How to invest in the right business

I came across a good article in the Star today, "How to invest in the right business" by Ooi Kok Hwa. I have extracted some good points, with my comments:

Warren Buffett, in his address as chairman to Berkshire Hathaway shareholders, said he uses four main criteria to select the right business: (1) a business that he understands, (2) one with favourable long-term prospects, (3) one that is operated by honest and competent people; and (4) is available at a very attractive price.

(1) a business that we buy must be simple and have stable and predictable future cashflow. Understanding a business will allow you to make better judgement on the profitability of the business; major opportunities or threat ahead and etc. That is the reason why, most of Warren Buffett's holdings are very easily understandable businesses, like fast food, theme park, razor blades, newspaper, insurance and etc., which most, if not all of us will come across everyday. He doesn't want to touch those high tech companies that he doesn't understand. That's also why, he was not hurt during the high tech meltdown in year 2000. So, very simply, just ask yourself "will this business make money in the coming years" before you buy any stock. If you can answer it confidently, you certainly have met the first criteria.

(2) For a company to have favourable long-term prospects, it needs to have a good economic franchise (good brand name), strong long-term pricing power, and high entry barrier (difficult for a competitor to set up another similar kind of business). A company that has strong pricing power and purchasing power will enjoy handsome profit margins. One example of this kind of business is Coca Cola, one of Buffett's long term favorite. Other famous holdings of Buffett also include McDonalds, Walt Disney, Washington Post and many more. These are companies that have dominant control in their market respectively and are very difficult for someone else to enter the market overnight.

(3) Investors must choose a company with a management of unquestionable integrity. This is one criteria that Warren Buffett put alot of emphasis on. There are many cruel examples out there on the streets which have washed away hundreds of millions of hard earned money from investors. Hence, investors should always check on the integrity of these managers. Investors need to be careful when investing in companies with high expansion, high trade receivables and poor internal controls. I agree this is one field that is very difficult to justify. One of my ways is by looking into a longer past trends of the company's history. I also like to look at the Director's remuneration package compared to the company's performance. Besides, do your homework in reading more business related news from the paper or internet, where you might be able to find out a thing or two about the company's directors.

(4) Lastly, we will only buy a business if it provides a "margin of safety" These are described by Warren Buffett as the 3 most important words in Finance. According to Benjamin Graham, if a company is selling at a 33% discount to its intrinsic value, the investment is said to provide a margin of safety. One mistake that most investors made, including myself, is overpaying for a business. There are companies that meet all the 3 criterias mentioned earlier, but these do not justified them to sell at super-high valuation. This is one of my main concerns on the China's market. It is undeniable that many China's listed companies have huge potential and are growing rapidly, but, most of them are selling at "mind-blowing" valuation. These are all so similar to the IT boom few years back in the Nasdaq market, where people were chasing high the high profile internet stocks like Amazon, Yahoo and etc, not to mention those that no longer exist today. These are called "over-hyped" valuations.