10 September 2023
Last week, I shared my thoughts on why I was more excited about finding attractive opportunities in the current environment than consensus. The key message was that not buying a company you like and understand because you were concerned about weakening macro was a colossal blunder. Of course, every rule has exceptions. If you are dealing with a cyclical business, especially a commodity company, it would be naive to put a brave face and ignore the macro.
Today, I am outlining seven critical criteria that make a great business and an excellent investment - an ideal combination I am trying to find. I hope this will help you in your own investment process. As for me, I soon plan to start ranking the investment opportunities that I come across, giving each company a score for critical criteria. This should streamline my research process and allow me to focus on the most promising opportunities.
Besides, two specific events inspired me to write this post. First, a friend of mine and a subscriber to the newsletter has recently forwarded me a 50-page study by Tweedy, Browne called “What Has Worked in Investing”. I realised it was one of the first documents I uploaded to my library, which I had completely forgotten about. Having studied dozens of studies of drivers of portfolio returns, Tweedy, Browne identified four key factors: 1) low price, 2) high share ownership by management, 3) a significant decline in a stock’s price, and 4) small market cap.
The second reason for writing this was the growing AI capabilities of various platforms. This made me wonder what part of the investment process could be outsourced or improved with AI. If I were to ask the smarted machine on Earth to find me the best investment, what exactly would I ask it to look for? Can I train it? I am also curious to hear what you think. Look forward to a thought-provoking discussion.
Hey Siri (sorry, ChatGPT), can you find the best business to invest in?
Below are my seven filters (criteria) to find a great investment opportunity:
I. Business quality
- Barriers to entry - how hard is it for a new company to start a business in this sector? A good example could be railroads which require billions of upfront investments and plenty of regulatory approvals.
- Switching Costs - how easy can customers switch to another provider?
- Economy of scale - does the business benefit from a growing scale. For many years, the more people searched up on Google, the better results it produced. As more people used Google, the company was able to provide more tailored digital ads.
- Product life cycle (pace of innovation) - how quickly a new product is developed and customer preferences change? Beverages (including alcohol), for example, are not known for rapid innovation.
- How much are earnings dependent on macro dynamic/commodity prices?
II. Industry
- Is it a growing sector?
- How big is the addressable market relative to current sales?
- How many competitors are out there?
- How severe is competition in the sector? Are competitors raising capital and investing more while cutting prices?
III. Key financial metrics
- Gross Margin (ideally, high and stable over time)
- Operating Margin
- Return on Invested Capital
- Historical growth: revenue, net profit, share count?
IV. Country/Currency risks
- DM - a more stable currency, property rights are protected, politicians have limited interference
- EM - higher currency, legal and political risks require a bigger discount to DM peers and fair value
V. Leverage
- Net debt/EBITDA
- Earnings volatility
- Capex/EBITDA
VI. Management and Capital allocation
- Evidence of value creation
- Long-term focus
- No expensive M&A deals
- Skin in the game?
- Recent insider activity (are executives and board members buying or selling the stock)?
VII. Valuation
- Absolute (5 - 10-15% FCF yield, single PE - for a growing business with 10%+ ROIC; 1 - 20x PE for a 1-3% earnings growth company)
- Relative to peers (1 -significant premium to peers; 5 - significant discount)
ChatGPT's actual answers
I asked ChatGPT two similar questions:
1) What is the best business to invest in?
2) What is the best stock to buy?
Here are its answers.
1) What is the best business to invest in?
2) What is the best stock to buy?
Here are its answers.
PS: I realise most of the criteria are still quite broad and subject to different interpretations. I guess this is where experience and some form of art come in. Personally, I remain sceptical that a machine can come up with a single best investment recommendation. However, minimising risks and introducing a more systemic approach that prevents us from making biased decisions is something we can probably expect from them. Let’s have a great discussion: what do think? Feel free to leave a comment under this post through the Disqus platform.
Question 1: What is the best business to invest in?
ChatGPT:
"The "best" business to invest in depends on various factors including your interests, expertise, financial resources, risk tolerance, and market trends. Here are some popular and potentially profitable business ideas across different industries:
Remember, it's crucial to conduct thorough market research, understand your target audience, and have a solid business plan before investing in any venture. Additionally, consider seeking advice from professionals in the industry you're interested in, and be prepared for the inherent risks and challenges of entrepreneurship. Diversification of investments is also an important strategy to spread risk. Consulting with financial advisors or business experts can provide you with more tailored advice based on your specific circumstances and goals."
- Technology and Software Development: This sector is always evolving, and there are numerous opportunities in areas like mobile app development, SaaS (Software as a Service), artificial intelligence, cybersecurity, and blockchain.
- E-commerce and Online Retail: The shift to online shopping has been accelerating, making e-commerce a lucrative industry. Consider niche markets, unique products, or specialized services.
- Healthcare and Wellness: With an aging population and a growing focus on health and wellness, businesses related to healthcare services, telemedicine, fitness, and nutrition can be promising.
- Sustainable and Eco-Friendly Ventures: As environmental awareness increases, businesses focused on renewable energy, eco-friendly products, and sustainable practices are gaining traction.
- Food and Beverage Industry: This includes restaurants, food delivery services, catering, specialty food products, and health-conscious alternatives.
- Education and E-Learning: The demand for online learning platforms, tutoring services, and skill-based courses has surged, especially with the rise of remote work and education.
- Real Estate: Investing in real estate, especially in growing or revitalizing areas, can be profitable. This could involve residential, commercial, or rental properties.
- Personal Finance and Investment Advising: Providing financial planning, investment advice, or related services can be a stable and profitable business, particularly as people seek to build and manage their wealth.
- Healthtech and Medtech: Develop and market innovative healthcare technologies, medical devices, or healthcare management solutions.
- Entertainment and Media Production: This includes areas like streaming services, video production, gaming, and content creation for various platforms.
- Home Improvement and Renovation: With more people spending time at home, businesses related to home improvement, remodeling, and renovation have seen increased demand.
- AI and Machine Learning Applications: These technologies are being integrated into various industries, from automating processes to improving customer experiences.
Remember, it's crucial to conduct thorough market research, understand your target audience, and have a solid business plan before investing in any venture. Additionally, consider seeking advice from professionals in the industry you're interested in, and be prepared for the inherent risks and challenges of entrepreneurship. Diversification of investments is also an important strategy to spread risk. Consulting with financial advisors or business experts can provide you with more tailored advice based on your specific circumstances and goals."
Question 2: What is the best stock to buy?
ChatGPT:
"I'm unable to provide real-time or the most up-to-date information as my knowledge was last updated in September 2021. Additionally, giving specific investment advice can be risky and is best done by a financial advisor or after conducting thorough research.
When considering which stocks to buy, it's important to keep the following principles in mind:
Remember that investing always carries some level of risk, and past performance is not indicative of future results. It's generally a good idea to have a diversified portfolio rather than putting all your resources into a single stock. If you're unsure about which stocks to buy, or if you're new to investing, seeking advice from a financial advisor is a prudent step. They can help you develop a strategy that aligns with your goals and risk tolerance."
If you enjoyed this post, the best thing you could do is to share it with your friends. I also appreciate all the comments and questions the readers post in the discussion section below the posts. What's on your mind? Anything I missed? Leave your comment below.
When considering which stocks to buy, it's important to keep the following principles in mind:
- Diversification: Spreading your investments across different sectors and asset classes can help manage risk. Don't put all your money into a single stock.
- Risk Tolerance: Consider how much risk you're comfortable with. Some stocks are more volatile than others.
- Long-term vs. Short-term: Are you looking for short-term gains, or are you planning to hold onto your investments for the long term? Your investment horizon can influence the types of stocks you should consider.
- Research and Analysis: Look into the company's financials, its industry, competitive position, and any potential catalysts (both positive and negative) that could impact its stock price.
- Stay Informed: Keep up with financial news, market trends, and economic indicators. This can help you make informed decisions.
- Consider Professional Advice: Consulting with a financial advisor or doing extensive research can help you make more informed investment decisions.
Remember that investing always carries some level of risk, and past performance is not indicative of future results. It's generally a good idea to have a diversified portfolio rather than putting all your resources into a single stock. If you're unsure about which stocks to buy, or if you're new to investing, seeking advice from a financial advisor is a prudent step. They can help you develop a strategy that aligns with your goals and risk tolerance."
If you enjoyed this post, the best thing you could do is to share it with your friends. I also appreciate all the comments and questions the readers post in the discussion section below the posts. What's on your mind? Anything I missed? Leave your comment below.