What To Look For When Investing Part 2

This is entry number two in the ten part series detailing the 10 characteristics to look for when investing in a stock. Today, we will take a look at the second characteristic to look for when buying a stock. These points can benefit the novice investor and the sophisticated investor alike.

Invest In Companies With Easy To Understand Businesses

Everyone wants to make money investing in the stock market, which often leads to making poor investing decisions by buying companies with incredibly complex and convoluted business models. While chasing high flying companies with incomprehensible business models can seem exciting while the stocks are soaring, you will find yourself left crying when these companies come crashing back down to earth.

You can make investing easier by buying companies that have business models which make it really simple to understand how they make their money. Online and traditional retailers often have the simplest business models to dissect. They sell a product and make a profit. How does Starbucks primarily make money? The answer is simple by selling coffee and food products. How does Nike make money? By selling shoes and athletic apparel. What about Wal-mart? They profit by selling retail items including groceries, clothing, toys and electronics. When you can easily understand how a company makes money, it’s much easier to analyze trends in the business cycle and understand when a boom or bust period is coming. You can understand the financial statements (income statement, balance sheets) and are able to gain a lot of insight by listening to the conference calls. Following the cash flow, same store sales, and margins will help to guide your investing decisions. If you understand how a company makes its money then you can be on the lookout for future growth opportunities. It also helps you to watch out for future impediments to growth.

Difficult To Understand Industries

Financial companies like Wells Fargo and large integrated oil companies like Shell have more complex business models and are much tougher to analyze and understand what drives earnings growth. As the financial crisis of 2008 demonstrated, many business companies reported strong quarterly earnings while hiding a great number of financial obligations off balance sheet. Most investors were blindsided when firms such as Washington Mutual, Wachovia, Lehman Brothers and Bear Sterns went belly up due to hidden financial obligations. General Electric was another good example. It is a company that participated in so many different business sectors including finance, aviation, healthcare, technology, and industrial that its earning statements were all over the place. The stock has dropped over the past decade from $50 a share to $9. 

Companies with extremely complex business models may actually represent a good investment opportunity but I prefer to stick to the advice of Warren Buffett and stick to my area of expertise. I have learned that it’s important to first be a defensive investor before chasing speculative opportunities that can cannibalize your potential returns.