DIY Investor Toolkit: We reveal the one question all investors should ask themselves when sizing up a potential share investment.
Most fund managers have their own ‘investment checklist’, which is essentially a wishlist of attributes they like to see embedded in a business.
The types of qualities they like to see varies, but some characteristics that crop up time and time again include a clear competitive advantage that cannot be replicated (such as intellectual property or a big brand), a management team that is financially prudent (generating plenty of cash to pay both its debt bills and dividends) and evidence that technological change is being embraced and will ultimately benefit rather than threaten future profitability.
In addition, a sensible share price valuation is also key, or else investors risk ‘buying high’.
Warren Buffett, the legendary investor, has his own list of qualities that he looks for. Among them, Buffett wants to own shares in businesses that are price-makers and therefore able to dictate what they charge for their product, rather than price-takers lacking the market share to influence the price.
As well as sizing up the merits, however, investors should also question the potential flaws of a business, such as too much debt on its balance sheet. Other common cons that fund managers do not like to see include: signs of a pronounced decline within the industry in which the business operates. Weak cash flows and highly complex business models are other vices that put investors off.
But, above all, what every investor should be asking themselves before buying a share is the ‘Amazon question’, according to Iain McCombie, who co-manages the Baillie Gifford Managed fund.
He says: “When buying a share, I am looking at what can go wrong as well as what can go right. In terms of what can go wrong, Amazon can come in and completely destroy a business and this is the question we ask ourselves constantly: can Amazon, which is always looking to enter new markets, come into the industry the business is operating in?”
McCombie, who has a 2.6 per cent stake in Amazon, the biggest in the fund he manages, notes a recent example of Amazon entering a new market, in this case the furnishings business. It has launched a new in-house furniture brand; once the news came to light, Wayfair, a more established business in the space, saw its share price negatively hit.
He adds: “Amazon continues to invest heavily in distribution as it believes the opportunity set will expand further as more third party sellers use its platform for their own e-commerce sales. Most analysts wrote Amazon off when it floated and what they missed, and indeed what it took us time to understand, was that the firm would be looking at new markets all the time.”
But, as successful as Amazon is, it is worth bearing in mind that some attempts to disrupt new industries do not always work. One example was the Amazon Fire Phone, which could not compete against the iPhone and androids.
Nick Train, manager of the Finsbury Growth & Income Trust (FGT), agrees that investors need to work out which companies will survive digital disruption. He says this is more important than whether shares are ‘cheap’ or ‘dear’. He adds: “‘In the future all companies will be internet companies.”
Spencer Adair, deputy manager of Monks Investment Trust (MNKS), is also wary of tech disruptors. He says half of the FTSE 100 looks vulnerable. “Traditional retailers, big oil companies, big pharma companies and the banks are all at risk.” He adds: “I question whether these businesses have a product or service that will be more popular in the future compared to today. We invest where we see profits and avoid the businesses that may be disrupted.”