In this edition of Investing chronicles, Lockstep CEO Paul Farah breaks down his five must-have stock selection principles to maximise investing success.
 

Last weekend was “The Woodstock for Capitalists”, also known as “The Pilgrimage” – I’m referring to the Berkshire Hathaway Annual General Meeting, where shareholders from all over the world flock to Omaha to hear the words of wisdom from “The Oracle” – Warren Buffett.

In past meetings, Buffett commented on how his company has grown to a size that restricts his ability to find quality companies to invest in, similar to what we discussed in Disadvantages of Institutional Investors. However, he mentioned that he could guarantee shareholders a 50% annual return if he started fresh.

This year, a keen Berkshire shareholder asked how Buffett would make this 50% annual return if he had only $1 million to invest as of today. Buffett’s answer was simple: he would look at all the listed companies, searching for high-quality businesses that no one else is looking at.

You can watch the video here.

Given my years hunting for and analysing obscure businesses in Africa, I feel more than qualified to do just what Buffett suggested.

So, let’s do precisely that. Going forward, I’ll spend my time sifting through listed US companies and dedicate Investing chronicles to discussing the process and revealing the companies I find.

I believe the benefits will be threefold:

• You will see the process I follow for finding and researching companies I am interested in investing in.
• We will learn many valuable investing lessons, which we can discuss as they unfold.
• We will hopefully find some amazing companies worth investing in together.

Hopefully, this sounds as exciting to you as it does to me.

Before we begin, however, I need to discuss the principles I follow when researching a company. I have touched on this in Master smarter investing: A guide to company analysis, but I want to give you my “must-haves” for any company.

Principles I follow when researching a company

1. Invest within a circle of competence
Our goal as investors is to value a business, but this becomes impossible if we don’t understand the company or how it makes money. So, I gravitate towards my circle of competence, and ideally, it is a business I find exciting (because it’s hard to thoroughly research a business I find boring).

Businesses I don’t understand and tend to avoid:

• Mining and other commodity-type businesses
• Pharmaceutical companies
• Insurance companies
• Cryptocurrencies

Of course, there will be exceptions, but I am unlikely to invest in any of the above sectors.

2. Invest in high-quality businesses
Determining quality can be tricky, but there are two ways to do this: quantitatively and qualitatively. I tend to use a combination of both.

i) Quantitative measures:
First, I look for a high return on capital (ROC). ROC measures the return a company can expect to earn for every dollar reinvested into the business.

Next up is revenue growth. We want to see a history of revenue growth and, more importantly, the potential for that growth trajectory to continue. After all, there’s no point in investing in a company that’s stuck in neutral.

Lastly, healthy operating margins are essential. A business that can convert a large portion of revenue into operating income will outperform a company with a similar revenue profile and a lower margin – that is just simple maths.

Although not set in stone, this is my qualifying criteria:

ii) Qualitative indicators:
Let’s discuss the softer side of assessing a business’s quality.

Not all businesses are created equal, and understanding various business models is critical to finding quality businesses. The more you know, the easier it is to distinguish between a gem and a dud. Check out my post Investing like Buffett: Finding the “moat” around a company for a deeper dive into this.

3. Invest in healthy businesses
How do you determine the health of a business?

i) Balance sheet analysis:
First, we delve into the company’s balance sheet – the financial snapshot revealing what it owns (assets) versus what it owes (liabilities).

What’s crucial here?

Well, a healthy business should own more than it owes. A business must be able to pay down its debts over time as it generates cash from its day-to-day operations, even better if it owes very little!

Together, we’ll sift through these balance sheets, learning what to look for and what are red flags.

ii) Cash flow statement:
As important as the balance sheet is the cash flow of the business.

You’ll be surprised how often investors ignore this, believing the cash will magically appear one day. A company’s ability to generate cash is its lifeblood. Without it, the business can’t survive, let alone thrive. We want a company that isn’t just paying its bills but also generating enough cash to fuel future growth.

4. Invest in businesses run by honest people
This is probably the most challenging aspect of an analysis because it is difficult to know if someone is honest. There are things we can look for, however…

i) History of management and ownership:
My experience has taught me that dishonestly is a character flaw, meaning that a person will unlikely go from being a crook to a saint. Therefore, if a manager’s or owner’s history reveals skeletons in the closet, we can assume that the person continues to operate dishonestly.

ii) Management compensation:

“Show me the incentive, and I will show you the outcome.”

Charlie Munger
 

Next up is examining how management is compensated. Is the CEO earning an exorbitant salary? Or is their compensation tied to meaningful metrics that align with shareholder interests?

According to Munger, this is the holy grail of how people are motivated, so we’re looking for leaders whose incentives are aligned with the long-term interest of the business and shareholder returns.

5. Invest in the business only when decently priced
Finally, we get to the easiest part – valuing the business.

In the post Why (some) risk is good for investing, we discuss valuation in detail, introducing intrinsic value and the importance of maintaining a margin of safety. I strongly suggest reading through this if you haven’t already in order to have a deeper understanding of valuing a business.

Our goal is not just to find great companies; it’s about acquiring them at a price that maximises our potential return while minimising our downside risk.

In summary:

Principle 1: Invest within your circle of competence

Principle 2: Invest in high-quality businesses

Principle 3: Invest in a healthy company

Principle 4: Invest in businesses run by honest people

Principle 5: Invest in the business only when decently priced

Over time, as we work through the five principles, we will better understand what to look for and what to avoid. If at any point you get lost or need more information, please don’t hesitate to get in touch with me.

Also, if there is a specific company you want me to analyse, I am more than happy to include the analysis in our newsletter.

Closing thoughts

I hope you are as excited about the journey we are about to embark on as I am.

While I am not guaranteeing 50% returns like Buffett, I can guarantee it will be an interesting learning experience for those who enjoy investing, especially those who love learning about new businesses.

And, hopefully, we will find some truly exceptional businesses that are yet to be in the mainstream’s field of vision.

There’s plenty more to discover with Lockstep.

Head over to Lockstep to subscribe to Paul Farah’s weekly investing newsletter. It’s never been easier to gain valuable insights that you can apply to your investment journey and take your money game global.

DISCLAIMER

* Paul Farah has worked in financial markets since 2006, holding positions at prestigious firms from New York to South Africa. Now, he manages his own money and provides access to his entire portfolio through his company Lockstep Investing. The views and opinions shared are his own and are for informational purposes only, it is not intended to serve as investment advice and it does not represent the view or opinion of Standard Bank. This information should be used as a starting point for generating investment ideas,and should not be relied upon as the sole basis for making investment decisions. Lockstep Investing (PTY) LTD and the Standard Bank of South Africa Limited will not be responsible for the results of any investment decisions made based on the views provided.