That surplus cash flow allows them to pay for increased marketing and innovation which, in turn, drives brand loyalty even more. This is a virtuous cycle that can produce a lot of wealth for those who are patient enough to ignore the stock market and stick their stock certificates in a vault for fifty years.
A major problem with this point is that inexperienced investors often mistake temporary hype with companies that have durable competitive advantages. A company being popular does not give it a durable competitive advantage. A company generating high growth in earnings per share doesn’t give it a durable competitive advantage.
4. The company’s management has a history of putting the interests of shareholders first.
They have a history of returning surplus cash in the form of intelligently-executed share repurchase plans and/or a dividend that grows at a rate comfortably in excess of the broader rate of inflation in the economy
This point is so important that I once wrote an article on it called 7 Signs of a Shareholder-Friendly Management. The short version is this: You want to go into business with executives who have your best interest at heart. You want them guided by the right incentives. You want them to nurture an environment that measures success by how the firm does for you, the owner, as well as other stakeholders such as employees.
More than a few times in my career, I’ve come across a business that had wonderful economics only to find managers were raiding the toy chest through obscene options grants, overly generous salaries, or questionable deals with inter-related entities that were controlled by family members. You’re the one risking your hard-earned savings. You’re the one on the hook if the whole thing collapses. You should get your fair share of any prosperity built on your precious capital.
5. The company’s market capitalization and enterprise value relative to net income are reasonable.
Even the best business in the world can be a terrible investment if you pay too high a price for it. Specifically, price is arguably the most important variable in the long-run as even a terrible business bought at a sufficiently cheap price can result in wealth accumulation under the right conditions. One of my favorite sources of research on this topic is out of Wharton, where one professor demonstrated the power of reinvested dividends in companies that were perpetually undervalued due to their sub-par economics. While they aren’t as good as a wonderful business bought at a fair price, it’s still an important lesson.
6. The company has a strong balance sheet that would allow it to survive difficult economic or industry conditions.
Storms have arrived, and will continue to arrive, in the economy as well as the capital markets. Often, these storms will provide no warning before showing up and wreaking havoc on your financial life. One way to mitigate this risk is to focus on disproportionately collecting businesses that have the financial strength necessary to survive even the darkest days of a period like 1929-1933 without having to issue stock at severely depressed prices (which, from an economic perspective, amounts to you, the old owner, having to sell off your ownership in exchange for a bailout).
Sure, these businesses might grow a little slower or provide a fraction of the excitement you might get from other businesses but you’ll be grateful you put your trust in them when the maelstrom is raging around you. While the past is no guarantee of the future, it seems to be a reasonable probability bet that firms selling the essentials of everyday life are, as a group, going to have an easier time maintaining their dividend distributions compared to companies such as, say, those involved in manufacturing automobiles.
Closing Thoughts on Investing in Stocks
It is worth noting that it doesn’t matter how good a business is, the stock market is volatile by its very nature. Even the best long-term investments fluctuate meaningfully, sometimes to a degree that can seem almost unbelievable if you haven’t lived through it.
Consider one of the most successful investments of all time, Berkshire Hathaway, the holding company of billionaire Warren Buffett. The firm’s Vice Chairman, Charles Munger, once remarked in an interview that no fewer than three times in the fifty plus years they ran the business, they watched the quoted market value of their Berkshire Hathaway shares collapse by 50% or more peak-to-trough. Despite this, the stock ultimately ended up increasing from around $8 per share when Buffett began building his position to $216,200 per share.
What if they had borrowed against their stock? Unless they had some outside source of liquidity that could be tapped to meet a margin call, any one of those three situations could have resulted in them being forced to liquidate their Berkshire Hathaway shares at a price far below long-term intrinsic value, ultimately costing them a fortune. In fact, one early Berkshire investor (who ended up becoming very, very rich, regardless) did exactly that. The moral of the story is to pay cash for your securities. In fact, you may want to even avoid having a margin account in the first place to avoid rehypothecation risk in addition to the risk of a margin call.