We often hear – buy good companies and you will do well over time.
If only it were this simple.
As an investor, your goal is to buy good stocks. Often, good companies have good stocks and they make you good profits. Even more so often, investors find themselves invested in stocks of great companies with no profits to show for after many years.
Why does this happen?
To answer this question properly, we will start by looking at what makes for a good company and what makes for a good stock. We will learn to find good companies that may not make you profits for a long time. And finally, we will look at bad companies that can make you significant amount of profits, if you invest in their stocks.
Good Companies are those that …
satisfy their responsibilities to their stakeholders on their way to maximize shareholder wealth.
Most investors and business minded people believe that a company exists to maximize profits for the shareholders. In a narrow sense, this is true. However, profit maximization is a delicate dance between competing stakeholder imperatives.
For example, one way to maximize profits for shareholders is to pay the employees as little as possible. However, this is not a sustainable strategy over the long term and shareholder wealth creation over long term will suffer.
Similarly, a company may change suppliers for the best price frequently. Hard nosed negotiating tactics to extract maximum value for the company in the short term is certainly prized in many companies. But is this good business?
In many forward thinking companies I have worked as a consultant, there is a great emphasis on supplier development. This involves things like, the company making capital investments to set up a supplier to succeed over the long term, regular training and socialization, integrating supplier systems with corporate systems for faster turnaround and less errors, etc. This is capital intensive but it rewards the company with great business relationships and long term loyalty. This can be very desirable for a number of reasons. But the benefits accrue over the long term and may take some time to build.
The company is vested in the success of its suppliers. These suppliers are in turn vested in the success of the company. They are each other’s stake holders. The shareholders will prosper over time, but perhaps at the expense of short term costs.
I took two examples of the stakeholders. Of course, there are many. The community they serve in is a stakeholder, and so is the tax payer.
A good company finds a way of balancing the needs of each of the stakeholder, as it pursues the goal of profit maximization.
How do Good Companies Maximize Profits Over the Long Term?
It would appear that competing stakeholder imperatives will be a drag on the company profits.
This is correct.
Good companies learn to make best use of their assets and operating leverage. If you give them a dollar, they will turn it into $1.15 after a year for a 15% return on equity (or better).
The way to maximize the ROE or Return on Assets is to find an advantage that other companies do not possess. For example, better technology, more efficient production line, more skilled employees, greater access to the federal contracts, being a regulated monopoly, etc are all the types of advantages that turns a normal company into a good or great company.
Good Stocks are those that …
make you more money over and above your hurdle rate.
There are 2 different variables in here that need to be figured out before you can call a stock a good stock.
1. What is your hurdle rate? What is the return that will satisfy you? This will need to be better than the return you can get elsewhere. For example, if your real estate holdings give you a 10% cash on cash return per year, you will not be interested in a stock that can generate a 9% per year return, even if this may be better than the overall stock market.
Your risk appetite comes into play here as well.
2. What is the time period in question? A stock can be a good stock over a period of next 3 months if it generates a 3% total return over this time. However, if the stock price levels out and does not appreciate any further for the rest of the year, the stock is no longer a good stock for the 1 year period. It may still turn out to be a spectacularly good stock for the next 5 or 50 years.
A good stock for one investor is not a good stock for another if their time horizons are different.
A good stock for the same investor may not be a good stock at a different time.
Good Companies with Bad Stocks
Some stocks are bad because they are very expensive.
If it is a good company, an expensive stock might eventually work out. But it is still a bad stock for the following reasons:
- Longer waits decrease the compounding benefit in your portfolio
- Longer waits increase the chance of management missteps, new competition or other market changes
- Longer waits increase the chance that you may get frustrated and exit the stock just a little bit too early
The only way an expensive stock can still work out is if the company has such a strong durable competitive advantage that it can continue to earn outsized ROI in the market for many years to come.
Bad companies with Good Stocks
Some stocks can be very lucrative even if the company may be poor.
Most of the really beaten down stocks fall into this category. The market tends to overdo the selling, and the stock ends up becoming too cheap. This is one of the reason why many value investors routinely consult the 52 week low lists. We are not looking for great companies. We are just looking for distressed stock that should appreciate to recognize its own value, regardless of the strength of the company.
Require a large margin of safety to the intrinsic value as you cannot predict how long and how deep the market can get irrational on the stock.
In Summary, Quality is Important, but Valuation Matters Most
An investor needs 2 things to be successful in the stock market: manage and eliminate the risk of loss, and compound quicker. A really cheap stock with large margin of safety can offer both these things, even if the company itself may not be very good.
Of course, the best is to find a good company with a cheap stock. These may not be easy to find. The next best option is to find undervalued stocks with large margin of safety regardless of the company quality. It is only after these that I might consider a good company with expensive stock as a possible investment. Probably not even then – cash works just as well. I can easily wait for a good company to become cheaper before I make a purchase.
In markets like today, patience is key.