When you buy a share of common stock, you’re buying more than just a financial instrument. You’re investing part of your wealth in a business and thereby becoming an owner of that publicly traded company. As an owner, you have certain rights: the right to vote on shareholder proposals, the right to receive dividends, the right to attend the annual meeting of shareholders. Generally speaking, you also have limited personal liability for anything the company might get sued for or for the debts of the company.

By becoming a shareholder, you hope to profit by risking the amount of your investment in the expectation that the company you are part owner of will create wealth in the future by growing the business in a profitable way. There is no guarantee, however, that any such investment you may make will pay off as expected. Hence, there is a risk that you might lose all or some of your investment over your investment time horizon. To minimize that risk, you naturally look to invest only in “good” companies. But can a good company turn out to be a bad investment?

Here’s a brief list of some attributes of a good company that most people would agree with[1]:

1. Profitable
2. High growth rate of revenue and profits
3. Good management

Profits – Who wouldn’t want a profitable company? But how are those profits in comparison to other companies in that industry? Are the profit margins holding up over time? Or maybe the company has too much debt (financial leverage), creating the potential for volatile earnings through the business cycle. Or maybe the company is capital intensive, generating small profits relative to the size of its balance sheet. Warren Buffet prefers investing in companies with high economic moats, meaning firms that have high barriers to entry from competitors.

Growth – Every business needs to grow to survive, but it is possible to grow too fast. There are many examples of companies that started out strong but grew at an unsustainable rate (anyone for a Krispy Kreme donut?). Sometimes, a high-growth industry attracts competitors, who collectively drive down prices and profit margins. This is good for consumers, but not so good for investors.

Management – This one is hard to argue with. Good managers can successfully navigate any company through the life cycle of the business. Even a seemingly “bad” company can still be blessed with good management that seeks to optimize the opportunities available to it in the marketplace, while also making wise financing decisions (like paying down debt or selling losing business segments, for example).

If we can’t blindly categorize good companies as those that are merely profitable or growing, is there a better metric? Finance Professor Aswan Damodaran of the Stern School of Business at NYU thinks that good companies are those that can earn more than their cost of capital (the rate of interest on any debt plus the rate of return required by stock investors). Companies that can do this consistently will continue to create wealth for their shareholders over time. Companies that fail to do this destroy shareholder value.

So, it’s settled. Only companies that earn more than their cost of capital are good investments, right? Not so fast. We are forgetting one essential thing. Is the stock fairly priced? Unfortunately, it’s not uncommon for such companies to be overvalued, since they are often very well-known and very popular. If you have to pay too much for the future earnings of a “good” company, the stock actually turns out to be a bad investment.

From this short blog, it should be clear that buying stocks can be a complicated and risky business (I’ve written about this in more detail here[2]). At Coyle Financial Counsel, we hire equity managers who understand the importance of “looking under the hood” at any potential investment. We believe in fundamental analysis and hire managers who know how to do it, whether they specialize in growth companies or value companies. Investing is an inexact science, however, because it is necessarily focused on the future. No one gets every investment right every time, not even Warren Buffet. But we think that paying attention to fundamentals improves your odds of meeting your investment objectives.

John Finley

John Finley, CFA, serves as Chief Investment Officer for Coyle Financial Counsel and is responsible for overseeing the investment process. John’s prior experience includes managing institutional fixed-income portfolios for corporations, pension funds, non-profit organizations and foundations at several large, global asset managers. With more than 20 years of institutional investment experience, he is energized by helping individuals understand the role investing plays in meeting their long-term financial goals.

www.coylefinancial.com
847-441-5644 | coyle@coylefinancial.com

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All information is from sources deemed reliable, but no warranty is made to its accuracy or completeness.  This material is being provided for informational or educational purposes only, and does not take into account the investment objectives or financial situation of any client or prospective client. The information is not intended as investment advice, and is not a recommendation to buy, sell, or invest in any particular investment or market segment. Those seeking information regarding their particular investment needs should contact a financial professional. Coyle, our employees, or our clients, may or may not be invested in any individual securities or market segments discussed in this material. The opinions expressed were current as of the date of posting but are subject to change without notice due to market, political, or economic conditions. All investments involve risk, including loss of principal. Past performance is not a guarantee of future results.

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[1] I’m indebted to Prof. Aswan Damodaran’s blog Musings on Markets for many of these insights, found here:

https://aswathdamodaran.blogspot.com/2017/03/explaining-paradox-why-good-bad.html

[2] https://www.coylefinancial.com/2021/04/21/stock-picking-is-a-risky-business/