When it comes down to it, people are fascinated by the stock market for one simple reason – they want to make lots of money.
One mistake that beginners often make is to buy the shares of companies that have been badly beaten up. They see a share that used to trade at £5 now selling for 50p, and think they’ve spotted a bargain.
This is known as ‘catching a falling knife’. As the name suggests, it’s a bad idea.
Sometimes the market does get it badly wrong on stocks. Betting on a big recovery by a troubled company is a strategy that’s been used by some of history’s greatest investors, such as Benjamin Graham.
But that sort of value investing takes a great deal of research and patience. We’ll talk more about the sorts of ratios value investors favour elsewhere.
However, the truth is that quite often, the market is right. The shares have fallen in price because the company was in trouble and might not recover.
So blindly buying shares simply because they have gone down a lot is a sure way to lose all your money.
How do you avoid this? The first step is to make sure you only buy good or great companies.
So what makes a great company?
The answer to this question is easier than you might think. Put simply, it has to provide something that people want which other companies cannot easily copy. You want to avoid businesses that have lots of competition.
You can see examples of this in your everyday life. Just how easy is it to compete with Coca Cola or Gillette razors? How many businesses don’t use Microsoft Office software? Yes, you can buy other – often cheaper – colas, razors and software, but they are often not as good. People prefer to pay for better products.
Another example is a company with a new wonder drug. The patent on this drug stops other people making it.
The key point is that if a business does not have lots of competitors, it can make more money for a longer period of time.
Think about businesses that struggle to make money every year. Why is this? It’s usually because they have too much competition. A classic example of this is the airline industry. Despite more and more people flying each year, the industry has had more money going out than it has coming in since it started.
It’s relatively easy for people to set up airlines and rent aircraft. They do well for a while when times are good. But when an economy turns down they spend a lot of money flying half-empty planes.
But how do you go about finding good companies? Help is at hand with one simple calculation.
It’s called return on capital employed (ROCE).
ROCE calculates what a company gets back (its profit) on the money it has put into its business (known as capital employed). I’ll explain how this works with an example.
John has spent his spare time making beer in his kitchen. His beers taste really good and have won lots of prizes. He reckons that he can make a living making and selling his beers.
He decides to invest £50,000 of his savings and gets a loan of a further £50,000 from his bank manager. He uses the £100,000 to buy brewing equipment and a small building.
He sells lots of beer. After he takes away costs of all the ingredients and other running costs, he is left with a profit of £40,000. This gives him a ROCE of 40% (£40,000/£100,000).
You can do the same calculations for big companies. For example, Apple’s iPhones and iPads are so profitable that it has a ROCE of over 300%. It achieves this because its competitors have yet to make products that persuade customers to switch.
Here’s the catch
Once you have found these great companies, you have to keep your eye on them. You have to ask whether the good times can last, and whether they can maintain their edge.
If consumers suddenly decide that Samsung or Motorola phones are better, then Apple could turn out to be a bad investment. Certainly any business which is that profitable and high-profile is likely to attract some determined rivals.
Great companies have that special product that people keep buying year after year. Working out which ones can sustain this, is the difficult part of investing.
The other big question is: how much should you pay for such a company? After all, it doesn’t matter how good a company is if you pay too much for it in the first place. We’ll look at how to work that out next time.
• This article is taken from our beginners’ guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here