3 Things to Look For When Investing in a Stock

If you’re just a day trader, don’t waste your time with this article. This is for us buy and hold types. Go check out some strategy on how to make 20% profits per day by doing affirmations in your parents’ basement after your house gets foreclosed on. It’ll be more your style.

Good. Now that the idiots are gone, let’s talk about the big secret behind making a huge amount of money using stocks, without paying huge taxes and with only doing a few hours of research per month (if you’re a little on the perfectionist side like I am), and possibly as little as a few hours a year.

Are you ready for the secret yet? Man, this would be a terrible time for me to have a fatal heart attack or something, wouldn’t it? All that glorious knowledge, lost to the ages. Alright, enough bogus tension-building. The secret is:

Buy great companies, hold them forever, and reinvest the dividends they generally pay.

Yeah, not much of a secret there. That’s only been known since about the 1960s in American writing… and for as long as there have been business people with a lick of sense.

But the part that takes a bit more sense is the obvious question: “What defines a great company?” I’m glad I’m pretending you asked, eager net cadet.

Some things I consider great about a company are:

1. Having a strong moat

Every financial guru has talked about this, so it won’t get a lot of air play here. Basically, a great moat means that the company does something that is very difficult for another company to do, because there are wide barriers to entry or to achieving a similar level of success.

If you start bottling a drink this week, it will take you awhile to become as well known as Coca Cola. It will also take you a bit longer than a weekend to develop the kind of market share dominance of a search engine like Google.

And if you want to have a unique patent like Female Health does (as in, the world’s only FDA approved female condom), it could take you years of struggling with regulatory approval and testing.

2. Having solid insider ownership.

The Hilton family only owns about 6% of their namesake hotels nowadays, but the fact that they still own any at all says a lot about their foresight. It has been said that good entrepreneurs build a great business and sell it for a huge profit… but great entrepreneurs build a great business, sell chunks of it, and their great-grandchildren live off of the dividends for what’s left over.

A company where the employees have some “skin in the game” beyond their paycheck is generally a winner. Wouldn’t you fight tooth-and-nail, if the company you worked for was your family’s long term future?

3. It throws off cash that it does not need.

There are two ways to think of this – free cash flow (actual cash that the company produces), and profit (the accounting view that the company is “making money”). There are important differences.

When a company spends money, it is said to be taking a loss. But when it depreciates an expense (such as the cost of a major piece of equipment or the construction of a new factory), it can “spread the expense” and actually look as though it is not making money. Cash flow without profit.

But on the other hand, the same thing can be said for when a company makes a lot of sales, but keeps most of these as notes receivable. They call that situation a good balance sheet but poor cashflow. And under generally accepted accounting practices, those notes receivable can also be considered profit.

So, buyer beware on that front.