Investment Criteria

What are the characteristics of a stock i like to invest in?

Welcome,

this issue differs from the previous. I will not present a new underfollowed stock. Instead, I will write a little bit about my personal investment strategy. I created a subsection for this on my substack profile as my investment strategy is constantly evolving with my learning process and I will probably write more about it in the future. But don’t worry, I have not forgotten what the initial idea of my substack is and will write about another underfollowed stock soon :)

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In this write-up, I will focus on the different characteristics of stocks/companies I prefer to invest in. Don’t take it as a complete checklist I always use before investing in a stock. It’s more a set of characteristics of some of the best-performing stocks I invested in in the past and that I felt most comfortable with and all the stocks had a different mix of these characteristics.

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Let’s Go!

1. Small Caps

There are different reasons why I prefer to invest in Small Caps instead of Large or Mid-caps:

• Statistics: Historically Small Caps outperformed Large Caps. US Small Caps for example outperformed US Large Cap between 1926 & 2010 by 2.03 % per year. Although lately, Large Cap seems to be the better investment as Small Caps often fell more, this is historically not untypical as I outlined in this Twitter thread. Most of the Alpha Small Caps generate, came from the 12 months after an economic trough, and before this phase, Large Caps often outperformed Small Caps.

• Law of large numbers: For a small company it is easier to double their revenues compared to a large company like Amazon or Google which already have a significant market share.

• No / less institutional investors: Institutional investors have much more resources to analyze a company than small investors like me. So competing with them seems rather unfair. But in Small Caps, we have an edge. Small Caps are often too illiquid for big institutional investors. So the biggest players with their horde of analysts will not focus on this segment, which makes the market less efficient and easier to find undervalued companies.

These are some of the advantages Small Caps have. But there are also some risks you have to keep in mind. Small Caps are often more volatile, have low liquidity when you trade them, and are often more dependent on a single business case or product compared to bigger, more diversified companies. It’s not unusual that the stock price is reacting heavily to news regarding the company and due to the low liquidity it is not easy to trade the stock immediately. You have to find out if you can mentally deal with these downsides.

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2. Secular Growth

I prefer companies that benefit from a secular growth trend. Secular trends are driven by fundamental changes in the economy such as evolving consumer behavior, demographic changes, or the development of new technology. The invention of the Internet is probably the source of the biggest secular trends of the past quarter century. Amazon’s success for example is based on the secular growth of the e-commerce market.

But Amazon is also great in developing new secular trends by itself as we have seen with AWS which now benefits from the overall Cloud Computing trends.

Companies can grow with the already growing industry they operate in. But be careful, a secular growth trend is not lasting forever and is also not that easy to identify. From today’s view, it is easy to say that E-commerce would have been a good bet in 1999, but back in 1999 it was not that easy. Is the Metaverse for example a secular growth trend? From the current perspective, this is quite unpredictable. So once you think you identified a secular trend, you constantly have to check your thesis using all the data and information you can get about this segment. E-Commerce sales for example are slowing down after they surged a lot during Covid. You have to decide whether this slowdown is lasting longer or is just a normalization of the speed that E-Commerce is taking market share from retail sales.

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3. Medium growth

I like to invest in companies that are able to grow sustainably over a long time period. I prefer medium growth over high growth. Medium growth is for me a sustainable CAGR of 10 % to 30 % over the next years. These growth rates are more sustainable than triple-digit high growth rates for example. Companies with such growth rates are of course interesting, but often this growth is more momentum-driven which makes it difficult to predict any numbers for the future. You have to check every quarter very carefully if the growth continues or slows down. Because once the growth is slowing down, be prepared for some heavy re-evaluation. No company will grow at such rates forever. For me, investing in medium-growth companies is a bit more stress-free. You still have to check how good the management is executing and how sustainable the growth is, but in my experience, you have some more time to make your decisions. For someone like me, who is not a full-time investor, this is an quite important aspect.

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4. Financial Health

The companies I invest in should be financially healthy. For me, the most important aspects here are profitability, solvency, liquidity, and operating efficiency (maybe will publish a separate write-up on what metrics I take a look at exactly here). It is more probable that a financially healthy company can survive a crisis or economic downturn. They even can become one of the winners of that downturn if their competitors were not financially healthy and were not able to survive that downturn. My sleep is much better in an economic downturn when my portfolio consists of companies that are financially healthy. Another aspect is, that I’m just not good at valuing unprofitable companies.

by “GetMoneyRich”

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5. Reasonable Valuation

I´m not the guy that is looking for dirt cheap stocks but I will also not pay 60x sales for unprofitable companies. The valuation must be reasonable for that particular company. Companies with high quality sometimes deserve a high(er) valuation and you can still make good money with it. One of the High-Level Takeaways of the Alta Fox Caste Study - Makings of a Multibagger - was that you shouldn’t rely only on multiples.

Makings of a Mulitbagger

But don’t overpay! Always calculate with a safety of margin. When I think that I found a stock that currently trades at a reasonable valuation (including the safety of margin) but not at a screaming undervaluation, I often buy a smaller starter position and when it gets cheaper I slowly discount-average. With that approach, I will never catch the bottom and probably lose some performance but otherwise, I probably would have never owned some of my best performing stocks. Especially because you get 100 different answers when you ask 100 Investors what a reasonable valuation is. But isn’t that the fun part of investing?

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6. Skin in the game

I prefer companies where the management has skin in the game. Evaluating the management is an important part of the analysis of a company. But it’s also one of the most difficult part for me. Executives can talk all they want, but the best vote of confidence is putting one's own money on the line just like outside investors. I think the probability that a management with skin in the game is interested in increasing shareholder value is higher than a management without insider ownership. This is of course no certainty. The CEO of Wirecard also had skin in the game, but it turned out that Wirecard was one of the biggest frauds in Germany.

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7. Underfollowed

As you might know, when you subscribed to my substack, I like underfollowed stocks. Some of the favorable aspects I already outlined in the “Small Caps Section” also apply to this point. Underfollowed stocks don’t get the attention of the horde of analysts. I don’t think that picking underfollowed stocks is necessarily leading to better performance. I just enjoy discovering these companies that are not on everyone’s radar. On the other side, I try to avoid the hyped “Hot Stocks”. These are often purely momentum-driven and don’t align with my long-term investing approach.

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8. Interesting Business

This is probably a more controversial aspect. Investing is my hobby and not my full-time job. This implies that I have to do the entire analyzing process in my free time. This process often needs several hours and days and once you own a stock, that process doesn’t end. However, when I find a company that genuinely interests me, I enjoy the search process and am willing to put in the time. For me, this is crucial to be a successful long-term shareholder. Many retail investors only invest in stocks for financial gain and don’t have a connection to the underlying business. When the share price doesn't behave as they had hoped, people start to associate that disappointing development with the progress of the company and sell although the business itself is doing well. I follow the business progress because I'm glad to be a shareholder in that amazing company, not merely for financial gain.

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9. Summary

These are some investment criteria that I look at when I’m searching for new investments. Keep in mind that this is not a list of criteria that ensures a good investment. This is a list I mainly made for myself, to find investments I feel comfortable with. For other people, these criteria probably won’t fit well as they have other goals or another investment style. You should also note that my own investment style is constantly evolving as I constantly try to improve and learn. When you look at my portfolio you will also find some stocks that don’t really fit into the criteria above. That is one of the reasons I made the decision to publish this write-up. I try to force myself to stick to my own criteria more precisely. Also, it will probably be interesting to look back at this article in a few years to see how my investment style has evolved since then.

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