How to Choose Good Stocks to Invest in?

Last Updated on August 28, 2020

Invest in a company stock that you want to own forever

As we said earlier, buying a stock expecting that it will grow in value for years, and therefore holding it for a long time is an investment; everything else is speculation. When you invest in company stock, you have to be confident that you are going to own it forever. This is the best way to ensure that you will invest in the best. Now, what kind of companies will qualify as investment-worthy and how do you identify them?

If you are currently investing in stocks, what is the method you use to select stocks? Is it low P/E, low Price/Book Value, High Dividend Yield?  These methods oversimplify investing and hence are inadequate. They don’t tell you about the earning capacity of a company — the key driver of its stock price in the long term. They may lead you to take a wrong decision.

The fact is that, in the short run, market sentiments drive stock prices up or down, irrespective of whether the stock is wonderful or not. But in the long run, the price of any stock is driven by the company’s ability to consistently earn profits.  And a company can earn profits consistently only if it has a wonderful business — a business which has done well and will continue to grow in the future.

Great businesses have one essential characteristic: they have a Sustainable Moat 

In olden days, a castle used to be protected by a moat — a wide channel dug around a castle and filled with water. The wider the moat, the more difficult it was for enemies to enter and capture the castle. For you, the castle is a company you want to invest in. And the moat is a sustainable competitive edge which protects the company from the competition and tough economic conditions! During tough times, companies fight harder to win customers, which usually leads to a fall in prices, and thus, margins. Only a company with a wide, unbreachable moat — a competitive edge — can maintain and grow its profits even during tough economic conditions.

“A good business is like a strong castle with a deep moat around it. I want sharks in the moat. I want it untouchable” – Warren Buffett

What would qualify as a real competitive edge, a moat?

If you had to buy toothpaste, which name comes to your mind? Most of us would think of Colgate, and many of us would buy it. Why? Because this is a name many in India have come to trust over the years. It is quite easy to make toothpaste, maybe even better than Colgate, but without the Colgate brand name, you will sell very little in India. This is the power of the Brand – the first moat. A strong brand helps a business to command a large market share and higher prices and makes it very difficult for competition to grow. Read more on this Moat

Wouldn’t we love to own a company that was the only one who could manufacture a particular product and had no direct competition? That is exactly what happens if a company has a Patent or a Trade Secret – the second moat. The most common examples: pharma companies with patents, and food and beverages companies with unique and usually patented recipes like Coca Cola and McDonald’s fries (which are made from specially grown potatoes!) Read more on this Moat

We use expressways/highways for hassle-free travel — fast, safe and comfortable.  And we have to pay a toll for using it, but we still prefer it. Wouldn’t you love to own a business that makes money every time someone uses it, and people have no option but to use it? Some companies have exclusive control over particular areas. That gives them the ability to collect a Toll – the third moat. For example, If you want to advertise a product in South India on a television network, you would have no option but to advertise on Sun TV, because of its very high viewership. Google AdWords is another example of a toll moat — you can’t reach people searching for something on the net without using Google AdWord because Google is the most popular search engine used by people! Read more on this Moat

We are all creatures of habit. We do not like to change, especially, if the change requires a little bit of effort. The fourth moat that a company can have is based on this and is called Switching costs.  It means a company has a product or service you are so used to, that changing or switching it is either very difficult or not worth it. Examples are Microsoft Windows and Microsoft Office. We are so used to them that changes to, say, Linux is not worth it for most people – even though it is free and offers certain advantages over Windows. Indian IT companies get most of their business from repeat clientèle because of this very moat. Read more on this Moat

One of the biggest factors on which companies compete on is price – the fifth moat. A company which can price its products very low and still makes a profit makes it difficult for the competition. For example, consider D-Mart (Avenue Supermarts Ltd.); its strong retail network and value retailing format combined with its large scale of operations enables it to offer good discounts on products. Read more on this Moat

So, the five types of moats that a company can have that can stand the test of time are Brand, Secret, Toll, Switching Costs and Price. A company can also have other moats like network effects, distribution network, etc.

What else is essential to qualify as a great business that is investment worthy?

In addition to a sustainable moat, two things are required:

1. An Excellent Financial Track Record over 10 years: Why 10 years? Because over a 10-year period, the company is likely to have experienced one full economic cycle — good and bad times; growth and recession. A business does not do well over a 10-year period just by accident! A company which has performed well over a 10-year period is most likely to have a moat. But does it mean that past performance is a guarantee of future performance? No, there are no guarantees, because the world is experiencing a high rate of change and disruption.  But the past performance and past behaviour of the Management give a very good indication of its future prospects. You need to understand how to look at the financial track record and separate the best from the rest. Read more>>
2. A respectable Management is a critical go-no-go criterion for investing in a company: Promoters and top management have to pass this test with flying colours. Because they run the company, they report the results and disclose information, and if there is any doubt about their honesty, you should completely avoid investing in companies run by them. Find clues and pointers to help you identify management that is trustworthy and respects interests of minority shareholders like yourself. Read more>>

To Summarise:

While investing in stocks, look for companies which have a sustainable competitive edge, i.e. a Moat. There are five types of Moats: (1) Strong Brands (2) Patent or a Trade Secret  (3) Ability to charge a Toll (4) High Switching Costs and (5) Low price. In addition to these Moats, look for (6) Excellent Financial Track Record over 10 years and (7) Trustworthy Management

Let’s understand each moat better.

‘Moat-1: Great Brands are an unbreachable moat’

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