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Using the 4M’s To Find The Highest Quality Companies

What are the highest quality companies that you can invest in on Wall Street and how can you find them? It’s a question that doesn’t have a consensus answer, you would think it would be easy to answer. The reason is that Wall Street tells you one thing about what you should invest in based upon your emotions, but the investments that actually make money won’t necessarily be recommended because they are ‘boring’ or don’t create wealth fast enough.

We all know how that can go. You can make fast money investing in stocks, but it is hard to do for a sustained period of time. The record holder for making money fast is Dan Zanger who turned $10K into $42M during a short stint in the first Internet Bubble (he says his return was professionally audited to be true).

It’s this kind of get rich story that inspires investors to seek out riches from places such as hedge funds or worse, “funds” offering high returns by Ponzi scheme. You should check your emotions at the door and use good investing strategy to make money. Here are some criteria that I use use to find the highest quality companies.

However, investing is part art as well as science. You are free to break or bend rules to help you find great investments where others fail to see value. Particularly when you are selecting individual stocks to invest.

A Simple Investment Strategy

We live in an age of almost unlimited information about personal finance, investing and companies. It’s not like 50 years ago when (according to some investor stories I’ve read) where you could find great investments that were mis-priced due to inefficiencies in information.

While we are more efficient in gathering information and routing out obvious incorrect valuations, people still invest based upon emotions. Buying high, selling low, and looking for the ‘next great thing’ before it becomes hot. Falling for Wall Street recommendations for companies that will be ‘winners’ tomorrow.

Let’s start by getting back to basics.

Without using any financial jargon, this is what I want from an investment:

  1. The company makes a lot of money on each product it sells.
  2. The product is ‘sticky’, meaning customers need it or depend on it.
  3. The company has a advantage in the marketplace that makes their product better or more desirable.
  4. When they make a profit after expenses, they send it to me.
  5. The business sells more product over time, but it costs no money to increase sales.

If an investment has all of these traits, it is a dream. Particularly, #4 and #5. In practice, a company needs to retain some of its earnings to spend to increase sales (#5).

If I were to summarize these criteria, what I want from an investment is not earnings growth, but more importantly, earnings consistency. There are thousands of people on Wall Street and many more amateurs who spend time and effort trying to predict what earnings for companies will be. This roller coaster of predictions and fortune telling make investing harder than it needs to be.

The difference between the criteria above versus what a typical growth investor seeks is in the financial measurement Return On Equity (ROE). ROE is the income created on the equity, the capital owned by shareholders. The growth investor assumes that a company can forever use its equity to increase profits at a high rate forever. When a company retains earnings over time, this excess profit adds to equity which makes outsized returns harder over time.

If you invest in companies with the highest quality, consistent earnings and then reinvest those earnings (through dividends or buybacks by the company) in similar quality companies over time, you will make lots of money with less risk and lower volatility.

To find these companies that meet my criteria above, I will use 4 criteria which I call the 4M’s: Moat, Margin, Management, and Minimal Capex.

Moat

Moat should be familiar. It’s a qualitative statement about how well the business differentiates itself in the marketplace, by a sustainable competitive advantage or entrenched market base. Moat is sometimes subject to interpretation and opinion. For example, does Netflix (NFLX) have a moat? One could argue that they don’t because the product they offer is easily duplicated by other well funded competitors, there isn’t really any barrier to entry. However, if you look at it from a customer point of view (which I am a customer of NFLX), you see that there is some loyalty and passion by customers for the company in the way it does business that differentiates it in the marketplace. Over time, it’s possible that their competitive advantage could become a true moat as NFLX becomes a stronger brand over time.

Moat’s that are the strongest are leading companies in mature industries with high barriers to entry. Tobacco comes to mind here. The growth phase of the tobacco industry (where competitors could compete and establish brands) is well in the past, as least for the first world economies. The added burden of strict regulation on sales and marketing in the industry essentially keeps any new competitors out giving the entrenched players oligopoly status.

Margin

Operating Margin is the percentage of operating profit that the company makes on its products. The operating profit is the money leftover from revenue after subtracting cost of goods and expenses. A company that has a high operating margin generates a lot of profit from each sale. You want to own businesses that make lots of money on its revenues.

Management

Management is probably the most important criteria to consider when investing in a company. You want management that is running the business for your benefit and not for the benefit of others. This is what you want from management:

  • Communicate with shareholders about the company strategy and goals, then stick with it.
  • Don’t do stupid things like leverage the business to make dubious investments.
  • Demonstrate commitment to shareholder return, using buybacks, dividends, prudent acquisitions.

There are too many cases where shareholders are treated badly versus well, I see it all the time. The companies that treat shareholders well do exist you don’t need to look that hard. I’ll give you an example here to demonstrate the difference. Go to Realty Income’s (O) website. It’s a shrine to their commitment to the shareholder which has been demonstrated with over 40 years of excellent operational performance. Compare this to a company like Common Wealth REIT (CWH), which has an external management structure whose interests are not aligned with shareholder interests and they have shown it through their actions. The stock performance of O versus CWH speaks for itself, because management matters.

Minimal Capital Expenditures (CAPEX)

Capital expenditures is the money used to invest to maintain or improve in the business. Money spent on capex is less money available to shareholders. If capex spending is low over the long term and the business can provide stable or improving sales, profits will go up over time.

The worst kind of business to own is one that requires lots of capex to maintain and has earnings that are cyclical to the economy. Businesses that are in capital intensive technology (like semiconductors) come to mind as companies that are constantly in boom/bust cycles.

Conclusion

In future articles I will provide specific examples of companies that fit these criteria. Also, I will use specific screen criteria that will be useful for you to find companies that match this strategy of stock investing. After working on this article, I’ve found a few great companies that I never knew about that may turn out to be great investments in the future. Look for more in the future.

 

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