Drawing from Warren Buffett, who famously said, 'I only invest in businesses I can understand,' and 'the more focused on its core business, the better'.
Of course, it also needs to be 'highly profitable' and, ideally, have 'honest leaders'.
Therefore, we define a 'great company' as: 'A highly profitable company, run by leaders with integrity, with a business model that's easy to understand, and that stays focused on its core'.
It's the kind of investment that lets you sleep soundly at night.
A Business You Can Understand
It's best to stick to business models that are within your 'circle of competence'—ones you can actually understand. That way, you can reasonably predict how they make money and what might cause them to lose it. Chasing hot industries you're unfamiliar with is never a good idea.
Your Area of Expertise
Value investing legend Peter Lynch said that everyone has an 'information edge'—and it's usually from their own line of work. You obviously understand your own industry better than an outsider, right? That's an immediate advantage. This is the exact 'information gap' a value investor should capitalize on. Go invest in those familiar industries!
Closely Tied to Everyday Life
Both Buffett and Lynch loved finding ideas in their everyday lives. They 'dig up' companies that are doing great business and have easy-to-understand models. Think of Coca-Cola, the top-selling soft drink; The Body Shop, which was always packed with customers; or Taco Bell, which seemed to be popping up on every corner. These are all perfect examples.
Focus on the Core Business
Great companies usually share one key trait: they 'Focus on their Core Business'.
They don't randomly dabble in fields they aren't familiar with. Instead, they focus on developing their 'core competencies'. When a business can stick to what it does best — and constantly optimize and innovate—it builds a unique competitive advantage.
For example, a food company that focuses on developing new products and improving its supply chain efficiency is bound to get stronger. But if it 'diversifies' by jumping into real estate, there’s a high chance that 'diversification' will turn into 'diworsification' — a total disaster.
Highly Profitable
The company you invest in 'has to be highly profitable.' (I mean, that's the whole point of investing, right?)
'Profitable' can be defined in many ways: high revenue, high gross margins, strong free cash flow, etc. You can use whichever definition works for you, and we'll dive deeper into those later.
ROE
On top of that, there's Return on Equity (ROE). For value investors, this is a classic, 'go-to' metric—it's one of Buffett's all-time favorite measurements.
The formula is Net Income divided by Shareholder Equity. Basically, it tells you how much profit the company generates for every $1 of equity the shareholders own.
If you're serious about value investing, this is one you'll definitely want in your toolbox.
Leaders with Integrity
Having a great leader is obviously important, but it's hard to quantify what 'great' means.
What you can do, however, is judge a leader's integrity. You can verify this by looking at their track record of public statements or earnings calls. In today's age of information transparency, this is easier than ever.
A company led by leaders with integrity is a non-negotiable if you plan to hold a stock for the long haul.
Comparing Against Itself and Its Peers
When picking a company, you need to compare it against its own history (year-over-year) to determine if it's improving or declining. It's best to look at companies that have been around for at least 10 years. The data is more stable, and at the very least, it proves the company has 'staying power.'
On top of that, you must compare it against its peers in the same industry. Ask yourself: 'Company A is good, but is there someone even better?' A value investor needs to find objective data to back up their judgment.