Concentrate On the Strongest Candidate
(This is part 2 of the Stock Investment Research process series.)
There was a small lake in a valley between three hills.
During summer months, most of the water in that small lake would evaporate away and the lake would reduce to nothing more than a small pond where the lake was the deepest.
And during rainy season, the lake will swell up again, spreading far and wide into fertile grassland plains in the valley.
Now, there lived several fishes, of varying sizes, in that pond. Some were big and some were small.
No matter what the season was, the big fish always had it good. How?
During the drought season as the lake shrinks in size, small fish would have less room to hide/swim away so it gets all the more easier for the big fish to hunt.
During rainy/flood season, the food is abundant anyway so the big fish will again find it very easy.
Being strongest has its advantages.
Just like in this small lake, in real markets too, stronger companies will always survive and thrive no matter how the prevailing conditions are.
During recessions, strongest companies will not only survive but also will find it easier to acquire smaller/weaker companies as their ‘preys’ get even weaker and more vulnerable. And during favorable market conditions, they will expand faster and increase market share, by virtue of them being able to spend more on marketing.
So our takeaway is, always concentrate on the strongest candidates. So we come to the second stage in our stock investment research process.
To recap, the 10 stages were:
- Understand my ‘Circle of Competence’ and operate within it.
- Concentrate on the strongest candidate
- Analyse the business model and competitive environment
- Assess management quality
- Assess financial strength
- Check for the presence of ‘moat’
- Estimate the Intrinsic value
- Understand historical price performance
- Insist on Margin of Safety
- Watch out for Exit signs/ Red Flgs
Strongest may not always be the biggest, although size and market share are important factors.
Strength of the company could be seen in many areas. Strong operating cash flows, high quality management, low working capital requirements, zero (or very low) debt, high brand recognition and customer loyalty are some such areas.
Earlier, as the first step in the research process, we decided to stick well within our circle of competence. So we are only looking in industries or sectors we know well and understand well. We don’t need to analyse each and every company in our chosen sectors. Only look at those who stand out in terms of quality of profit and quality of management. We will delve deeper into how to analyse these quantitatively later, but at this stage, we are in screening/elimination mode. Weed out all the ‘also ran’ companies and look only at those who really stand apart.
E.g. If your chosen sector was banking, find out the banks which have the best combination of size, good interest margins, consistent and good sales and profit growth, low non performing assets and reputable management. Narrow your analysis to just two or three.
You should be able to say why each one of your chosen set is a ‘stronger’ candidate.
Researching stocks will take a considerable amount of time, so spend your time very wisely. No point in wasting time researching mediocre companies or stupid ideas.
Always remember you are aiming to ‘own’ a few best quality businesses. So set the bar really high.
End of part 2. We will look into Business model and company analysis in the next part.