There are numerous important aspects of investing. Although investing is never easy, if I had to simplify it and share three key factors, it comes down to quality, value and growth.
The first and most important attribute when investing is finding a business of exceptional quality. They should be a leader in their industry. They are special, unrivaled, dominant or do a number of things collectively well — what some would refer to as “wide-moat.” They have certain characteristics that make them a truly remarkable business with sustainable competitive advantages.
Often, these companies have a high return on invested capital. A very small percentage of publicly traded companies fall into this category. If not, organizations may have to spend too much on marketing, provide a very high level of service, which could decrease margins, or reduce their price because they have too many people offering the same thing. Often these companies are fully priced, but occasionally there are opportunities after a period when the stock lagged the market or during a market correction. For example, in March 2020, when the pandemic started, most stocks were hit significantly, or during the Great Recession of 2008-2009.
The second most important aspect of investing is value. A great business, at an outrageous price, is not a great investment. It’s imperative to not overpay. If you overpay for a great business, it may not be a good investment. If we ever learned a lesson in value, it has been the last year. We were in a bull market in an ultra-low interest rate environment, resulting in so many businesses becoming overvalued. In some cases, quality companies have declined by 50 percent and still aren’t cheap.
We like to look for a window of opportunity. Markets drop faster than they go up, but when they do go up, it is for a longer period of time. It goes down quickly like an elevator but takes longer to go up like an escalator. Throughout U.S. history there has been an 88 percent chance the market will produce positive returns after five years; if you hold for 10 years, it’s roughly 97 percent. But if you significantly overpay or buy poorer quality companies, that reduces those odds. In the public markets, there is often volatility due to fear and uncertainty.
Valuation should never be ignored. There are a number of valuation metrics to use, like Price-to-Earnings, Enterprise Value-to-EBITDA and Enterprise Value-to-Free Cash Flow that serve as a starting point before deeper valuation analysis. Buying things at an outstanding value provides a margin of safety and could potentially increase your returns.
The third most important aspect of investing is growth. A great business bought at a very attractive valuation but that doesn’t grow can be a very poor investment, just like a great business with incredible growth but overpaid for can lead to poor returns. Growth is a major driver of the value of a business over time. It’s important to understand what drives the price of a stock. Over the very long term, the stock price is entirely a reflection of earnings growth or growth in intrinsic value.
However, over a one- to three-year period, it is typically one-third the broad stock market movement, one-third the industry and one-third the company specifically. If the company has substantial growth, high customer retention and good margins, it could be an indication of an outstanding business. If you talk to customers and employees, you can probably gather the majority of what you need to know. One of the best indicators of happy customers is happy employees, and, in turn, happy shareholders.
Ultimately, there are many factors, both qualitative and quantitative, that one could share on an investment checklist, but if you want to keep it simple, then remember quality, value and growth. ●
Umberto P. Fedeli is CEO of The Fedeli Group
