Can Your Tip Pass This Ten-Point Test Before Investing?

The next time your friend whispers advice in your ear, use this tool to help you decide what to do next.

I generally caution against mixing friends or family and money. Yet, if we look at some recent surveys about what investors depend upon when making investing decisions, many have indicated that they give equal weight to tips from friends or relatives and information from the annual report of a company.

However, let’s face it- we may think the world of these well-intentioned people, but this does not mean they are expert money managers. So, how do we know if they are on the right track or leading us down a dead end street? We run their tip through this ten-point test.

Essential Points

  • Advice about investing is most often given to us by friends
  • We will learn the difference between investments and speculations
  • The majority of tips we receive from friends will not pass this test

1. What is the business’ track record?

Any business we invest in should have an extensive and profitable history. I was once given a tip to invest in Lithium. The company was pitched as a small, up and coming company that had developed a revolutionary lithium producing manufacturing process. The only hitch was that it didn’t produce much revenue and its expenses totalled over $12m annually.

To predict whether this company was going to be profitable required psychic abilities, (which I don’t have), or an expert knowledge of this type of technology (I wouldn’t qualify for that either). Without these abilities, this is all speculation. My point is, if we don’t have the necessary knowledge, then we shouldn’t buy it.

When we are dealing with companies that are a bit more predictable, we first want to review 5 to 10 years of financial statements. By looking at cash flow and reported underlying profits, we can get a good sense of the long-term profitability of the company. If we don’t at least do this, we will have a hard time telling the difference between short-term cyclicality and long-term growth or decline.

2. Does the company have a sustainable competitive advantage?

A company that has a sustainable competitive advantage is a company that has the highest long-term returns and is a company that is more likely to last.

Companies that have sustainable competitive advantages include Sydney Airport, which holds a monopoly position and the ARB Corporation whose trusted brands give them pricing power. Then, on the other end of the spectrum are commodity producers. These are companies that, unless they are low-cost, put the business and their owners’ success at the mercy of market prices. Just look at resources companies like BHP and Rio Tinto.

A good rule of thumb to use when determining whether a company has a sustainable competitive advantage is whether, compared to other companies, they have high margins or high returns on capital employed.

3. Is the company regulated?

Generally, regulation is a positive thing. It tells us that an asset is monopolistic and that it’s earnings are consistent. However, the downside is that regulation can limit a company’s returns to some extent. Let’s take Spark Infrastructure as an example. Spark is an electricity distribution company, capped so that it cannot use the monopoly to abuse its power. In order to make a decision based upon a tip, we need to have a good understanding of regulation and the ways in which it can change.

The bad news is, when unexpected changes do occur, they are mostly not for the better. For instance, let’s say that tomorrow, Sydney Airport suddenly makes a regulation related announcement. I think we can say confidently that it would be the parking fees that would be regulated rather than a pricing increase for landing charges.

4. How does the company handle its debts?

When a company goes under, it is usually because of its debts.

The best business to invest in is one that doesn’t have any debts, or one that, even in the toughest conditions, can pay its interest costs and still be successful. This is where the information we compiled about the company comes to good use. We should also make sure to gather data on the debt level and interest expense of the business.

If, even in average or boom times, the company’s interest coverage is anaemic, it could eventually require additional equity to stay alive, or it may not survive at all.

5. How competent and trustworthy is management?

If we owned stock in a small neighbourhood store, wouldn’t we want to know that the person running it had experience, worked hard, was an honest individual and knew every aspect of the business? Of course we would. So, why would we expect anything less from companies in which we invest?

When considering whether to invest, we should make sure that the manager communicates honestly with shareholders, has a good amount of experience and a solid track record in their industry. We will also want to know the degree of inside ownership as well as what their plans are for the future of the business.

6. Is the stock trading at a price that is reasonable?

In order for us to profit, we must be confident that we will receive more in returns than we are paying. After answering the preceding questions, we should have a good understanding as to whether the price of the stock is reasonably priced.

7. Is the business within your sphere of knowledge?

To find out, we should start by asking ourselves some questions about the business.

  • Who are the customers and suppliers of the business?
  • What does the company produce or what services does it offer?
  • How does the company make its money?
  • Does it really make money?

Once we have answered these questions, we should think about the overall industry.

  • How competitive is the industry is and where does the company fit into the competitive structure?
  • Is the industry cyclical? If it is, where in the cycle is it currently?
  • Are there structural changes happening?
  • Finally, ask whether this is an industry you want to be involved with?

It is certainly true that by staying within our sphere of knowledge we wind up losing out on a certain amount of opportunities. That being said, while we might lose some opportunities, we also avoid a lot of losses by not taking on risks we don’t understand. Think about it in these terms. If the company in which we gave  investment to started having problems, would we know what went wrong? If our answer is no, it is likely that it isn’t within our sphere of knowledge.

8. Can we explain our rationale when investing into a business?

Before investing, we should be able give a short explanation as to why we are investing. Our explanation must be built on facts, not upon what we are hoping to happen. Saying, “I just know this is going to work” is not a valid argument for deciding to act on a tip.

Peter Lynch once said that the ‘story’ of a stock must focus on the specific characteristics and outcomes of a company.

9. What could possibly go wrong?

The main objective when investing is to avoid losing money. Losses can and do occur, but one way of avoiding it as much as possible, is to figure out all of the possible problems that would steer a company in the wrong direction. For instance, it could be that the company is sensitive to small downturns or perhaps losing a major customer would devastate the business.

When doing our risk analysis, we should be focusing on those circumstances that are most likely to have a negative impact and if those scenarios do come to fruition, it would hurt the most.

Before the start of the United States market’s  ‘lost decade’, in 1999, Jim Grant said, The tricky thing about risk is that it is more threatening as it seems less obvious; and less threatening as it seems more obvious.’

10. Is our psychology acting as a roadblock?

Many times, the way we view circumstances that are before us, affects our ability to achieve success.  When we are confronted with a friend who has had great success with their investment and see that others around us are enjoying high returns, we can easily gain a false sense of security and begin relaxing our standards.

A very powerful obstacle is the fear of missing out on the next great opportunity. As much as we like and trust our friends, we have to be careful about giving the advice so much weight that we abandon the core principles of investing.

My purpose here is to give you a process to help you decide whether it is advisable to follow a tip (and hopefully safeguard your money and friendships too). The likelihood that most of the tips run through this test won’t pass, but if one does make it through, you will be in a great position.