Value Investing Principle #2

Today I’m going to talk about Value Investing Principle #2.

Value investing has 4 easy principles for you to follow which have helped me to get pointed in the right direction on how to decide which stock to buy. If you want to read more about the 4 principles, check out here. Let’s jump into the second principle now.

Value Investing Principle #2: The business has a natural quality to it that provides an advantage for it.

Not all businesses are created the same. And remember, when we buy a stock we have the mindset that we’re buying the whole business. Meaning, we need to assess the whole business when it’s on our radar and we’re deciding if we should invest in it or not.

Businesses often start out for the same reason - they’re trying to help a customer with a problem they’re having but after time passes, businesses start to go on different paths. Some paths are more successful than others. This is when differences between businesses become apparent. Some businesses seem to do a whole heck of a lot better than others. Have you ever wondered why this is?

Value Investing principle #2 sheds some light into why some businesses do better than others. They have a natural quality about them that gives them an advantage against their competition. It allows their business to last for many years when their competitors aren’t able to. A good word to describe principle #2 is a moat. 

When you choose a business to invest in (buy stock in), you want to be as certain as possible that the business will not only be around in the future but also be successful. Principle #2 helps with predicting if a business will be around in the future because it identifies its natural lasting quality. Some businesses have more than one lasting quality.

How can you tell if a business has a natural quality to it that provides an advantage for it?

It has to do with five numbers that all businesses will share with you on their financial statements. From these five numbers, you determine the growth rate of each one and they’ll let you know if the business has a moat or not.

1. Return on Investment Capital (ROIC)
2. Sales growth rate
3. Earnings per Share (EPS) growth rate
4. Equity growth rate
5. Free Cash Flow growth rate

You’ll want to create a spreadsheet that tracks the last 10 years for each number above. Then find an online resource that’ll help you calculate the growth rate of each. By calculating the growth rate of each of the 5 numbers, you’ll have a window into the future based on how the business has done for the last 10 years. If each number is growing at or equal to 10%, there’s a moat present which will likely help it to continue growing at that same rate. 

Curious to know more about different types of moats? I’ll dive into this in my next article.

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