Stock Shastra #2 – Buy a wonderful business and not just a stock!

We said in Stock Shastra #1 that Investing in stocks is not rocket science, not as difficult as it has been made out to be. You don’t need to be an expert to do it. You just need to buy a great business with the mindset of an owner. Let’s see why this is important and how you can find this kind of business.

Why do you need to buy a great business?

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? Or is it based on charts showing peculiar patterns? These methods are completely inadequate because they over-simplify your investing method. 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. It’s much like the story of three blind men who encounter an elephant for the first time and attempt to learn about it by touch alone. The first touches the trunk and thinks the elephant is like a snake; the second touches the ear and thinks the animal is like a fan while the third touches the leg and thinks it is like a tree.

So, what is the best way to avoid making this mistake of over-simplification and at the same time, have a simple but robust way of investing in stocks? The answer is Stock Shastra #2: Buy a wonderful business and not just a stock. The fact is that, in the short run, market sentiments drive the stock prices due to which any stock can go up or down, no matter whether it is wonderful or not. But in the long run the price of any stock is driven by the company’s ability to earn profits consistently.  As Benjamin Graham says,

And a company can earn profits consistently only if it has a wonderful business!

How do you find a wonderful business?

A wonderful business is one which has done well and will continue to grow in the future. It mainly has three characteristics:

1. An Excellent Financial Track Record
2. A Sustainable Moat, and
3. Respectable Management

An excellent track record is proof of its successful past whereas a sustainable moat and respectable management will drive the growth in the future. Hence, to find such a wonderful business you need to look for these things.

To find whether a company has an excellent financial track record, you need to see whether it has performed very well over atleast the past 10 years. Why 10 years? Because, over a 10-year period, the company is likely to have experienced one full economic cycle: good & bad times; growth and recession. A business does not do well over a 10—year period just by accident! A question may arise in your mind: Are we saying past performance is a guarantee of future performance? No. But past performance and past behaviour of management give enough clues for the future.

A company which has performed well over a 10-year period will most likely have a moat. A moat is a strong competitive advantage that helps the company survive in tough times and helps earn consistent profits. Consider the example of Colgate. Its moat is its brand, which is known all over the country.

What if a company has an excellent track record, a strong moat but has management who was arrested for a FERA/Excise Duty violation? Would you invest in such a company? The business must have a good, credible leader and management who drive the growth of the company.

Having shortlisted a company that has good financial track record, a strong, sustainable moat and good management, you are on course to find a company that has a high probability of performing well in the future.

The next Stock Shastra will talk about a simple and powerful lens through which we can identify if a business has an excellent financial track record.

You should also read the following:

1. Stock Shastra #1: Stock Investing is not Rocket Science!
2. Stock Shastra #3: You just need to look at 5 Financial Parameters to shortlist a wonderful company!
3. Stock Shastra #4: Look for companies with unbreachable moats
4. Stock Shastra #5: Great Brands are an unbreachable moat
5. Stock Shastra #10: Look for a trustworthy management, that respects the interests of minority shareholders