Looking to minimise your dud investments and pick more winners? Before you invest in stocks, here are five signs of a strong business from Aussie online investment club Strawman.


Competitive advantage

The best businesses have features that give them an edge over the competition.

It’s what famous investor Warren Buffett refers to as a ‘moat’ – where a business is the castle and the moat the competitive advantage it wields to protect long-term profit and market share.

The moat is something that enables a company to capture a larger share of the market and possess substantial pricing power, Strawman says.

The VanEck Vectors Morningstar World ex Australia Wide Moat ETF (ASX:GOAT), for example,  includes companies with long terms sustainable advantages over their peers like Amazon, Alphabet, Coca Cola and Lockheed Martin.

“Scale, network effects, brand and switching costs are some of the major types of competitive advantage,” it says.

“They’re not especially common — at least not in a meaningful way — but those that possess them are usually able to generate exceptional long term returns for shareholders.”

It’s also important to see how this competitive advantage is changing: is the moat getting bigger or smaller over time?


Does management have wins on the board?

A capable, aligned and honest management team are worth their weight in gold — probably a lot more, says Strawman.

Look for companies where the board and management:

“Importantly, favour those that focus their efforts on building long-term value over short-term results,” Strawman says.


Strong balance sheet

There’s nothing wrong with a bit of debt for stocks with a consistent revenue stream, Strawman says.

“In fact, it can really help juice investor returns if applied judiciously,” it says.

“But companies that are too leveraged, with little cash reserves and unreliable cash flows are potentially only one bad quarter away from needing a bailout from shareholders.

“It’s not worth it.”


Attractive reinvestment potential

Companies that can reinvest profits back into the business at high rates of return are compounding machines that can deliver exceptional long-term returns, Strawman says.

“Those that can’t can still be ok, but are probably better off distributing any excess cash to shareholders in the form of dividends — otherwise they risk seriously eroding shareholder wealth.”

A good indicator is looking at the Return on Incremental Equity, which determines the effectiveness of capital deployed. The higher, the better.


Is the industry growing or shrinking?

No matter how attractive a business may appear, if it operates in an industry facing structural challenges it’s going to struggle to deliver good returns for investors.

“Shareholders in department stores, traditional media and fossil fuel companies (to name just a few) know this all too well,” says Strawman.

“Far better to be sailing with the wind at your back.”

The share price of retail giant Myer was trading as high as $3.47 back in 2009, but encroaching competition especially from online operators has been weighing on the business.

The share price is now at a fraction of its 2009 high, trading at 30.5c today.

Many thermal coal stocks are in the same boat.