As investors, we may be tempted to deploy our capital in businesses that prioritize profitability and total shareholder returns. But to pick out the big winners you need to look at a much wider range of factors than simply focussing on the numbers.

Corporate Culture

The evidence shows that businesses that pay attention to all of their stakeholders, including customers, employees and suppliers, are more likely to produce better shareholder returns in the long-term.

In their seminal 1982 work, ‘In Search of Excellence’ Tom Peters and Bob Waterman looked at the characteristics of successful American businesses.

They selected thirty-two businesses that met their criteria as ‘excellent companies’. In order to make the selection they used a number of criteria, including compound asset growth and total return on capital. Peters and Waterman found that the most successful companies had a strong corporate culture. Their internal values were much more likely to be focussed on customers, staff, or product quality than they were on profit or shareholders.

Paradoxically, the companies that appeared to care least for their investors, ended up producing far better returns for their shareholders than their competitors.

If you had invested $10,000 in the 32 public companies that Peters and Waterman selected, over the following twenty years it would have returned $140,050 as compared to the average market return of $85,500.

The cultural values propounded by Peters and Waterman have strong echoes today in some of the ideas expressed by businessmen like John Mackey of Whole Foods with his conscious capitalism, Jim Sinegal’s staff-centred approach and willingness to work with suppliers at Costco, or Monty Moran’s focus on staff development at Chipotle combined with co-CEO Steve Ells’ focus on providing the customer with the best possible food.

One of the excellent companies selected by Peters and Waterman was IBM – a flagship company for American industry in 1982. Eleven years later, IBM was in trouble. Deep trouble.

IBM needed somebody to turn the business around, and the recipient of the poisoned chalice was one Louis Gerstner.

Gerstner came from a consultancy background with McKinsey – an old-fashioned firm that emphasized hard numbers. When he came to IBM, nobody expected a dramatic turnaround. The market expected the hard-headed Gerstner to analyse the business, pick it apart and break it up.

Instead, he executed a remarkable turnaround, learning a lot about business and himself in the process. He said:

‘Until I came to IBM, I probably would have told you that culture was just one among several important elements in any organization’s makeup and success — along with vision, strategy, marketing, financials, and the like… I came to see, in my time at IBM, that culture isn’t just one aspect of the game, it is the game. In the end, an organization is nothing more than the collective capacity of its people to create value.’

It is true that not all successful companies subscribe to all of these values. Ryanair has had a reputation for treating its customers like cattle. Amazon has been accused of riding roughshod over its staff in its obsession to look after the customer.

But overall the evidence shows that companies with strong cultural values are more likely to deliver strong, long-term returns to the investor.

Total Addressable Market

In order to achieve superior investment returns it is necessary for the companies that we invest in to achieve strong growth.

If a company’s customers already comprise 90% of the market it is going to be difficult for that company to grow unless it finds new products to sell or is able to offer its customers compelling upgrades to existing products.

A company with 0.1% of the market that delivers better products than its competitors, has the potential to deliver amazing growth.

The total, worldwide value of customer spending for a product or group of products is referred to as the Total Addressable Market (TAM).

Knowing the TAM allows you to make an assessment about a company’s potential for growth. Consider a company that turns over $1M with a total addressable market of $100M. If it is realistic for the company to command a 10% market share, then 10% of the TAM is $10m and the company could grow to 10 times its current size.

Much of the debate about whether Apple is a good investment centres around analysts’ assessments of its room for growth in a market where it already has a dominant position.

Reinvestment Potential

In the last section we saw how a company’s growth potential is affected by the total addressable market for its products.

Another factor that can hamper or aid growth is the ease with which a business can reinvest its earnings.

A fine dining restaurant may get rave reviews because of the unique talents of its chef patron. The TAM for this business may be huge, but it is impossible to grow the business as the chef cannot be replicated. The business may generate lots of cash – but it doesn’t have a way to spend it.

On the other hand, a restaurant business selling burgers or burritos has fantastic growth possibilities. Once the management finds a ‘formula’ that resonates with the public, the business can keep adding new restaurants as fast as it can earn the money to pay for them. This is one of the reasons why successful restaurant chains have produced fantastic returns for investors.

Companies may make decent profits, but if they are to grow there must be a straightforward way for them to reinvest those profits back into the business.

A business which has small revenues in comparison to a large total addressable market, and an easy route to reinvest profits, can deliver huge growth.

Capital Requirements

Some businesses require large expenditures of capital in order to generate revenue. Heavy engineering firms, builders and aircraft companies cannot generate income without first making major investments.

Other companies such as consultancies or recruitment organizations require little or no initial capital. These businesses are often referred to as ‘capital light’ industries.

Some organizations position themselves to be capital light. The company responsible for the computer chips that power most smartphones, ARM Holdings, doesn’t actually make any chips at all. The chips are designed in-house and the design is then licensed for manufacture elsewhere.

ARM uses its resources where they can add most value – at the computer workstation designing chips. Offloading the capital risk of manufacture is a smart move. Many other chip designers follow this model – known as fabless manufacturing.

Some companies require a high initial capital investment, but have low ongoing capital needs. Firms such as Facebook or LinkedIn initially spend heavily, building a web infrastructure to support millions of users. But once that investment is in place, additional users can be supported at virtually no additional cost.

Software companies spend years developing products, but once a product is complete it can be sold at a high price with no further expense.

It is easier for a company with a low capital requirement to become profitable than it is for a company with a high capital requirement. Airline companies, with their high capital needs have had a notorious reputation as unsatisfactory investments. Warren Buffett famously, once said of the Wright brothers ‘Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favour by shooting Orville down’. 

A business which has already incurred the lion’s share of its required, capital expenditure and is now reaping the reward of growing revenues with low ongoing costs can make a particularly attractive investment. For example, a business that has produced a well-received software product has overcome the development risk and can look forward to making high-value sales with fat margins. But the gravy does not last forever – products like this will at some point need to be upgraded and/or eventually replaced so it is important to establish whether the business is carrying out research and developing for the future.

Personal Experience

An excellent way to evaluate whether a company is a good business is through your own personal experience. This was one of Peter Lynch’s favourite strategies. In ‘One up on Wall Street’ Lynch writes, ‘The best place to begin looking for the tenbagger is close to home — if not in the backyard then down at the shopping mall, and especially wherever you happen to work’.

Often, it will be the good personal experience that first alerts you to a business. If you see a long line forming at a restaurant; or if you see a product selling like hot cakes at the local store: this could be your edge over the closeted, Wall Street professional.

As soon as you see an opportunity like this get on the internet and start digging. If the business makes the grade on all the other important metrics, you could be one of the early birds that gets in on the stock before it takes off.

Low Profile

Wall Street analysts tend to concentrate on widely held stocks with a large market capitalization. Some companies can have undervalued stock prices for no other reason than lack of attention. As these companies grow the street begins to take notice and their stock prices rise.

When you research a company on the internet you will usually see an option for ‘Analyst Coverage’. If a business has few analysts listed, that is a good indication of an under-covered stock. For further confirmation, listen to a replay of the latest conference call and note which analysts participate in the questions at the end of the call.

According to the old adage, ‘where there’s muck there’s brass’. One of the peculiarities of the stock market is that many people are put off investing in companies in unattractive industries such as waste disposal, graveyards, or funeral services. (Although they do not quite fit into the ‘low-profile’ category, the much-despised tobacco industry has provided some of the best returns in the stock market.)

Unattractive, under-covered industries may lack the allure of high-tech businesses, but these cinderella stocks often turn out to be hidden gems. Keep an open-mind and you will be rewarded if you are willing to venture where the squeamish fear to tread.

Special Circumstances

Most businesses come upon hard times at some stage. Sometimes there can be a genuine business problem. Other times there may be an unjustified drop in the stock price.

In 1963 American Express became embroiled in a huge scandal involving non-existent stocks of salad oil held as collateral by one of their borrowers. Consequently the stock tanked (no pun intended).

While others fled the stock, Warren Buffett looked at the circumstances and decided that this was essentially a good business having bad luck and ploughed 40% of his partnership’s investments into American Express.

Within a year the share price had recovered 40% of its value and went on to rise for many years thereafter.

‘Short Sellers’ are market participants that place their trades in reverse. They sell a stock that they do not own hoping to buy it back later at a lower price (more on this in chapter eleven). Some short sellers perform a useful function – their analysis and research may alert investors to problems which may not have materialized otherwise. But it is unusual for short sellers to be motivated by the desire to be public guardians.

Because share prices are prone to sharp downward movements on bad news it is easy for a short seller to move a stock price by making vague insinuations. If that stock has enjoyed recent gains, nervous holders are likely to sell and take profits at the slightest sign of trouble.

Businesses that have enjoyed rapid growth and seen a corresponding increase in their share price are a prime target for short sellers. They will brief friendly journalists to create rumours in the media and write articles on web sites such as ‘Seeking Alpha’, often using false names.

Technically speaking this practice is market manipulation – a prohibited practice that carries heavy penalties. But on a practical level, it is difficult to prove and very few culprits are prosecuted. This lack of regulatory enforcement allows the short sellers to make easy profits.

Most private, individual investors do not have these methods at their disposal. But the activities of the unscrupulous short seller can create good opportunities for the savvy investor. When a stock that you are following falls through an obvious short attack, spend some time researching the background.

It will often transpire that the bear case is a mis-mash of half-truths, non-specific allegations and maybes.

There is no rush to invest in a company suffering a short attack. Shorts will have a co-ordinated series of moves over a period of weeks or months. Stock prices go down quickly, and may suffer several sharp declines as the shorts release their ammunition.

Once a stock has been tarnished the market is normally slow to recognize its mistake and it may take months or even years to recover to a fair valuation. Choose your entry point wisely and allow patience to be rewarded.

Reasonable Share Price

Many novice investors begin their search by looking for ‘cheap’ shares. The great investors – those that we have chosen as the model to use for this book – take the opposite approach. Warren Buffett summed it up nicely, ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price’.

If you should happen to overpay 10% or even 30% today for a business that will compound growth at 20% for the next 20 years, it’s hardly a disaster. Would you really prefer to miss out on all those years of stellar growth for the sake of a short term ‘saving’?

You may often find that a high quality business will trade at, say, 25 times earnings while its competitors trade at 16 times earnings. A price conscious buyer may resolve not to over pay and wait patiently for a chance to buy at 18 times earnings during ‘a dip’.

You may be lucky, and that dip may come next week. Or it may come in two years time, by which time the shares are now double in value. Or it may never come at all.

That’s not to say you should pay ‘any price’ even for a really good business.

A good business that is richly valued presents a difficult buying decision. Is it worth overpaying today for a great business? How will you feel if there is a dip in the market next week and the price falls by half? But on the other hand what if no dip comes and the price sails into the stratosphere before you have another chance to buy?

There is no straight answer, and how you handle questions like these will shape your future as an investor.

If you really like a business, the best approach is to take a small stake and add to it over time at better value points.

Next Topic: Does the Story Make Sense?