Investors in value stocks are always up against it. If you are buying out of favour stocks then you come to expect some nasties and get used to them. But it doesn’t mean you should go forth blindly. If you can recognise a company with a consistent operating history and good historic business model, you’ll be better placed to ascertain when a stock has simply fallen out of favour, or come upon temporary hard times and therefore profit handsomely when it overcomes the glitch and returns to prior glories.
This is precisely the approach eventually taken by a certain Warren Buffett. As his assets under management grew and grew he became tired of just looking for ‘bargains’. He found more often than not that once a bargain always a bargain. Instead of just looking for any company selling for a cheap price he started to look for great companies at fair prices.
He likened businesses to castles at risk of siege from competitors and the marketplace. Truly great companies are able to dig deep economic moats around their castles that become increasingly impregnable to competition and market pressures. These moats bring either pricing power or cost reductions which help sustain very high returns on capital, leading to higher cashflows and thus ‘satisfactory’ returns for investors.
But where Buffett has been so canny is in recognising when great companies are being marked down by investors for making temporary solvable mistakes – here are some of the clues that Warren Buffett looks for to find great businesses.
Three financial clues of a good company
When a stock picker takes a closer look at a value stock situation its essential to look at its operating history. While current numbers may look poor, the clues to a good recovery situation often lie in whether the company used to have a strong business model – here are a few financial clues that it did....
1. High sustainable free cashflow
Great businesses tend to have several things in common. Firstly they make a lot of cash. Cash is the lifeblood of any business and without cash all businesses fail. If a company can’t make cash from its own operations it will have to resort to raising cash from new shareholders (which dilutes your stake) or borrowing money from lenders (which raises the risk of financial distress).
Free cashflow is most easily defined…
