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That sunrise business bathed in the light of a market dawn might look bright and shiny, but is it a flash in the pan with less enduring value than its duller cousins? Peter Webb finds patience is a virtue

I have spent many years studying the purchases of successful investors, and the big question has to be: Is there a short cut to replicating such stock picking successes?

Your overall objective, of course, is to buy a great business at a good price. The simplest part of this equation is to buy at the right price. Companies trading at very low valuation ratios have always outperformed their more expensive partners in the market. High dividend yields, low price to earnings, low price to cashflow all throw off good candidates. The problem you have with all these financial ratios is that they are historic. The essential differentiator between good investors and super investors appears to lie in that most oblique of skills – predicting the future.

Peering into the future

If you can buy a great company at a reasonable price your valuation at today’s price will be much higher the further you discount returns into the future. For that to happen, you need not only to pick the right price but the right company. By the right company I mean a company that will stay around, in the market and able persistently to deliver returns to shareholders over reasonably long periods. The big problem with predicting the future is that the future hasn’t happened yet! So how do investors qualify the longevity of their positions?

When we look for longevity most people would immediately point to competitive advantage. Companies that have high barriers to entry will prohibit new entrants to their arenas and, where less competition exists, companies can survive in their current modes of operation for longer.

Other contributors to competitive strength include bargaining power over customers and suppliers, and having a product that cannot be easily replicated or replaced with new technology or large amounts of money! But all these factors can be discounted somewhat if the competition between remaining competitors is fierce.

Key characteristics

Super investors, though, also appear to look for other characteristics to enhance the longevity of returns.

• Clarity – What does the business do? Is it simple to understand and does it generally do one thing? Businesses that are focused on one core discipline tend to do it very well. Larger businesses that are not dependent on one market or discipline often let one area subsidise another, often by accident. Is the management focused on the core operation or tempted to diversify?

• Unchanging and enduring character – What would force the business to change direction either in terms of what it does or the market addressed? I would bet that Wrigley’s is very likely to be still selling chewing gum in ten years’ time, but if you owned a business that made in-car entertainment systems, would it still be selling the same things in a decade? Unpredictable businesses tend to eat a lot of investor cash as they have to re-invent themselves just to stay in business.

• Does the management need to make difficult decisions? – These often mean a demanding market place and quite probably a mistake at some point. They also restrict the type and cost of management and staff the company can recruit. Making easy decisions allows management to focus on efficiency and market development rather than dragging it into complicated scenarios.

• Pricing power – If the company raised prices tomorrow would it affect business drastically? If the cost to the customer represents a small proportion of total expenditure it is likely the customer will be less price-sensitive. Lumpy sales and earnings tied to large one-off contracts are much riskier and tend to lead to a lot of examination and therefore cost exposure to purchasers.

• Is return on equity and return on capital employed high? – If the company possesses favourable characteristics then the return on equity or capital should reflect this. Check to see if there is a trend in these figures. Also check to see if the board is measured on increasing return rather than earnings, this is a key to significant shareholder value.

• Vitamin or painkiller – Does the market need the products or are they a ‘nice-to-have’? Painkillers solve problems; vitamins are just supplements and are likely to be susceptible to big fluctuations in purchasing sentiment.

Once you have assessed these characteristics, it also makes sense to invest in companies that are not involved or likely to be involved in litigation or regulatory issues. This could significantly shorten or dent your prospect of a good quality return.

Enduring businesses tend to be less exciting than their high-growth brethren, but they also tend to be a lot cheaper. Buying a business at a good price that will produce returns over very long periods takes a bit of effort and discipline, but the rewards can be significant.