To find great companies, look for bad ones

If you're searching for good businesses, you may be asking the wrong questions. 

It seems like a foolproof method: if you want to find great businesses, use an online screener to filter for qualities like high returns on capital, wide profit margins, lots of free cash flow etc. You'll find plenty of stocks that meet your criteria.

Unfortunately, there'll be plenty of zircons masquerading as diamonds too. Capitalism being what it is, a company earning good results today can expect plenty of competition tomorrow. For it to continue earning great returns, it needs a sustainable competitive advantage. 

Charlie Munger, Warren Buffett's deputy at Berkshire Hathaway, knows how to find great stocks. 

'Frequently, you will look at a business having fabulous results,' he said in his biography Damn Right!'But the question is, 'How long can this continue? 'Well, there's only one way I know to answer that. And that's to think about why the results are occurring now ... and then to figure out what could cause those results to stop occurring.'

Mathematician Carl Jacobi isn't a household name but he had a great approach to solving problems: 'Invert, always invert'. In other words, you can often find the solution to a problem, not by searching for that solution, but by excluding everything else.

When trying to decide whether a business is a great one, it often helps to flip the question around and ask 'what would make this a lousy one?' After running a positive filter for traits you want in a stock, go one more step and filter for the negative too.   

Here are three negative filters we like to use at Intelligent Investor

Bad balance sheet

Few things cause as much trouble in business as a leveraged balance sheet. A large amount of net debt or a low interest coverage ratio could spell trouble, even for the best companies. Small dips in sales can quickly swing the company to a loss, and declining asset values can wipe out shareholder equity. Debt magnifies the downside.

Excessive leverage also has a way of encouraging dilution. Good but leveraged companies that hit a rough patch usually don't have difficulty raising capital - as Westpac did, for example, in 1992 - but shareholder returns will be anchored if a company has to issue stock at knock-down prices.  

Poor management

As the saying goes, 'you can't do a good deal with bad people'. Watch for things like overly promotional language or managements talking endlessly about industry trends, rather than the specifics of the company's strategy or product. Good management teams tend to use matter-of-fact language and don't sugarcoat bad news or consistently blame it on external factors. Anything else, and it might suggest management is trying to mislead you.

Excessive salaries or the liberal use of stock options - which quietly transfer the company's ownership to insiders - is also a well-trodden path to poor shareholder returns. Nepotism is another. 

Rising competition

As we mentioned earlier, good results tend to attract competitors. Truly high-quality companies have sustainable advantages that insulate them from competition - things like economies of scale, strong brands, government licences, and patented technology.

When we recommended members avoid Mayne Pharma (ASX: MYX) 18 months ago, one of our major concerns was growing competition in the US generic drug market due to low barriers to entry. Since then, it's become so bad that only a third of generic drugs approved by the FDA last year were actually launched, because companies can't sell them profitably. Mayne's share price has fallen 25% since then. 

If you find a seemingly great company, look at what is happening in the wider industry. Have dozens of new business licenses been issued recently? Or is the industry consolidating towards an oligopoly? It's harder to build a sustainable competitive advantage in an industry with low barriers to entry. 

By following up your positive investing filters with a few negative ones - poor management, excessive debt, and rising competition - you're more likely to avoid the disaster stocks masquerading as gems.


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