We consider whether a potential investment possess one or more of the following specific favourable investment characteristics:
It is simple and easy to understand
The simpler the business, the better. Excessively complicated companies are best avoided. Ideally, one should be able to draw the product or service with a pen or describe it to a child. If possible, the company’s product(s) may be sampled. One should strive to identify and follow the most important industry specific factors that drive the business’s profitability.
It is unloved or out-of-favour
A company with terrific earnings potential and a strong balance sheet may be out-of-favour for non-economic reasons such as the following: it sounds boring (has a boring name); it does something dull (e.g. makes plastic cups); it does something disagreeable (e.g. waste management); it is depressing (e.g. a burial business), or it is listed in a country that is currently out-of-favour etc. In such instances, there may be a lot of time available to purchase the stock at a discount. Then, when the stock becomes trendy and overpriced, one can sell the shares to the trend-followers.
It is a spinoff
A spinoff is the creation of an independent company through the distribution of new shares in the spinoff company from an existing parent company. Spinoffs of divisions often result in lucrative investments.
Typically, investors are sent shares in the newly created company as a bonus or a dividend for owning the parent company. Large institutions (in particular) which receive spinoff shares tend to dismiss these shares as pocket change or found money and often sell the spinoff shares without regard to intrinsic value. Sometimes large institutional shareholders are not permitted to own the bonus shares because the spinoff company is too small or because it operates in an industry that does not fall within the institution’s investment mandate – so the large institutional shareholder sells its allocated spinoff shares for non-economic reasons.
Furthermore, some investors who receive spinoff stock don’t want to read the prospectus (sometimes over 800 pages long) that accompanies the offering and, instead, they decide to sell the stock. The prospectus is often blasé and understated and is not accompanied by heavy marketing typical of hot overpriced IPO’s.
Often, company insiders want to and are incentivised to invest in the spinoff and are motivated and free to prove their worth through cost cutting and creative measures. The spinoff transaction often uncovers a previously hidden investment opportunity. Large parent companies do not want to spin off divisions and then see those spinoffs get into trouble, because that would bring embarrassing publicity, therefore, the spinoffs normally have strong balance sheets and are well-prepared to succeed as independent entities.
It is unfollowed
A stock with little or no institutional ownership and analyst following is a potential bargain because the less competition for and interest in the stock, the more likely it is to be undervalued.
It operates in a no-growth industry
Hot fast-growing industries attract a lot of competition which puts pressure on profits. A company operating in a no-growth industry is less likely to face stiff competition and therefore has more leeway to gain market share and grow earnings.
It has a niche
An exclusive franchise is often best positioned to raise prices. For example, drug companies and chemical companies have niches – products that no one else is allowed to make. An aggregate (rock, sand and gravel) business most often has a niche because it’s expensive to transport the aggregate and there is typically only one aggregate business per town. Strong brand names are almost as good as niches because they are expensive and it often takes many years to build public confidence in them.
It sells products that people must keep buying
Businesses with recurring revenues (such as razor blade sales) are often less risky and more profitable than businesses with once-off product sales (such as toys).
Its insiders are buyers
The purchasing of shares by company management is often a signal that they are confident in their business. When insiders are purchasing shares aggressively, one can be comfortable that, at a minimum, the company is unlikely to go bankrupt in the next six months.
When management owns stock, then rewarding the shareholders becomes a first priority. Whereas, when management simply collects a paycheck, then increasing salaries becomes a first priority. Since bigger companies tend to pay bigger salaries to executives, there’s a natural tendency for corporate wage-earners to expand the business at any cost, often to the detriment of shareholders. This happens less often when management is heavily invested in shares.
It is more telling when lower ranking employees buy shares than when the CEO buys a few shares. Insider selling is not necessarily a sign of trouble, however insider buying is usually a good sign.
It is buying back shares
Buying back shares is often the simplest and best way a company can reward its investors. If a company has faith in its own future and its shares can be purchased at a reasonable price, then it may be wise for the company to invest in itself, just as the shareholders do. When stock is repurchased by the company, it is taken out of circulation, shrinking the number of outstanding shares and increasing the earnings per share, which in turn has a positive effect on the stock price.