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The Seven Habits of Highly Effective Investors

  01/08/10 10:50, by Len, Categories: Personal Financial Management, Investment Management

Source: Article by AJ Cilliers - December 2009

Warren Buffett has often pointed out that to invest in a particular share is to buy a small piece of an underlying company. If this seems glaringly obvious, we could be excused for wondering why so many individuals buy shares with scant regard to the actual company they are buying into. Investment writer Glen Arnold has two words to describe such people: “uninformed speculators.”

How, then, can we ensure that we swell the ranks of the investors and avoid the dreaded “speculator” category? We have identified seven key actions that responsible and effective investors should consider before parting with their cash:

1. Study the numbers
Many share pickers avoid the company’s accounts, and who could blame them? Accounting statements are often seen as being complex and daunting, but really do represent an important first stop on the analytical trail. Serious investors should make the effort to understand the basics of income statements, balance sheets and cash flow statements, as well as the detailed notes that accompany them. It will take a fair bit of time and self-education, but should pay handsome dividends down the line (if you’ll excuse the pun).

While it is true that accounting rules can be used creatively to manipulate income statements and balance sheets, it is still worthwhile getting to grips with these important sources of financial information. The cash flow statement is far more difficult to manipulate, and is regarded by many as the most important of the three financial statements.

Good companies generally produce clear and understandable accounts, with plenty of supplementary schedules to assist in the interpretation of the company’s results. Companies which present confusing and unhelpful accounts should be regarded with caution.

2. Consider the industry
An analysis of the accounts will give us a good idea of the company’s past performance. What we would now like to know is how sustainable is that performance, and what potential is there for future improvement? To answer these questions we need to know the nature of the industry (or industries) in which the company operates.

Michael Porter of Harvard University developed a classic framework for analysing the desirability of an industry. Known as the “five forces” model, Porter maintained that there are five factors which drive competition in any industry. These are the rivalry among existing firms, the threat of new entrants to the industry, the threat of substitute products or services, the bargaining power of suppliers, and the bargaining power of buyers.

If we consider food company Heinz, for instance, it is not overly concerned by competitors as its powerful brand name and excellent distribution systems set it apart. Heinz also faces little threat from the entry of new competitors into the industry, as any new entrant would need decades to build a similar brand name and distribution capabilities. What is of concern, however, is the growing power of Heinz’s customers, the supermarket chains. Because of their buying power, the giant food retailers are able to negotiate aggressively on price and as a result are eating into Heinz’s profit margins.

The nature of the forces operating in any industry effectively determines the long-run rate of return of the industry. One would want to invest in the “right” companies, operating in the “right” industries – that is, companies with a strong competitive position in industries which promise good long-term returns.

3. Consider the firm’s competitive position
Having selected a good industry, one would now want to identify a good company in that industry. A good company would be one which consistently earns a return greater than the average return earned in the industry. To do this, the company would need something special amongst its bundle of resources. In particular, the firm would need one or two extraordinary resources, resources which would give it a competitive edge compared to its industry rivals.

These extraordinary resources would allow the company to offer the same benefits to customers as its rivals, but at a lower price, or unique benefits at a higher price. South African Breweries (now SAB Miller) is an excellent example of a company with extraordinary resources. SAB has 98% of the beer market in South Africa, mainly because it has kept out competitors by building special relationships with suppliers and customers. Although SAB is highly profitable, it has managed to reduce its prices year-on-year (in real terms) for over two decades.

SAB has also formed strong relationships with its distributors. Many of its truck drivers are former employees who have been helped to set up their own trucking businesses. As most beer sold in South Africa is sold via unlicensed shebeens, SAB has established an informal relationship with these customers via a network of wholesalers. SAB also makes sure that the shebeens have refrigerators and, if necessary, generators.

Any entrant into this market would have to develop its own special relationship with truck drivers, wholesalers and retailers. In all likelihood it would have to establish a completely new, separate and parallel system of distribution. Even then, it would lack the legitimacy which comes with a long-standing relationship.

Look, then, for a company which can do one or two key things better than its rivals. This may be all that it takes to make superior returns in its industry.

4. Bet on the jockey as well as the horse.
A good company in a good industry is likely to have developed its reputation for one reason; the fact that it is run by an experienced and competent management team. Just as an experienced jockey can turn a good horse into a great one, so can the right management team transform the fortunes of a company.

Great companies are often run by great people, who surround themselves with the best and the brightest. They also make sure that, when it is time to hand over to a successor, that person has been groomed for many years and is totally familiar with every aspect of the company’s business. Names such as Harry Oppenheimer and Anton Rupert spring to mind; not only did these men build great companies during their lifetimes, they left a legacy of good management which will sustain their firms for many years to come.

Make sure that your chosen company has a strong leader and a great management team. More than anything else, it is the most likely predictor of long-term success.

5. Read the annual reports
Not only should you concern yourself with the financial statements appearing in the firm’s annual report, you should read the report itself. This spells out the CEO’s and the management team’s business and management philosophy, and is a vital indicator of where the company is going in the future.

Reading a company’s annual reports on a regular basis will give you a far better understanding of its business. You will also get to know whether management is telling a consistent and credible story. The annual report invariably provides a brief CV of each director, detailing both experience and qualifications. If you are not familiar with the management team, this should give you an indication of how well qualified they are to manage your investment. A further internet search should provide further evidence of their experience and ability, and might also uncover a few skeletons.

6. Read the financial press
You would be well advised to subscribe to a few decent financial magazines and a good daily financial newspaper. Once you start taking an interest in a company, you will be amazed at how often its name crops up in the media.

As you broaden your knowledge of financial and investment matters, your reading will become ever more meaningful. You are also more likely to appreciate the importance of what, to the untrained eye, are snippets of disparate information. With a keener understanding of the company and its operations, and a broader appreciation of its business philosophies, you may make connections which can lead to profitable and satisfying investments.

7. Consider the price
Once you have made your decision to invest, consider whether the share represents value at its current price. A good place to start is to compare the PE ratio of the share to the PE ratio of the market as a whole; the share’s PE ratio should ideally be a bit below that of the market. A PE considerably higher than that of the market means that the company is seen to have considerable growth prospects. The only problem might be that the market has already factored this growth into the share price, and if the growth estimates have been on the optimistic side then the share is probably overvalued at present.

The PE of the JSE is currently 16. We can compare this to the PE of the blue chip company we mentioned earlier, SAB Miller, to illustrate our point. At present SAB is trading at a PE of 24, reflecting the fact that SAB’s share price has improved from R145.00 per share last November to R220.00 now, just a couple of rand below its annual high.

SAB has just released interim results which indicate that profits are 6% higher than forecast, despite a 1% drop in volumes and a 6% fall in revenues. This suggests efficient cost control rather than real growth, another indicator that the PE of 24 might be somewhat on the high side.

This all serves to illustrate the importance of carrying out a company analysis by way of the previous six points. Only after conducting such an analysis would we have a better feel for SAB’s growth prospects, and would we be able to decide whether the current price represents good value.

Disclaimer: And in closing....
In investing, as in most aspects of life, there are no guarantees. Applying the above-mentioned seven principles won’t necessarily ensure success every time you buy shares, but will certainly improve your chances. Share picking can be a fascinating and enjoyable pastime. Educate yourself and apply the seven habits of successful investors, and it should turn out to be a profitable one as well.

Reference: The Financial Times Guide to Investing, by Glen Arnold. Published by FT Prentice Hall, 2004.

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