Wednesday, September 1, 2010

Create the experience: the profits will follow


The ability to create great memories for your customers can be a really defining competitive advantage. Ikea, Disney, and, to a certain extent, McDonald’s with its “Happy Meals” are all companies that do a good job at creating great memorable experiences for their customers.
Many aspiring entrepreneurs talk about creating a good experience for their customers, but seem to fall short most of the time. In this article, I will talk about some of the ways how creating unique memories for customers can benefit the bottom line.
Loyal customers or loyal generations of customers
When we were kids, my brother and I would always look forward to Friday, as that was the day my mum would take us out for McDonald’s. I didn’t ask for a happy meal (the burgers in there were too small for me), but would instead get my mum to buy me a double cheese burger and whatever toy they had for that week.
It is these memories that make me put McDonald’s at the top of the list when deciding which fast food restaurant I want to eat at. It is also these memories that will make me want to bring my kids in the future to McDonald’s to let them experience what I experienced and enjoyed when I was a kid, and if they enjoy it as much as I did, I think they too will become loyal customers of McDonald’s.
So, companies that can create happy, unique memories for customers will have more loyal customers and maybe even generations of loyal customers. Fun business fact: According to the article “Zero Defections: Quality Comes to Services” in the Harvard Business Review, companies are able to increase their earnings by up to almost 100% by retaining 5% more customers.
Increased sales at a company’s other business divisions
Customers that had a good experience with a particular company through contact with one of its business divisions will be more likely to buy products from that company’s other divisions. Take Disney for example, kids that enjoyed one of its movies might persuade their parents to take them to Disneyland or buy Disney merchandise related to the movie.
More sales as a by-product of the experience
Some companies are really known for the experience they create that people just go their outlets just to go there. For example: You’ve people tagging along with their friends to Ikea just to walk around checking out cool furniture and living spaces and eat Swedish meatballs. These customers might have no intention of buying anything, but there’s still always the possibility that while walking around, these customers spot a piece of furniture or two that they might like and decide to make a purchase.
So, by creating a great experience, companies get the opportunity of making sales to customers that might not originally have any intentions to buy. The extra sales these companies generate will have an impact on their bottom lines.    
Premium pricing
A great experience or a great memory is a distinguishing factor that really sets a company and its products apart. By being differentiated and having products that are differentiated, companies are able to command higher prices which will translate to higher margins and profits.

In conclusion, the ability to create a great experience and memory for the customers should be taken into account by investors when evaluating the competitive advantage and investment appeal of companies, and aspiring entrepreneurs should try and build their businesses to be able to provide value to customers in the form of a unique and good experience.If you have any questions or have anything to add, please don't hesitate to comment.

The eternal battle of REIT vs. Physical Real Estate


Owning shares in REITs or directly owning real estate (or even owning both asset classes) can be part of an effective investment strategy. REITs and physical real estate can provide investors with nice passive income and if bought at the right price with the right fundamentals, can turn out to be great investments.
 There are benefits of owning each of these asset classes, and in this article, I will talk about some of the advantages of investing in REITs as well as some of the advantages of investing in physical real estate.
Scale
Unless you’re really rich, you might not be able to directly invest in hotels, office towers, shopping malls, and warehouses. Investing in REITs will allows you to become a part-owner of these types of assets, which can potentially produce better returns than residential properties or other lower value real estate.
Being big is not always a great thing, as REITs might not be able to take advantage of smaller opportunities, which won’t have much of an impact on their bottom lines. This is where individual investors that really understand real estate have an advantage in terms of being able to directly invest in real estate that REITs don’t consider, and which might produce better returns than REITs.
REITs can prudently take on more debt, percentage-wise, than most individual investors as they have a much more diversified portfolio of real estate, which cash flows are sufficient to make interest payments and cover other costs even if occupancy rates fall. Investors should, however, beware of REITs that take on more debt than what the investors believe is prudent, as too much debt is always bad, no matter what the asset class. REITs can also potentially have significantly lower cost of funds than individual investors.
Management
REITs like companies are run by management teams. If you’re not experienced or don’t like the activities involved in procuring and holding real estate directly, it might be a good idea to just buy shares in REITs. Some REITs might have really good management in place, which is capable of identifying real estate investment opportunities that can potentially produce significantly better returns than opportunities individual real estate investors can find by themselves.
Individual investors that really understand real estate can also potentially earn higher returns than a lot of the REITs out there. REITs can also be run by bad management teams, and instead of creating value for shareholders, these management teams can very well destroy shareholder value instead.
 After taking into account some of the costs incurred in the operations of a REIT (selling, general, & administrative expenses), investors might actually earn lower returns than if they were to directly hold and manage real estate themselves. A good management team can, however, achieve better profit margins and better returns on their real estate portfolio than the profit margins and returns achieved on the real estate portfolios of a lot of individual investors, as their experience, expertise, and knowledge of the business allows them to manage the portfolio more efficiently and at a lower overall cost percentage-wise.
Low entry cost and liquidity
Investors require much less capital to invest in REITs than directly investing in real estate, and REITs have better liquidity than physical real estate, as buying and selling shares in REITs is just like buying and selling shares in publicly traded companies. So, REITs have physical real estate beat in these 2 categories, but investors with sufficient capital and a long-term horizon shouldn’t have much to worry about in terms of entry cost and liquidity when directly investing in real estate. 
Growth
In his “Conservative Investors Sleep Well” writing, Philip A. Fisher wrote, “It has already been pointed out that in this rapidly changing world companies cannot stand still. They must either get better or worse, improve or go downhill. The true investment objective of growth is not just to make gains but to avoid loss.”
If you don’t like or don’t really know how to manage a real estate portfolio for growth, you would be better off investing in REITs, as the management teams of the REITs will manage for growth (or at least try to) for you. REITs with good management can actually achieve pretty good growth rates based on their size and the industry.
Individual real estate investors that know what they are doing can opt to manage and grow the profits of their real estate portfolios on their own, as some of the individual investors that really understand real estate are able to grow profits at a higher rate than a lot of REITs. Individual investors also have quite a significant advantage when it comes to growth, as unlike REITs, individual investors don’t have to pay out 90% of the taxable profits from their properties as dividends, and can reinvest the profits to grow their portfolio.
If you’re interested in investing in REITs and physical real estate you might want to check out this article I wrote Real Estate Real Returns. If you have any questions or would like to add anything, please feel free to comment.


Business lessons from a low-cost carrier


A lot of great businesses are based on a low-cost model and creating value for customers. Companies like McDonald’s and Wal-Mart are just a few examples. In this article, we will take a look at a few things we can learn from Air Asia’s rise to being the largest low-cost carrier in Asia.
Building strong brands
Having strong identifiable brands is one of the greatest sources of competitive advantage for a company, as the brands differentiate the products of the company. This will translate into consumers looking to the products or services of the company as a top choice to satisfy their needs, and this allows the company to command a premium on the price of its products (even if the business model of a company like Air Asia chooses to forego charging a premium and keep prices low). Companies like Disney and Coca-Cola created hugely successful empires on the basis of having a strong brand or a portfolio of strong brands.
Air Asia has been successful in building its brand into a regional powerhouse, and leveraged the Air Asia brand into the largest low-cost carrier in Asia. Air Asia is also taking advantage of its strong brand to branch out and get a stronger foothold in the air cargo business.     
The founders of Air Asia understand how important branding is, and are also building brands in the budget hotel, mobile operator, and consumer financial services businesses, as well as other businesses. 
Business model
Air Asia doesn’t only cut costs the typical way such as acquiring more cost-efficient planes, but also cuts out services that might not provide a lot of value or might not be as relevant to customers as compared to much lower air-fares. A person who happens to be travelling light on a particular trip might not get much value out of being able to check-in heavy baggage for free.
Customers’ needs do change, and not all customers want the same thing at any one time, and some customers are willing to pay for additional services on top of the basic air-travel service. Air Asia tries to provide good value to as many of its customers as possible by adopting a “pay-for-what-you-want” concept. The company provides customers with the basic service of getting them from one point to another at low prices, and those customers who want additional services such as on-board food or heavy baggage check-in pay extra for the additional services they consume.     
 Taking control of other parts of the value chain can enable a company to further cut costs. While technically not really qualifying as taking control of part of the value chain, Air Asia once had plans to build a low-cost carrier terminal to further reduce costs. When deciding on whether to take control of part of the value chain, a company has to look at the returns it can expect to obtain on the investment needed to take control of that part of the value chain, the opportunity costs in terms of the return on investment that could be achieved by pursuing other projects, and the ability of the company to manage a part of the value chain that could be significantly different from its core business.    
Air Asia is able to experience lower costs due to the sheer size of its operations, which allows it to enjoy economies of scale and other size-related advantages. The company is also digitalizing its business and encouraging customers to use their website as the point of transaction. This can result in lower-costs for the company as well as increased convenience for the customers.
Here are some pretty general things, but are also things that are beneficial to think about in terms of perishable services and price sensitivity:
 Airlines provide a perishable service in the sense that when their planes take off, the revenue lost from the empty seats cannot be recouped. Air Asia understands this and offers super-low prices for people who book in advance and advertises these low-prices in its advertisements, which not only informs its customers about the low prices, but also reinforces the Air Asia brand as the airline to go to for rock-bottom airfares.
 Air Asia gradually raise ticket prices as the date of the flight approaches, this allows them to take advantage of the lower price sensitivity of customers that travel on short notice.

Being a bigger part of the experience
The founders of Air Asia are also building their budget hotels, mobile operator, and consumer financial services businesses. While fine on their own, these businesses tie in very well with the budget airline business and are all part of the “travel experience.”
Someone who wants to travel from one place to another needs transportation; this is where Air Asia comes in. That person might also need a place to sleep at night; this is where the budget hotels come in. The traveler might also need to make phone calls back home or might need a convenient and secure way to buy stuff; this is where the prepaid mobile cards and prepaid debit cards come in.  
Companies that successfully build businesses around an experience are able to enjoy cross-selling opportunities and increased share of their customers’ wallet. But like efforts to control other parts of the value chain, companies should look at things like return on investment and current expertise and capabilities.
Huge market potential
Air Asia serves a huge market in the form of low-income to middle-income consumers in general that are looking for affordability and value in terms of air-travel. This market provides the opportunity for Air Asia to sizably increase its sales for the long-term (assuming of course that management is capable), which ties in well with one of the fifteen points highlighted by Philip A. Fisher in the book “Common Stocks and Uncommon Profits” as things an investor should look for in a stock, that is, “Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?”
Increase in sales is only good if there is a similar or greater percentage increase in profits over the long-term. There are many cases of companies overpaying for acquisitions or committing to costly expansions in an effort to increase revenue, only to find they are racking up huge losses down the road.
Conclusion
In conclusion, this article looks at some of the things that we can learn from a budget airline, and that can be applied to other real-life businesses or looked out for when analyzing stocks.
 I personally enjoy thinking about business models and trying to fit these business models with companies that I’m analyzing for potential investment, or trying to come up with business ideas applying these models or a combination of models. Both investors and business owners can benefit from learning about different business models as investing in stocks and owning businesses should be thought of as the same thing.   

Profitable Diversification


When investing, you should only diversify when you do not know what you are doing, as this will reduce the risk of losing a significant portion of your money in a few bad investments. Aiming for diversification when you understand how to value stocks or have identified a lucrative business opportunity isn’t really a great thing as you run the risk of adding to your portfolio mediocre investments and experience overall portfolio returns that are lower than what you could have achieved if you invested your money only in the good stuff.
In this article, however, I will look at diversification from the angle of the companies or businesses. I will look at situations where private businesses and listed companies created good value for their shareholders by diversifying their operations.
Market Diversification
Setting up their core businesses in new markets is one way for companies to grow by replicating their success in different markets, and diversify where they generate their revenues, which somewhat protects companies from a downturn in some of the markets they operate in, as profits generated in their other markets can, to a certain extent, make up for the shortfall in profits or at least cancel out some of the losses from markets that they are not doing so well in.
Whether it’s going into a new market or investing in a whole new business, one of the main reasons for diversification is to spread out and reduce risks.  Take the recent financial crisis for example, the investment banking divisions of quite a few integrated financial companies contributed significantly in shoring up these banking groups’ profits.
Product Offering Diversification
Product offering diversification can increase a company’s profits by appealing to a different market segment or increasing the company’s share of its existing customers’ wallets by selling them stuff that they already buy from other companies. McDonald’s introducing its McCafe product line is a great example and is now a significant contributor to McDonald’s revenue growth.
Related business line diversification
This is similar to the diversification efforts discussed above, but instead of just offering a new product line that is more or less an extension of its existing business operations; the company goes into a different, but still somewhat related business. For example: A lot of luxury fashion brands are in the apparels business, fine watches business, the perfume business, as well as other luxury fashion related businesses.
  Like the luxury fashion companies, some companies are able to leverage their brand and expertise and go into related businesses with somewhat of a head start in terms of a ready customer base. Firstly, these companies export their brand from their core operations to their new ventures, this will significantly reduce the efforts needed to build a well-established brand, and customers are more likely to buy stuff with a recognized brand. Secondly, the company’s customer bases from their existing core operations might opt to switch to the products offered by the company’s new venture; this too will contribute to the new business line’s starting customer base.    
Diversifying into related businesses really shines when a company is able to create more value for its customers through its diversified operations and cross-sell to its customers, products from its various business divisions. Take those integrated financial companies for example, they make it convenient for their customers to do stuff like invest, pay bills, save, and use their credit cards. This convenience creates value for the customers. The integrated financial companies also get the opportunity to increase revenue by cross-selling their various financial products to the customer.
Unrelated business line diversification
This is where companies go into businesses that might not be related to their existing core businesses. There’s nothing wrong with that though, as long as the company goes into businesses where it can get good returns for shareholders. Berkshire Hathaway invests in or owns many different kinds of businesses, and it has created great long-term value for its shareholders. 
So, why and why not diversify?
 We have discussed the benefits of diversification in terms of cross-selling, appealing to different market segments, and channeling shareholders’ funds into businesses that can generate above average returns. Now, let’s look into some of the other reasons for diversification:
Diversification can in some situation be an easy way for companies to generate additional revenue. I remember watching some news channel and there was this story about offices being built on top of open-space parking lots. This is one of the examples where diversification can be a way for companies to maximize the utility of their current resources and increase revenues without a lot of effort. I don’t know if this counts as diversification, but turning industrial waste into useful products is also a good way to earn extra revenue and maximize utility of resources.
Diversification can be a way for companies to defend their business from changing trends and new competitors. Take a fast food chain for example, if it’s in a situation where customers are moving up to casual dining restaurants, it might do well to set up its own casual dining restaurant brand to try and recapture revenue lost due to a smaller customer base.
 Some companies can effectively transfer its knowledge, technology, and expertise from its core business to other lines of business and be successful in those business lines. If proper research is done, companies like this can profitably diversify its operations.
In some cases, the value of the company’s diversified business divisions put together as one greatly exceeds the sum of all the company’s business divisions measured individually. Take Disney for example: Most of its business divisions add value to the other divisions.   
Here are some reasons why companies shouldn’t diversify:
Diversifying into businesses where returns are low is a not a good thing, and shareholders will be better off if the company paid out dividends instead of going into businesses with low returns.
A company should not diversify its operations if there is still a lot of room for its core businesses to grow, and its options as to new businesses to invest in are not as good as its core businesses in terms of long-term profitability.
Companies should also avoid diversifying into businesses that they do not have and are not easily able to build expertise in.
Companies that are short on liquidity should put off diversifying their operations and conserve cash, least they spread themselves too thin. Many companies have destroyed significant shareholder value if not completely wiping out shareholder value because of a lack of liquidity. Companies also shouldn’t focus on diversifying if they have too much debt, and should instead pay down some of its debt and build up book value before investing in new businesses.
 So, these are my thoughts on diversification, and I hope they can be of some use to anyone who reads this article in terms of decisions to diversify their private businesses or when evaluating the diversification efforts of public listed companies you can buy shares in. How about you guys, any thoughts on diversification that you would like to share? Or perhaps I missed something out or you might have some questions. Whatever it is, please feel free to comment and share. Thanks for reading.

Real Estate Real Returns


Real estate like stocks is an asset class, and some investment principles and valuation methods that apply to stocks also applies to real estate. In this article, I will look at some of the things that we should take into account when analyzing the investment appeal of real estate.
While it’s true that stocks generally provide investors with higher returns than real estate, there are situations where, if proper research is done and if bought at an attractive price, real estate can turn out to be great investments.
Real estate is also a good source of passive income that can contribute to the spending power of retirees and allow them to enjoy their golden years more comfortably. Passive income generated by real estate investments can also allow younger people the freedom of not relying too much or at all on their jobs, and gives them a safety net to strike out on their own. Income from real estate assets can allow you to keep buying when the market is undervalued and everyone but the smart guys are selling.    
Occupancy Rate
Whether you’re buying an apartment or investing in REITs, investors should look for a high occupancy rate. It is supply and demand; a high occupancy rate means that there is less rental space supply and this will increase the odds that rent can be raised successfully. For REITS, you can usually find the overall occupancy rate for a REIT’s properties in their annual report. For real estate like an apartment or a house in a suburb, investors should look at areas where houses are mostly occupied (if anyone knows how to check the occupancy rates for housing areas, please feel free to share, thanks).
Investors can also try and approximate the occupancy rate of their properties needed to make mortgage payments and cover maintenance costs. For example: A property investor might own 5 condo units, and need to rent out at least 2 units to break even on interest and maintenance costs.
Here are the steps I use to roughly determine the occupancy rate needed to breakeven for a REIT (This is assuming that majority of the REIT’s revenue comes from rental and not property management or etc):
Step 1: I find out the revenue that can be achieved at 100% occupancy. I assume 100% occupancy = max revenue and make the necessary adjustments with current revenue and current occupancy rate.

Step 2: I minus depreciation from total expenses.

Step 3: I express the expenses ex-depreciation figure in terms of a percentage of maximum revenue, and that percentage will be the occupancy rate I think is needed to breakeven.

 Liquidity and Cash
Whether you own a few condominiums or have bought stock in a REIT, cash is important to protect you from adverse conditions where occupancy rates are low and rental yield is falling. If you own a few rental properties, you need to make sure you have enough cash to at least make mortgage payments and maintain your properties in case some of your tenants suddenly shift out.
REITs with high occupancy rates don’t need to carry much cash, as unlike individual property investors, REITs own many properties and have many tenants; this diversification of income sources reduces their financial risk in the event where some of their tenants decide to move out.  
Mortgage
It’s important to lock in low mortgage rates whenever possible as any increase in the mortgage payments you need to make affects the returns you earn. But when mortgage rates are affordable but not cheap, investors may consider having a mix of fixed-rate and adjustable-rate mortgages on their investment properties, as this will allow them to enjoy overall lower rates if mortgage rates fall, and be somewhat protected if mortgage rates rise.
How conservative you are should also determine the type of mortgage you should opt for. Investors looking for stable income should get a fixed-rate mortgage and stably earn the difference between rent and costs every month. I personally will not take out adjustable-rate mortgages on my investment properties if I only have in my portfolio one or two properties, as the risk of lower cash-flows or even negative cash-flows due to an increase in mortgage rates is too much for me.
For a REIT, I look at the average interest rate of its debt, to see whether it’s acceptable or not.  I also look whether the REIT has a significant portion of debt coming due in the short- to medium-term, and if it can build up enough cash from now to then to finance the portion of debt coming due. I also find out how exposed the REIT is to increases in interest rates by looking at how much of their debt have variable rates.
Adding value
One of the ways REITs are able to add value to their properties is by renovating their properties to fit in more units they can rent out or increase the appeal of the malls to attract more shoppers which will be followed by the REIT being able to charge their tenants higher rent.
Individual property investors can also add value to their property investments. They can furnish their properties, build more rooms in their properties, or etc. What matters is that the investment made to enhance the value of the property results in higher rental income where the estimated additional rental that will be earned represents healthy returns on the value enhancing investment.
 Valuing Real Estate
To value a property, investors should discount the estimated future rental cash-flows minus estimated future maintenance costs back to the present. If investors are looking for high returns and not just stable income, then the discount rate should be higher (I use 12%) than the discount rate of 6-7% that I recommend for stocks, as unlike stocks, rental income from real estate can’t grow much (increases in rental earned due to inflation don’t count, as you will still get the same purchasing power with your increased rental income; selecting good locations might result in long-term rental income growth that outpace inflation, but it will be more prudent not to take this potential growth into account).
After discounting back to the present the future net cash-flows the property is estimated to generate, we get a figure that’s almost the value we think the property should be worth. I say almost because we still need to add to the figure legal costs, and any other costs associated with acquiring the property. Investors should buy properties that are at a discount to the value the investors think they are worth.

The price of physical real estate hardly ever drop so low that you can earn double digit  returns from the rental (at least I don't think it does from where I come from), but like a company, the returns from real estate can be improved by taking on debt. But investors should make sure that they can comfortably service whatever debt they intend to take on. You would probably have guessed by now that I'm not a physical real estate investor, or I wouldn't even think of demanding a 12% return on a real estate investment without using any debt(that just goes to show how much more attractive I think some companies are as compared to real estate right now  that I would need such a good return before I would consider investing in real estate).

But when stocks aren't as attractive anymore, then I would of course seriously consider physical real estate as an investment if I can earn 12% returns, maybe even 10%, by employing modest leverage.

The things I talk about in this article are by no means everything an investor needs to know about real estate investments, whether it’s buying shares in a REIT or buying real estate directly. For example: Investors planning to invest directly in real estate like a condo unit should also pay attention to things like location and etc.
I value REITs the same way I value stocks. Here’s my article on some of the things I look at when evaluating stocks for potential investment: Things I think about before making investment decisions

If you have any questions or have anything that you would like to share please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

5 tips for your new business venture


Opportunities
Opportunities are everywhere; all we have to do is look. Opening a nice cafĂ© in an office park where there are hardly any food outlets or setting up a gifts shop in a popular mall that doesn’t have any other gifts shops are examples of the many opportunities out there, just waiting to be exploited.
With so many great, simple, straight-forward businesses we can start, it amazes me how some of the people I know keep coming up with some really weird, or just plain cockamamie ideas whenever we talk about business.
While it’s true that there are many business opportunities out there, aspiring business owners should narrow down the opportunities they should pursue based on the types of businesses they understand and are passionate about (e.g. an animal lover who has worked in pet shops before can consider opening his very own pets shop). Once the list of opportunities is narrowed down, we need to then pick from the list the opportunity that we believe will generate for us the highest returns on investment long-term.
Create value for your customers
When asked the question of how to get customers, quite a lot of people will say stuff like charge lower prices, or have a great promotional campaign. While this might get you some customers in the short-term, you won’t be able to retain long-term customers, which are the main driver of profits.
The best way to retain loyal customers is to create value for them. So, instead of focusing on ineffective promotional activities, or other activities that don’t really add customer value, we should focus the efforts of our business into understanding our customers and finding out what matters to them, and focus on doing the things that matter really well. We should also identify and cut out activities that don’t add value, so as to deliver to customers, products with great value, and still earn good margins.     
Don’t get me wrong, I do believe in an effective promotional campaign to grab the attention of customers. In fact, some forms of promotion actually benefits both the customers as well as the business (e.g. a clothing retailer can have a facebook page with articles containing fashion tips and photos as well as videos of their models, this creates value for the customers. The business on the other hand gets the benefits of having a platform to advertise their products to customers that willingly look up their facebook page and are likely to buy their stuff; the company is also able to get feedback from comments left by customers).
 Keep costs variable and have low fixed investments
When starting a new business, there will be uncertainty about how well your product will be received; at this point of time, it will be more beneficial for your business to have variable costs make up a significant portion of its total cost structure, as your business will be more flexible in responding to either increases or decreases in demand. Having more of your business’ costs as variable costs also gives your business more agility in terms of making any changes to its operations.
Some activities require scale, or technical expertise, or even both to be performed effectively and in a cost-efficient manner. Businesses just starting out can save money by outsourcing this type of activities to other companies that can do them better. This will also allow the company to direct more of their efforts at their core competencies.
By making less fixed investments and outsourcing certain of your activities, you can actually reduce the capital needed to start your business; this can translate into a higher return on investment, as well as allow you to expand your business at a faster pace. 
Profit margins and return on investment
Aspiring business owners should go into businesses that both generates high returns on investment and have good margins.
Your business’ profit margin is the percentage of revenue your business gets to keep as profit. The higher the profit margin, the more money your business makes, which can then be channeled to expansion or used to pay out dividends. Businesses with higher margins also need to sell fewer products to breakeven. 
Your return on investment is simply the money that your invested money makes, and investors should only look to start businesses that will produce for them good returns (We want our money to work hard and not be deadbeats producing for us lousy returns, don’t we?). High returns on investment also mean that we recoup our investments in our businesses more quickly.
Start a business that doesn’t require much effort on your part
While it’s really great if you are happy about the prospects of running your own business, you should try and start a business that doesn’t require you to be there for it to function. The main points of investing your money and setting up businesses are to make your money work for you and not having to rely on working for your paycheck, as your businesses and investments generate passive income for you as you pursue your main passions in life. If you’re passionate about your business and would like nothing else but to come and work at your very own company every day, then more power to you; you’ve got yourself probably the most important ingredients for business success, passion.


Things I think about before making investment decisions


It is important to be independent in our decisions to invest, and be able to evaluate and understand the companies that we are considering for potential investment. In this article, I want to share with you some of the things that I look at when deciding if a stock is a good investment or not.
Revenue
To pick out a stock that will create good long-term value for its shareholders, investors need to look at the sales figure to see if it is growing at a healthy rate long-term.
Investors should, however, make sure that the company is not over-aggressive in its expansion and taking on too much debt; spreading itself too thin. Investors should also make sure that the company is not in the habit of regularly issuing new stock to fund its growth, as this kind of activities will dilute the holdings of shareholders. The best companies are usually the ones that can mostly or fully fund their expansion from internally generated funds.
Investors also shouldn’t overpay for stocks with high growth rates, as this can put them in a situation where they find themselves with big losses because a high-growth company they bought shares in missed earnings estimates by 0.1% or something.
It is important to figure out if the growth rate of the company is sustainable by reading the annual report for information on growth and looking at the industry the company is in, as well as the size of the company in relation to the size of its largest competitors. A company doing $8 billion dollars in sales in a mature industry where its biggest competitor is only doing $10 billion dollars in sales generally can’t grow much and shouldn’t have too high a rate of growth.
Most important, however, is that an increase in sales is only a good thing if there is an equivalent growth rate or a higher growth rate (due to scale) in income over the long-term. We will look into income a little later in this article.
While I do believe that investors can get good profits from investing in large-cap stocks, I also believe that if investors are looking for stocks that have the potential to go up 20-30 times in value that they have to look for this kind of gains in small-cap to medium-cap stocks. It’s much easier for a $20 million dollar company to grow ten times its size than it is for a $100 billion dollar company to even double its size.   
 Operating Income
Investors should look for companies with operating incomes that are rising. There don’t have to be an increase in income every quarter or even every year, but there should be healthy growth in profits over the long-term.
The operating margin is the percentage of revenue a company translates to profit before paying interest and taxes, and before taking into account non-operating profits and losses. A company earning higher margins is able to expand faster and better fund its expansion from funds generated internally, while relying less on debt or issuing new shares that will dilute the holdings of its shareholders.
Many companies make losses during recessions as demand for their products drop. Companies with high operating margins are, to a certain extent, somewhat protected from adverse economic conditions and may still make at least some money during bad times. Additionally, when there is an increase in the costs of materials, companies with higher margins are able to delay passing on the increased costs to the customer and gain market share from their competitors that have no choice but to raise prices early.   
While it’s true that investors should generally look for companies with high profit margins, investors should also take into account things like business models, return on equity, and expansion plans. Wal-Mart for example thrives on a business model that entails low margins, because it is its business model that permits it to earn a high rate of return on equity and experience great growth that turned it into the largest retailer in the world. All this has translated to very impressive profits for shareholders over the long-term.
 Companies spending aggressively on expansion will temporarily experience lower profit margins (It is important that each dollar a company retains to expand its business, returns to shareholders in the future as more than a dollar plus whatever return shareholders could acceptably have earned had the company instead paid out dividends with the money used for expansion).
Net Income
While operating income allows us to have a better idea of the efficiency and growth of the company, net income is a more accurate measure of the current profitability of a company, as net income takes into account taxes and interest expense.
The Price/Earnings ratio can help investors tell if a stock is cheap. Generally, a low P/E ratio indicates that the stock is cheap. Investors should, however, take into account that a low P/E ratio could also be a sign of bad things to come. The P/E ratio could also be low because of big one-time gains (which should be taken out when evaluating profits). Companies can manipulate earnings, or accounting rules can give temporary boosts to earnings, and these things will also result in the P/E ratio being unreliable.
Investors should add the latest annual net income figure available with net income figures from the past few years and average them out. This will somewhat give investors a more normalized view of profits. The same goes for operating income and return on equity.
Return on Equity
It isn’t difficult for companies to increase earnings. Companies can for example, take on more debt or retain earnings to deploy in profit generating projects. What’s important is the return on equity, as that is the rate of return earned on shareholders’ money.
 Here are some questions investors need to ask themselves with regard to return on equity:
“Does the increase in assets and liabilities due to the company taking on more debt translate to an increase in return on equity that’s significant enough to compensate shareholders for the increased risks inherent in holding stock in a company that has become more leveraged?”
“Can the company continue to achieve an above average return on its equity that’s constantly rising (due to retained earnings)?”
 Investors should always look for companies with high returns on equity (and if possible, rising return on equity), but should also beware of companies earning high returns on equity solely due to the fact that they are taking on lots of debt and operating on very low levels of equity in comparison to their assets.
When analyzing stocks, it is important to see if the return on equity is consistent over the long-term, even if equity has been gradually rising over the years. If the amount of debt has been rising over the years, investors need to make sure that the increase in assets paid for with money the company borrowed resulted in an increase in return on equity that is acceptable.
These are some other things that investors can factor in when evaluating a company’s return on equity:
As an organization grows bigger, it might not be able to sustain its growth without adding new products to their product line, expanding into different lines of business, or entering new markets. The company’s expanded operations might not be able to generate a return on equity that’s similar to that of its past operations (This assumes that the company uses mostly retained earnings and little or no debt to fund its growth). In this kind of situations, investors need to ensure that if the company is not able to achieve a return on equity that is as high as the past, the company has to at least achieve a return on equity that’s above average.
Increased competition is another factor that can reduce a company’s profits and ultimately the company’s return on equity.
Balance Sheet Strength
Investors should generally look for companies with as little debt as possible and as much cash as possible. I usually look for companies with current assets totalling at least 40% of total liabilities and 150% of current liabilities.
For me the more cash the company has the better, as cash allows a company to weather downturns and even take opportunities during downturns to acquire assets at depressed prices. While on the surface I think it is a good thing for a company to have lots of excess cash, I also would need the company to have a great track record in terms of using its cash wisely, whether it has been known to make great acquisitions at reasonable prices, launching share buyback programs when the company’s stock is undervalued, or etc.
Companies shouldn’t have excess cash for a long period of time as not only will inflation erode the value of the company’s cash holdings, but the shareholders will be much better off if the company paid out its excess cash in dividends.
I can’t remember the exact quote, but Warren Buffett once said something along the lines of “If you’re smart you don’t need debt, and if you’re dumb you shouldn’t get involved with debt in the first place.” I try to recall this quote every time I think about personally taking on debt to invest, or buying shares in a company that have a little bit too much debt for my liking.
I generally dislike debt, but I do understand that companies can benefit from taking on debt when the cost of debt is very low. However, I find it important that the company don’t take on more debt than it can very comfortably manage, no matter how low the company’s cost of debt is. When evaluating if a company has taken on too much debt, I generally look at book value to total liabilities, cash to total liabilities, and owner earnings to interest payments.
Another thing I look at when investing in a company that has debt is the maturities of the company’s debts in the short to medium term, and if the company is able to build up enough cash to repay any maturing debt in the near to medium term. I also look at the company’s cost of debt and will tend to exclude the stock from my list of potential investments if the cost of debt is too high, as not only will it be harder for the company to service its debt, but it is a sign that there could be something fundamentally wrong with the company that justifies it having to pay higher interest rates on its debts.
This segment of the article describes very generally some of the things I look at when evaluating companies’ balance sheets. There are of course other things that investors should take into consideration when evaluating a balance sheet.
 Owner earnings
Warren Buffett wrote about a concept he called “owner earnings” in Berkshire’s 1986 letter to shareholders. While it has been quite some time since I read about owner earnings, this is how I calculate owner’s earnings:
Net profit (I try and take out one-time gains or losses) + depreciation and amortization +/- certain      non-cash items - average capital expenditure needed to maintain current profitability and competitive advantage - increase in working capital (if there is).
Some companies might be building up cash, and this might result in a significant increase in working capital. I try to take this into account by factoring out the cash portion of the working capital increase once the company’s total cash reaches a certain percentage of current liabilities(depending on the industry the company is in and what you believe is enough cash for the company to run smoothly).
After calculating the owner earnings figure, I will discount the company’s owner earnings for the next 20 years (I use 20 years as I feel that this is the minimum timeframe for long-term investing, investors can of course use their own timeframes) to the present at a discount rate of 6-7%. I suggest applying a 6-7% discount rate, as I feel these are the returns investors can very reasonably earn over the long-term by dollar cost averaging into a low-cost index fund.  The value I get from discounting all the owner earnings to the present will be the base from which I will determine the company’s intrinsic value.
After I’m confident that I’ve roughly arrived at the intrinsic value of the company, and I believe that the stock of the company will make for a good investment, I will generally apply the margin of safety  concept popularized by Benjamin Graham and buy the stock only if it trades significantly below intrinsic value. I generally look for the market price of the stock to be at least 40% below my estimate of the stock’s intrinsic value but may require less of a margin depending on factors like high profit margins, strong cash position, and etc. No matter how sure an investor is in his or her calculation of the intrinsic value of a stock, the investor, to be prudent, should still have a significant margin of safety when investing, as this will give the investor some protection if things at the company don’t go well, if there are adverse economic conditions in the future, if the investor’s valuation of the company is off, and etc.     
Investors should note that different people may come up with a different value for owner earnings, as well as a different intrinsic value for the same company.
Competitive advantage
Companies need to have some sort of a competitive advantage if they are to produce good returns for shareholders over the long-term. A great brand or a great reputation, an effective distribution system, an exceptionally strong focus on the customer, being the low-cost producer, having a product that’s the de facto standard, and having a great business model that is incredibly difficult to profitably copy can all be a source of competitive advantage.
Economies of scale can be said to be a source of competitive advantage, but I wouldn’t, in most cases, count on it being a lasting competitive advantage over the long-term as some competitors can gain scale with time. There are also an increasing number of smaller companies that are able to effectively compete against their larger counterparts due to the fact that they are able to successfully integrate technology into their business models. Don’t get me wrong, economies of scale is great and can contribute to a company being a low-cost producer, I just don’t think it’s a very substantial long-term competitive advantage on its own.
I do, however, believe that having a near monopoly over a market is an excellent source of competitive advantage. Companies that have achieved almost monopoly status not only get all the possible advantages of scale in their markets, but also pricing power as a result of their huge market share, as well as significantly higher margins than they normally would due to a lack of meaningful competition which would most certainly put pressure on prices.
Usually, there is a reason why some companies are able reach a point where they’re almost monopolizing their respective markets. The reason could for example be a license that makes the company the sole distributor of a certain product, or the company has a product or line of products that have become the de facto standard in their product category (example: Windows engine). These reasons are the things that make these companies able to somewhat sustain their near monopolies over their markets.
Intellectual property, especially in industries like the pharmaceutical industry, can be a great source of competitive advantage assuming that the company has a great R&D department that works closely with the production and marketing departments to consistently come up with feasible and profitable products that have a big enough market potential for the company to enjoy really huge returns (needed to compensate for the risk that the new products won’t be successful) on R&D costs and the costs needed to bring the new products to market.
There are also competitive advantages that are unique to their industries. In the banking industry for example, a large cheap deposits base is a source of competitive advantage.
Great management is also a very good source of competitive advantage. Here are a few things to look for to tell if management is good:
Management is committed to enhancing long-term shareholder value. Management that aims to enhance shareholder value will do things like buyback shares when the stock is undervalued, pay out dividends when the company can no longer reinvest earnings at higher returns than shareholders can, and focus on activities that will result in long-term profits.
Management has a good track record of doing what they say, whether it is to cut costs, reduce debt, increase revenue contribution from a certain division, or etc.
Management is committed to keeping costs low. This can be seen in terms of the company’s selling/general/administrative expenses being significant lower than that of similar size competitors.   
Management is conservative. A company that is run by conservative management will have low debt levels and hold enough cash on its balance sheet to ensure that the company doesn’t find itself in financial trouble. The company will also distance itself from risky activities.
The executives own shares in the company worth significantly more than their total annual compensation.  The shares these executives own should come not only from stock options, but also from them investing their own money on their own account. While this doesn’t indicate that management is good, it ensures investors that management’s interests are aligned with the shareholders.
Management should be honest and open with shareholders, whether it’s about the current performance of the company, the company’s goals and the progress made towards those goals, the slip ups of the company, or etc.
Price & Understanding your investments
Companies in different industries are valued differently. For example: book value and cost of funds are important in determining the value of a bank, while a lot of weight is put on same-store sales figures in the evaluation of the investment appeal of retailers.
Not knowing what to look for in a particular industry, can lead to investors not being able to properly value companies in that industry. Because of this, investors should put their efforts into analyzing stocks in industries they understand, as this will increase their chances of properly identifying and valuing a truly great company. It is also important to note that great companies can be found over many different industries, and investors will be better off specializing in and really understanding a few industries (even one will do) as opposed to knowing just a bit about many different industries.
Investors should always try to avoid overpaying for stocks, and should instead just build up cash and wait for the stocks they like to become undervalued. This is one of the most basic rules in investment, and everyone knows this, but there will always be people who will still do it anyway, whether they realize it or not. A 50% loss on overpaying for a “hot stock” that has come back to ground will require the stock to go up by a 100% (which could be years) from its no longer irrational price just for you to breakeven. So, even if you are confident that you’ve found a really great stock, you should wait till the price of the stock drop to a point where if bought, could turn out to be a very great investment.