How to identify companies in which to invest

In an ocean of between 200 and 245 million companies worldwide, according to the World Bank, “the key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” 

This quote by Warren Buffett, the Chairman and CEO of the Berkshire Hathaway management company, contains one of the five main qualities that a quality business must have to be considered a good investment, while, of course, taking into account barriers to entry, structural growth, cash generation and high return on capital. 

This concept, developed by economist and researcher Michael Porter four decades ago, refers to the unique characteristic that endures over time that differentiates a company in its sector. Apple's technology, Coca-Cola's secret formula, Zara's ability to restock cheap garments, Ikea's affordable furniture... these are some examples of leading companies in their markets that have found/created that unique need in consumers. 

The above is closely linked to another of the key elements to identify companies in which to invest, and are the barriers to entry that make it difficult for competitors to enter a market. Such is the case of the ability to produce and distribute with economies of scale, customer loyalty to a brand, the replacement cost that forces the outlay of a high initial investment, regulation to protect intellectual property or the aforementioned network effect.

A business that offers a product or service in a sector with structural, not circumstantial, growth, is another guarantee of success. This means satisfying demand in an activity with the ability to grow in the long term, since it is underpinned by a trend, and not a passing fad. These trends are currently related to sustainability , digitalisation and the change in the population pyramid. For example, the greater longevity of people benefits companies that satisfy the so-called silver economy, which covers the needs of the third and fourth ages, and not only those related to health, but also others such as cosmetics, leisure, tourism, technology, food, etc. 

In accounting, it has always been said that revenue is vanity, profit is sanity and cash is king. Having liquidity is essential for dealing with the unexpected and making strategic decisions, but also for growing without being forced to resort to external financing, which is very appealing to any investment manager. 

ROE (Return on Equity) is the metric par excellence to measure a company's profitability. It reflects the return on a company's net assets, which determines its ability to generate value for shareholders. The higher the ROE compared to the cost of capital, the higher the return a company can generate in relation to the equity it uses to finance itself. 

Other points used to identify companies with growth potential are that they be leaders in concentrated markets with the ability to set prices and, of course, another maxim of any investment guru: not investing in a business that can't be understood.

Even so, a company may turn out to be a bad investment. Professional management is key to maintaining strong portfolios and protecting yourself against value traps that make a seemingly high-quality company end up being a fiasco.