Coke, Kraft Heinz, and Campbell Soup are all market-leading companies that have generated strong growth in revenues and earnings for decades. They were at their peak when many baby boomers were coming of age, but now that those consumers are becoming older, these companies face challenges. They can continue to innovate, but if consumers aren’t changing their buying habits, then the companies won’t see much growth. Their dominance today has already come under threat as millennials are driving a shift in food preferences. I want to go over How to Distinguish Good Companies from Good Investments.
You need to understand the fundamentals:
These companies’ financial statements might not impress you. They paint the picture of a mature industry. Their revenues haven’t grown in years, and in many cases, they’ve declined. Some of them were able to squeeze out slightly higher earnings from their stagnant revenue through cost-cutting, but that strategy has its limits. All of these businesses will be around in a decade, but their revenue won’t be much different from what it is now.
But if you look at the stock charts of these companies, you will find no signs of poor performance. In fact, many of the stocks have had great performance over the last couple years. Many of these companies have very strong global brands and investors that are unconcerned about their financial viability. They ignore what they are paying for the company and only focus on one thing: its dividend yield.
Investors often overlook an inconvenient truth when they buy shares in a company that pays dividends: They end up paying a pretty penny for this dividend. If interest rates rise or if the consumption of their products change, any of these companies could be hit from both sides. Their earnings will stall, and investors will take their eyes off the dividends that these companies give out. Then suddenly investors will see these companies for what they are: classic American companies with their growth days far behind them.
One of the most basic principles of investing is that the value of a stock comes largely from the earnings it produces. That theory explains why stock prices tend to rise over time. Earnings growth leads investors to value shares more highly from year to year, as companies either reinvest those earnings into their businesses, make strategic acquisitions of other companies, or return money to their shareholders through dividends or share repurchases.
How to Distinguish Good Companies from Good Investments?
A strong reputation, a good competitive advantage, and popular brands may make a company’s stock appear to be a great investment idea. However, a study by CFA Institute and Morningstar found that securities with unpopular traits receive higher returns than those that are popular. This is because the market has already priced in any effect from a stellar reputation or large market capitalization.
For example, many investors are drawn to the equity of larger companies because of risk and liquidity concerns. Some may be drawn to companies with excellent reputations or brands. But all of that information is public: Great companies are often overvalued simply because they are great companies. A group of finance researchers have also found that companies with little or no competitive advantage produce the highest returns, albeit with a greater amount of risk.
The price in a rationally efficient market should already reflect a firm’s competitive sustainable advantage, brand power, and company reputation, so these factors should not be important to an investor who only cares about risk and return.
When it comes to unpopular assets, it can be difficult for investors to look past their poor performance. After all, when an asset is unpopular and under performs, there’s usually a good reason for that. Things like mounting losses, declining market share or a shrinking market for one’s product are often indicators of continued poor performance rather than of what one value manager optimistically calls ‘troubles that are temporary’.
