Professional investors like Warren Buffett and Peter Lynch have made (and in Buffett’s case, still making) extraordinary returns in their careers by investing in and holding on to high quality businesses. But, what exactly does it mean to measure a business’ “quality” in the context of investing in the share market? Here are two qualitative strategies that may assist you in your search for great companies. 1. Recognize your Circle of Competence Unless you are a master of all trades and jack of none, choosing to invest in shares that belong to your area of expertise is…
Professional investors like Warren Buffett and Peter Lynch have made (and in Buffett’s case, still making) extraordinary returns in their careers by investing in and holding on to high quality businesses. But, what exactly does it mean to measure a business’ “quality” in the context of investing in the share market?
Here are two qualitative strategies that may assist you in your search for great companies.
1. Recognize your Circle of Competence
Unless you are a master of all trades and jack of none, choosing to invest in shares that belong to your area of expertise is generally a good idea. That’s because you would be in a better position to analyze the true worth and future prospects of such shares.
For example, an individual who works in jewellery retail might understand the ins and outs of the industry. Thus, he may well know more about a jewellery retailer like Aspial Corporation (SGX: A30) as compared to say, a bio-technology outfit.
The same could also be said even for someone who works in a niche part of retail, such as the sale of massage chairs and related products. Such an employee could make use of his industry knowledge to gain a better understanding of a company like OSIM International (SGX: O23), which has seen 21 quarters of consecutive growth in profit.
2. Keep a lookout for economic moats
Companies which have certain competitive advantages tend to maintain their leadership position in their respective industry or field – in other words, they possess an “economic moat” (an investing phrase made popular by Warren Buffett). With an economic moat, such companies are able to protect and grow their profits, thus growing their market value over time.
Below are several competitive advantages that investors can look out for in any company that they might be interested in:
* Brand Equity – There are certain companies that often get associated with a certain product or action. A classic example would be that of Google and internet search; it’s very common to hear someone say ‘I’ll Google this’ as a short-hand for saying ‘Let me find out more about this on the internet.’ Such powerful associations often help to bring customers back to a company and that’s very useful for investors. In the local context, BreadTalk (SGX: 5DA) might be one company that’s often associated with or thought of first when it comes to creatively-baked breads and bunds.
* High switching costs – As I’ve written before, “A good example is enterprise database services and software. Migrating from an existing enterprise database system to another could entail the risk of knocking out all essential services if the switch isn’t handled well. Besides, such a move can be a brutally costly and complex procedure. In light of that, it’s easy to see why customers tend to stick with such services once implemented. When companies get sticky customers, it’s easier to derive sustainably high profits for years to come.”
A company like Silverlake Axis (SGX: 5CP), whose technology forms the ‘central nervous system’ for a bank’s many different platforms (the firm offers an Integrated Banking Solution product that helps process and control the distribution of all information received from different platforms), provides one such instance. Banks and financial institutions that adopt the company’s solution would find it very hard and costly to switch to something else; anecdotally, that’s also supported by how the company has been a core system partner with Oversea-Chinese Banking Corporation for almost 20 years.
* Low cost producer: The idea here’s that a company that’s able to produce goods at a lower cost than its competitors, provided there is no compromise on quality, can also have a meaningful advantage in its markets.
* Scalability or the Network Effect: These are companies that have the potential to add on new users to their network over time and thus build up the value of their network. That’s a powerful competitive advantage to have because it’s tough for new competitors to pry users away from a network that already has many other users. For instance, why should consumers carry a credit card that no merchant is using; at the same time, why should merchants want to accept a credit card that no consumer is carrying? This is why Visa and Mastercard are such dominant forces in the credit card business.
A local example would be Jardine Cycle & Carriage (SGX: C07), which distributes more than 50% of the cars in Indonesia. A wide distribution reach like what the company possesses gives it the potential to increase its market share further.
Foolish Bottom Line
All told, while an investor can take the two qualitative strategies above as a general guideline, the list is not exhaustive. In addition, it’s also important for investors to understand how to interpret the financial results of a company.. I’ll soon be sharing how you can use three popular financial metrics to aid you in your search for investment opportunities. So, stay tuned!
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor James Yeo owns shares in any companies mentioned.