Put the Odds in Your Favor: 3 Attributes of a Quality Investment

Source: Thinkstock

Source: Thinkstock

With thousands of stocks to choose from, investing can seem daunting. How do you pick the winners from the losers? True, you can simply buy an index fund and bet that business in general will improve, but in doing this you wind up buying the losers along with the winners. So while it may be difficult, it is worth taking the time to sort out the winners to add to your portfolio.

The following three tips should make this easier. If an investment satisfies these conditions, I believe that it will have a much higher likelihood of generating superior long-term returns. Keep in mind that this isn’t a guarantee — there is nothing certain in investing and the best we can do is put the odds in our favor. But if you know how to do so, you will almost certainly be a successful investor.

1. Look for companies with wide economic moats

An economic moat is an attribute that a company has that makes it very difficult for other companies to compete with it. For instance, a company can own a patent (e.g. a drug company), a well-known brand [e.g. Coca Cola (NYSE:KO)], or it may simply own a business that requires a lot of infrastructure and land that is virtually impossible to replicate (e.g. rail-transport companies.) Companies with wide economic moats are virtually impervious to competition, and as a result, managements have one less thing to worry about when it works toward generating shareholder value.

Investors should keep in mind that not all economic moats are the same, and that some are wider than others. For instance, brand loyalty can be fickle, and so except in a few cases, brand moats are not as wide as, for instance, land and infrastructure moats. As an investor, you should analyze a company’s moat and as yourself what it would realistically take to compete with it. If you can easily come up with an answer that doesn’t require much capital and which falls within the realm of probability, then that company probably doesn’t have a wide moat.

Source: Thinkstock

Source: Thinkstock

2. Look for companies with strong cash-flow

You invest in companies because you want it to earn money in order to be able to pay you a regular dividend that grows over time. Thus, you want to look for investments with strong cash-flow. Cash-flow is the life-blood of a company. As opposed to earnings, cash-flow comes in the form of generating sales from business operations. Earnings can be generated in all sorts of ways: for instance, if a company owns shares in another company and these shares rise, the company can mark that gain as earnings, but it can’t call it cash-flow. Cash-flow can be reinvested or distributed to shareholders, and it is much more difficult to manipulate.

As an investor, you want to find companies that generate a lot of free cash-flow. Companies that don’t have this are vulnerable to losses. Furthermore, even if a company has an economic moat, if it doesn’t have cash-flow it might not be able to defend it should the need arise. For instance, Amazon (NASDAQ:AMZN) is a company with a wide economic moat but no cash-flow, and if there is a downturn in sales or if a new competitor rises up Amazon could be in trouble. A company such as CSX (NYSE:CSX) has strong cash-flow in addition to its moat. This means that it can defend its moat so that it can continue to generate cash-flow and return capital to shareholders.

Source: Thinkstock

Source: Thinkstock

3. Look for companies with secular tailwinds

A secular tailwind is a social or economic trend that has a real impact on the economy as a whole, as well as the companies within it. A good example is the shift towards electronic payments (e.g. credit cards and debit cards) away from payments using tangible currency and checks. This is a trend that has been going on for a long time, and it is set to continue regardless of any strength or weakness in the economy. Companies that are directly involved in facilitating this trend [e.g. Mastercard (NYSE:MA)], or similar trends, are going to benefit significantly. Furthermore, even if the economy weakens, these companies are going to continue to benefit from whichever secular trends that they are facilitating.

When looking at secular trends to invest in you need to be careful. First, make sure that the trend isn’t over, or close to being over. For instance, there was a secular growth trend in computer sales 10-20 years ago, but this trend has peaked and investors can no longer profit from it. People still by computers, but the number of computers sold isn’t meaningfully outpacing economic growth or population growth. Second, make sure that the trend hasn’t already been widely discovered by the market. If it is, you could find yourself overpaying for stocks and justifying your actions by arguing that the secular trend will drive the stock to new highs. Recall the bubble in 3D printing stocks that burst at the beginning of the year. This is a secular trend that is still in play, but it had been over-discovered and over-loved. Now, however, that these stocks are down 30 percent – 70 percent or more, and now that there are investors doubting the strength in this trend it might be time to buy these stocks.

Ultimately, if you screen your investments for these trends, you should be able to screen out most of the losers that trade in the market, and while you probably won’t pick winners every time you will be in a better position to do so.

Disclosure: Ben Kramer-Miller is long CSX.

More From Wall St. Cheat Sheet: