At the supermarket, you don't fill your trolley at random. You check the date, the label, the price per kilo. Yet many people buy a share because a friend mentioned it. When it comes to choosing shares, the best method looks a lot like a good shopping list.
In short: choosing a share means checking that you understand the business, that it makes money regularly, that its debts stay reasonable, that its profits really turn into cash and that its price is reasonable compared with what it earns.
Mr Market, the moody neighbour
In 1949, Benjamin Graham, Warren Buffett's teacher, published The Intelligent Investor. In it he tells the story of Mr Market, a moody business partner who turns up every day offering to buy your share of your joint business, or to sell you his. Some days he's euphoric and asks a huge price. Other days he's gloomy and sells everything off cheap.
Graham's lesson: you don't have to accept. Mr Market is there to serve you, not to tell you what to think. What matters is what the business is really worth.
The 5-question shopping list
- Do I understand what it sells? If I can't explain it to a 10-year-old, I pass.
- Does it make money, and regularly? One good year isn't enough: look at several years.
- Are its debts reasonable? A heavily indebted company falls over at the first gust of wind.
- Do its profits turn into real francs in the till? Profit on paper is good; cash actually collected is better.
- Is the price reasonable? This is where the P/E ratio from our last article comes in handy.
Example: two fruit shops
- Shop A made, in thousands of francs, 10, 11, 12, 12 and 13 over five years. Average: 11.6. Little debt.
- Shop B made 15, then lost 5, then made 20, 2 and 8. Average: 8. Lots of debt.
In some years, B did better than A. But over time, A earns more, more regularly, with less risk. At the same price, the shopping list clearly favours A.
What the research says
In 2000, Joseph Piotroski, a researcher at the University of Chicago, tested a list like this one: 9 simple questions about companies' accounts (Is it making money? Is its debt falling? Are its margins improving?). Among cheap shares, those with the best scores did markedly better, on average, than the rest between 1976 and 1996. A simple list, applied with discipline, helps you sort the wheat from the chaff.
A word of caution: even a good list guarantees nothing for any single company. That's why you never put everything into one share.
Try this tonight with your child
Pick a company they know: the brand of their cereal, their trainers or their favourite game. Ask questions 1 and 2 together: "What does it sell? Who buys it? Will people still buy it in 10 years?" Write their answers down. They're already thinking like an investor.
Read also: How many years to pay back a business? · Why "a bit of everything" protects you
Further reading
- Graham, B. (1949). The Intelligent Investor. New York: Harper & Brothers.
- Piotroski, J. D. (2000). Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. Journal of Accounting Research, 38 (Supplement), 1–41.
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Educational content, not investment advice. No company named or implied is a recommendation.