The 4 M’s You Should Know Before Buying A Stock
How to look for potential good companies to study? Where to even start if I do not even have a clue on what ratios to use when I am doing a stock screening?
I’ll be honest with you. The easiest way to start is to be more observant and curious the moment you wake up. From the toothpaste you use to brush your teeth under the Colgate-Palmolive Company, the breakfast you eat every morning, be it Gardenia brand bread manufactured by QAF Limited,the MILO or Nescafe produced by Nestle (Malaysia) Berhad, you’ll suddenly notice, investment ideas are almost everywhere.
Once you start to get the hang of it, curiosity will pique you to be eager to know more about these companies. Let me share with you the 4 Ms I look at before I proceed to invest more time and effort to study a company deeper!
Every listed company has a business or a few businesses. For a company’s business to be successful, it must have a competitive advantage or edge over its competitors. The first M – Moat is perhaps the most important M that I look at.
What is a moat?
A moat, in a very simple explanation, is a man-made lake, that usually surrounds a castle. Back in the days, moats usually serve as a defence to deter enemy troops from attacking and entering a castle in huge troops.
Warren Buffett popularized the term economic moat, in which he explains, is the competitive advantage that a company has, to prevent its business from being attacked by competitors.
An economic moat can range from having a strong product brand, patent, copyrights, or regulation protection. One simple example will be Bursa Malaysia Bhd and Singapore Exchange Limited, both in charge of securities listing and managing the stock exchange of Malaysia and Singapore respectively. Apart from them, no other companies are in the same business, making them the sole monopoly in their respective countries.
A great economic moat will shield a company from competition and disruption, just like the olden days where moats serve as a castle defence. So having a good economic moat is, in my opinion, the greatest advantage any company could have in a competitive world.
One of the simplest yet most effective ways to differentiate a great company from a mediocre company is by looking at the margins. A great company will be able to achieve a higher and more consistent profit margin compared to its competitors.
Hartalega Holdings Berhad (Hartalega) and Top Glove Corporation Berhad (Top Glove) are two giant glove manufacturers listed on the Kuala Lumpur Stock Exchange. Both are in the same industry, manufacturing rubber and nitrile gloves.
But if we were to compare the net profit margins of both Hartalega and Top Glove side by side, we can notice that in terms of margin, Hartalega does have the upper hand, with a historical net profit margin of around 20+%. Top Glove on the other hand only managed to achieve a net profit margin of around 10+%.
This means that Hartalega Bhd is more efficient in generating profits compare to Top Glove Bhd. This means if I am looking at investing in the glove industry, I would focus on Hartalega Bhd first before looking at Top Glove Corporation Bhd.
A company needs to prove that it can produce cash from its business operations. Under accrual accounting, a company can always record higher revenues with higher accounts receivables. A potential red flag can be raised if operating cash flow does not follow the trend of revenue growth.
Even when a company has proven it has the ability to rake in cash from its businesses, the next question to ask would be how would the company deploy the cash it has? Will it be paid out as dividends? Will it be used to pare down debts? Will it be reinvested for capital expenditures?
Again different companies in different sectors will be undergoing different phases of growth. An exciting growth company should be concentrating on reinvesting its cash in rapid expansion mode while stable cash cow companies should be paying out regular and sustainable dividends. So do keep an eye on how a company utilizes its money!
Last but not least is the management, the directors, officers and managers running the company. Just as the famous Chinese saying of “A great rider needs a great horse, a great horse also requires a great rider”, great companies achieve more under great management too!
There are currently 3 companies worth 3 trillion USD. All 3 of them have visionary and exceptional management to guide them to where they are today. Tim Cook, CEO of Apple Inc., Jeff Bezos, founder and CEO of Amazon.com, Inc. and Satya Nadella, CEO of Microsoft Corporation.
All 3 of them are powerful managers, and surprisingly all 3 of them manage tech-related companies. In a world where science and technology are evolving so rapidly, it is pivotal for them to be always focusing on where their companies would grow towards.
We have seen Amazon starting off as selling books to selling almost everything to now streaming music and video. Microsoft, which sells software and operating systems for personal computers, even came out with gaming consoles (the X Box) and is now focusing heavily on cloud computing.
It is a heavy responsibility as a company leader to venture into the realm of the unknown. And if a venture is successful it opens up a new economic moat and niches segment that the company can monetize on to deliver more profits. But the downside of a potential failure would also pose huge risk to the company’s performances as well
I would be lying to say that even after all 4M’s are met, investing in these companies would be a sure-win game. There are many factors that can affect the course of a company’s performance and direction. But by knowing these 4 factors coupled with prudent risk analysis and assessment, the chances of succeeding in investing would increase.
Then again, even if everything is in place, the last piece to the jigsaw puzzle is the T factor.
The friend of a fantastic investment – Time!
Persevere in your stock analysis, and have the Patience to watch the company grow!