The following are the characteristics of a safe stock/company:
- It has a high-quality and ethical management team.
- It is surrounded by a reasonably strong economic moat.
- It is shareholder-friendly.
- Its revenues, profits, and operating cash flows are either growing or stable.
To figure out whether a stock is safe to invest in, look for the following factors:
1. Ethical and High-Quality Management
A high-quality management team ensures:
- Teamwork: The senior management encourages teamwork and ensures that the whole (end result) is greater than the sum of its parts (individual effort).
- Focus on Customers and Stakeholders: The management keeps the company laser-focused on its customers and their needs, present and future. The management team focuses on making high-quality products, gathering customer feedback from time to time, and improving products and services based on the feedback gathered. It is not just the customers that such companies are focused on – they also pay attention to the needs of their investors, employees, vendors, and the community.
- Qualifications: A quality company employs highly-qualified, experienced, and professional management team members. A strong senior management builds efficient smaller teams within the organization, sets the organizational goals and objectives, ensures productivity, creates a process-driven culture, and generally makes the work more meaningful and pleasurable.
- Monitoring the Company’s Growth: A professional management team always keeps up-to-speed with the company’s progress and is a step ahead in laying the path for the future. Such a team minimizes the risks and maximizes opportunities, and all their decisions are rational and based on facts, knowledge, and evidence.
2. A Strong Economic Moat
In stock market jargon, an economic moat can be any one or more of the following:
- A competitive advantage that a company has built up over the years because it has become a well-known and sought-after brand, or solid assets and cash reserves that the company has built, which help it gobble up the competition as soon as it appears threatening.
- Entry barriers – A company with a strong economic moat creates very high entry barriers for newcomers. Entry barriers can be an exorbitant setup cost, an unshakeable brand, or the company can enjoy unmatched economies of scale.
- Easy access to low-cost capital – this becomes possible, for example if the company has developed a niche, cutting-edge product that is perceived to have a bright future by venture capitalists or the public. Such companies spend millions on research and development and build edgy intangible assets. Note that such companies may not be profitable in their formative years: for example, $AMZN, $TSLA.
- A product that is so edgy that customers just want to own it. Also, people who buy the product spread the word about its usefulness, creating a network effect: for example, $AAPL.
A shareholder-friendly company is one that:
- Provides clarity about its dividend and buy-back policies – Such companies spell out clearly how, and under what circumstances, will profits be distributed among the shareholders. Note that such companies buy back the stock only when they believe that it is under-valued.
- Requires the senior management and other executives to own stock in the company to ensure that they have skin in the game – The idea is to make the management-level folks think that they are running their own business and are not just employed in a 9–5 job.
- Creates efficient internal control measures that promote robust corporate governance practices – Related-party transactions are disclosed and conducted at arm’s length. Corporate scandals are rare, if at all, in such companies.
- Ensures that the CEO and the executive team are not excessively compensated – Also, such companies monitor the performance of their employees regularly and weed out the non-productive workers.
- Ensures that voting rights are granted in a way that does not abuse minority shareholders’ rights.
- Communicates efficiently and transparently with its shareholders.
4. Growing Revenues and Profits
If a company has an efficient and progressive management team, and is surrounded by a deep and wide economic moat, it is natural that it will keep growing its revenues and profits. Such companies are very agile and they change business strategy at the first sign of any macro-economic development. You will be surprised to learn that companies that scaled up their technology adoption and innovation after COVID-19 landed went on to grow their revenues 5× times more than their laggard competitors!
If you come across a company with the aforesaid characteristics, you may assume that it is a relatively safe stock to bet on for the long term. Try and seek out a mid- or small-cap stock with these qualities because such stocks can go on to become multi-baggers. While a large-cap stock with such traits will also reward its shareholders, it may not appreciate as much as mid- or small-cap stocks because most large-cap stocks have already put on a whole lot of weight after the Fed slashed interest rates post the COVID-19 event in March 2020. Happy stock picking!