Countless books have been written about what it takes to do well in the stock market. Each investor has his or her own investment style, and aspects like personality, targets, and risk tolerance are important particularities to consider when it comes to developing a successful investment strategy. However, at the end of the day, the most important drivers of long-term investment returns can be summed up in three simple ideas
1. Look for competitive advantages
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage”.
Warren Buffett
Competitive advantages are the tools that a company possesses to keep its competitors at bay and continue delivering value for shareholders in the long-term. There are different sources of competitive advantages: brands, technological superiority, cost advantages, or patents to name a few examples. Investing in companies with strong and sustainable competitive advantages can be the single most important factor for long-term success, at least according to Buffett.
Think about The Walt Disney Company (NYSE:DIS) for example, the company benefits from its tremendously valuable intellectual property which sets it apart from the competition. Disney owns brands like ABC, ESPN, and Pixar among others, and it has the rights to profit from an amazing portfolio of fiction characters, from Mickey Mouse and Tinker Bell to Spiderman and Darth Vader.
These may not be tangible assets, but they are real economic value: The Walt Disney Company (NYSE:DIS) monetizes its intellectual property through different venues like movies, shows, amusement parks, cruises, and merchandising among others. No competitor can replicate these assets, and that´s a big differentiating factor which allows the company to generate above average profitability for its shareholders through the ups and downs of the economic cycle.
When a company has strong competitive advantages, it can generate growing sales and earnings over time, and that means that the shares become more valuable with the passage of time. Investing in companies with sustainable competitive advantages means that time is on the side of the investor, and it can be a crucial aspect when it comes to avoiding the most expensive mistakes.
2. Valuation matters
Valuation can be tricky; there is no objective way to tell when a stock is undervalued or overvalued. But as a general rule, we can use valuation ratios to grasp an idea about how cheap or expensive a stock is at current prices, buying high quality for bargain prices can be a powerful tool for superior returns.
Caterpillar Inc. (NYSE:CAT) is a nice example to consider, the company has a rock solid competitive position in the machinery industry due to its brand presence, nationwide dealer network, and reputation for quality. This means that the firm is in a privileged situation to benefit from the long-term recovery in construction spending, which is showing clear signs of a post crisis turnaround, but still has plenty of upside room on the way towards historical averages.
On the other hand, economic weakness in China and other emerging markets has created concerns over demand in the commodities and mining segment, and valuation seems to be reflecting that uncertainty. At a P/E ratio of around 11.6, Caterpillar Inc. (NYSE:CAT) is trading near the low end of its historical valuation range, so it´s offering a lot of potential for investors once the scenario becomes more optimistic for the company.
It´s very complicated to tell if things will get better or worse for Caterpillar Inc. (NYSE:CAT) over the coming quarters, especially when it comes to the unstable Chinese economy and global commodities demand. But on a long enough horizon, let´s say something like three to five years, chances are that things will improve substantially, and current prices may look like a juicy bargain when seen in retrospective.
Apple Inc. (NASDAQ:AAPL) may present a similar opportunity to purchase a high quality company at a discounted valuation. Even if competitors have managed to reduce the technological gap over the last years, Apple Inc. (NASDAQ:AAPL) still owns what is arguably the most valuable brand in the hardware business, and its products command higher prices and fatter profit margins than those of the competition. Besides, the company´s ecosystem tends to generate strong loyalty among customers.
Growth in the iPhone segment has clearly slowed down due to competition from Samsung and other manufacturers; especially in emerging markets where pricing is a big disadvantage for Apple Inc. (NASDAQ:AAPL). But, the iPad is still performing strongly, with 65% more units sold in the last quarter versus the same period in the previous year, and the same goes for the iTunes segment which delivered a 30% increase in revenue for the quarter.
Tim Cook has been quite explicit about new product categories reaching the markets in the middle term, and coming from Apple, I wouldn´t underestimate the possibilities. Besides, the company has announced a huge buyback program of $60 billion through the end of 2015, in combination with a 2.70% dividend yield, this means a generous reward for investors’ patience while they wait for new products from Cupertino.
At a P/E ratio of 10.6, Apple Inc. (NASDAQ:AAPL) is substantially cheap from a historical perspective, so the company seems to be priced for lackluster growth rates over the next years. From a long-term perspective, the risk and reward equation looks particularly convenient for Apple investors.
3. Think long-term
If your portfolio has a long-term horizon, it should be managed with a long-term mentality. The media likes to pay a lot of attention to issues like short-term market movements or macroeconomic forecasts. The truth is that not even the so called experts have a big chance of consistently making accurate predictions on these matters, so investors should better spend their time and energy looking for the best companies to invest their money while keeping their eyes on long-term goals.
Investing and trading are two very different things. When investing, a stock holding should be considered in the same way as an investment in a private business. You may be willing to sell if the price offered by the market is too good — perhaps excessively optimistic — or if the business seems to be deteriorating and losing its competitive advantage. But, for the most part, actively trading in an out of positions is likely to be a losing proposition.
When you focus on the next years, as opposed to the next weeks or months, you get to make decisions with a clearer perspective and focus your attention on those things which are really important with regards to your investment horizon. Like if that wasn´t enough, this also leads to a healthier and less stressful lifestyle.
Bottom line
Selecting companies with strong and durable competitive advantages, paying attention to valuations and managing your portfolio with a long-term horizon may sound too simplistic, but that doesn´t make it any less effective. On the contrary, a simple and straightforward strategy can be a powerful driver of superior investment returns.
Andrés Cardenal owns shares of Apple, The Walt Disney Company (NYSE:DIS) and Caterpillar Inc. (NYSE:CAT). The Motley Fool recommends Apple and Walt Disney. The Motley Fool owns shares of Apple and Walt Disney.
The article 3 Simple Steps for Successful Investing originally appeared on Fool.com.
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