How to identify companies in which to invest

How to identify companies in which to invest

Communications

When selecting companies to form part of portfolios, fund managers look for companies with at least five attractive features that will guarantee their long-term continuity and, therefore, offer potential profitability. 

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

This quote from Warren Buffett, chairman and chief executive officer of the Berkshire Hathaway holding company, includes one of the five main qualities that a quality business must have in order to be considered a good investment. Of course, we must also take into account barriers to entry, structural growth, generation of cash flow and a high return on equity. 

Competitive advantages

This concept developed by the economist and researcher Michael Porter four decades ago refers to a unique feature that is sustainable over time that distinguishes a company in its sector. Apple’s technology, Coca-Cola’s secret formula, Zara’s ability to quickly restock inexpensive garments, Ikea’s economical furniture…these are some examples of companies that are leaders in their markets because they found/created that unique need in consumers. 

Barriers to entry

What is said above is closely connected to another of the key elements in identifying companies in which to invest, which are barriers to entry that hinder the entrance of competitors into a market. These barriers include a company’s ability to produce and distribute with economies of scale, client loyalty to a brand, the switching cost that requires the payment of a high initial investment, regulation to protect intellectual property and the aforementioned network effect.

Structural growth

A business that offers a product or service in a sector with structural, not cyclical, growth is another guarantee of success. This is about satisfying demand in a business that can grow in the long term because it is protected by a trend and is not a passing fad. Currently, these trends are related to sustainability, digitalisation and change in the population pyramid. For example, the longer life expectancy of people benefits companies that serve the so-called ‘silver economy’, which covers the needs of the elderly and very elderly, and not only those related to health, but also other needs such as cosmetics, leisure, tourism, technology, food, etc. 

Generation of cash flow

In accounting, it has always been said that companies die due to cash flow problems and not because of their profit and loss statement. Having liquidity is essential in order to handle unforeseen events and to take strategic decisions, but also to grow without being forced to rely on external sources of finance, something that is very attractive for any investment manager. 

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High return on equity

The return on equity or ROE is the best ratio to measure the profitability of a company. It reflects the performance of the net assets of a company, which determines its ability to generate value for its shareholders. The higher the ROE compared to the cost of capital, the higher a company’s ability to generate profits by financing operations with its own resources. 

Other positive points when identifying companies with growth potential is that they be leaders in concentrated markets with the ability to set prices, and another maxim of any investment guru is, of course: never invest in a company that you do not understand.

Despite everything, it may finally turn out that a company is a bad investment. Professional management is key to maintaining strong portfolios and protecting yourself from value traps that mean that an apparently premium company ends up being a failure.