sins. A strong tailwind provides strong earnings momentum and, importantly, sentiment momentum.
5. Appropriate price action
We use technical analysis (charting) to confirm we are acting in sync with the greater market. You can be totally right fundamentally, but wrong on your timing. As John Maynard Keynes wrote: “Markets can stay irrational longer than you can stay solvent”.
Yes, some of the very best investment opportunities are found by taking a contrarian approach. But this is where many self-directed investors have missed the point: having identified a high-calibre contrarian opportunity, you should wait until the sentiment begins to turn before starting to build a stake.
In doing so, investors save both capital (“cheap” stocks getting cheaper), time and emotional energy – which is substantially under-appreciated.
There are, of course, other criteria we apply on a case-by-case basis. Sometimes we do so deliberately and consciously. Many times the assessment takes place in the depths of our sub-conscious, drawing on our catalogue of mistakes and learnings from the past 22 years.
But if we do truly learn from our mistakes and the mistakes of others, then the passage of time will work in our favour. As the Chinese proverb reads: “With time and patience, the mulberry leaf becomes a silk gown”.