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10 Golden Rules of Equity Investing

Updated: May 19, 2022

"A balance sheet is like a backbone"

Treatment of minority shareholders

When considering a company, the first question you need answered is ‘who controls it?’ The second is ‘do you trust them?’ Minority shareholders are just one of many company stakeholder groups (others include employees, the government, suppliers, bankers and major shareholders such as a founding family). While you should not, as a minority shareholder, expect priority over the other stakeholders, you should expect to be treated fairly. And this depends on whether you can trust whoever controls the company to act in a fair manner. The controlling party need not be a shareholder. In the case of electric utilities, the respective government can often exercise considerable control over tariffs. Electricity prices are a socially-sensitive issue which politicians may sometimes pander to at the expense of minority shareholders. But it is also true, more often than not, that the controlling party is a

shareholder, usually the founding family or a conglomerate. It requires a certain amount of faith, but the best way to judge whether the controlling party will act fairly in the future is to see whether it has acted fairly in the past. Those that have a good track record of equitable treatment of minorities should be held in high regard. Until they slip up that is, though in my experience past behaviour is a pretty accurate predictor of future behaviour.

Remember that companies are about people not assets

A company is essentially a group of people with a common goal, namely to create the best possible product at the best possible price. This is what I call ‘quality’. Sure, companies need fixed assets but they are worthless without people. Once one thinks in these terms, one can appreciate that predicting the long-term performance of a company is all about assessing the quality of its people.

Balance sheet strength is critical

Companies fail largely because their businesses are poorly financed. A strong balance sheet tells you many things. Most importantly, it tells you that the company is very unlikely to fail.

But balance sheet strength is not just about the liabilities. It’s also important to look at the assets. What a company does with its cash is very instructive. Does it have too much? Is it gambling with it by investing it in exotic financial instruments? Cash generation is paramount but, once generated, a company must invest it wisely, keep it safe or pass it to shareholders. A balance sheet is like a backbone; it tells you about the character of a company.

Understand what you’re buying

You don’t have to understand how silicon chips work to buy a silicon chip maker, but you do have to understand what they are used for, as well as some of the basics of manufacturing process such as the inputs and costs. On the other hand, simple products like mortgages can be wrapped in businesses that are hard to understand. If there is something about a business that doesn’t make sense, such as how an industry with low barriers to entry creates profits well in excess of the cost of capital, walk away. As the old adage goes, if something looks too good to be true, it probably is.

Be wary of overambition

It is often tempting for companies to expand capacity or even invest in areas outside their core area of expertise. One should be very wary of such ambition, as it naturally means a

reduction in focus on core capacity, let alone the implications for balance sheets. A focus on the top line tends to be great for stakeholders such as employees, suppliers and bankers, but rarely for minority shareholders.

Think long term

Unless you need your money back soon, you should think long term and avoid getting caught up in the daily noise of markets. This is for two reasons. First, it makes sense to align your own investment time horizon with that of the companies in which you invest. You’ll find that all good companies - and even some bad ones - have a long-term perspective. If a company builds a factory, for example, it expects to generate returns from it for at least ten years, as you should from its shares. The second reason is that short-term price movements are mostly inconsequential as they are largely about temporary loss (and gain) of capital. What you should be worried about is permanent loss of capital and this is all about assessing a company’s long-term business prospects.

Benchmarks are measuring devices not portfolio construction tools

The worst reason in the world to buy something is because somebody else did. This is essentially what you would be doing if you allowed your portfolio to mimic the benchmark index. A company’s weighting in the index tells you only what has happened in the past, not what will happen in the future. Furthermore, there is a lot of rubbish in most benchmarks that

with a little hard work can be avoided. Successful investing requires thinking differently. This may at times feel uncomfortable but you should learn to embrace the feeling as a sign you’re on the right track. To put it in the simplest terms, to beat the benchmark you must deviate from it.

Take advantage of irrational behaviour

The efficient market hypothesis is nonsense. Markets are driven by humans, humans are irrational, thus markets are irrational. Occasionally, something happens and investors panic. You should take advantage of these instances, not join the stampede (or, if you are going to rush for the exit, be the first.) Think of a 20% fall in a share price as you would a 20% sale at a department store, an opportunity to buy cheap.

Do your own research

In the case of the medical or engineering professions, for example, there is usually a precise standard for a given procedure. In the investment industry, while this may be true with respect to, say, ethics, when it comes to investment decisions, not following others

is the key to success. Indeed, you want to be ahead of the herd, and this means doing your own research. Broker research has its uses, but it is no substitute for doing your own analysis and coming to your own conclusions. It’s about being accountable for your decisions as much as anything.

Focus on industries in which it is possible to have a sustainable competitive advantage

Some industries produce more economic profit than others. How much economic profit a sector or industry tends to produce is often a function of how difficult it is to enter. High

entry barriers can therefore provide a sustainable competitive advantage for incumbents. Take banking. Unlike retailing or steel manufacturing, there are all sorts of obstacles to starting a bank. Not only does one need licences from one or more regulators, but one has to build up trust with depositors as well as a network of companies to lend to. As such, banks tend to produce excess returns on capital which can often be sustained over the long term. Assuming, that is, that they stick to the simple business of lending and deposit taking.

Published in Aberdeen marketing

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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May 26, 2022


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