One of the more difficult parts of navigating a falling market is when to start buying. It’s easy to become overly bearish as markets fall and sentiment becomes negative. To be clear, while markets especially overseas have fallen substantially, I still think there is more pain ahead. But that doesn’t mean there are not opportunities to buy specific stocks emerging or that it’s too early to think about the types of companies we want to buy down the track once prices have fallen further.
When looking at the universe of companies to invest in you come across a range of business models. But what types of businesses and business models are best? To an extent it depends on the company and industry. Ultimately, you want growth over the long term and reliable profits. Easier said than done, especially in today’s world where technological disruption can reduce a once great business to an also ran in 5-10 years.
There are two critical elements to investing in stocks. The first is identifying great companies. The second is identifying the price you should pay for that companies shares. These are completely separate issues. Both are critical. While seemingly obvious they are often overlooked by investors. But what types of companies are best? What are the common traits the great companies have that the others don’t have?
I think for the next couple of years it's going to be difficult for a lot of companies that produce physical products. The price of all the materials and components are going up. It's really difficult to source some commodities, especially electronics for example. Then you’ve got supply chain issues which compound all these issues and make it a logistical nightmare for companies to ship their widgets to the stores.
For that reason, I do think that software will come back into favour at some point when everyone realises that there’s no shortage of software product. The Software as a Service (SaaS) business model is a great business model. It doesn’t cost a lot to add a new subscriber. The right software product is a very attractive business. But not all software companies are the same.
The ideal business for the next few years in my opinion has the following traits:
Competitive advantage that is difficult for others to replicate
Business customers not consumers
Pricing power to fend of rising inflation and costs
Network effects
Not making a widget or product where cost inputs are going up dramatically
Growing profit
Reliable subscription revenue
Customers don’t leave – low churn
An example of this type of business would be Microsoft. Microsoft is a great business. It ticks all the boxes I am looking for. As things get tough economically businesses are not going to cut their Microsoft Office 365 subscriptions. There are few reliable alternatives. There is no brand more synonymous with your daily work that Microsoft. Everyday hundreds of millions of people depend on their software, tools, and apps to run their business. They are essential. It's all cloud based and growing.
Apple is another example. It’s a cash cow and a juggernaut. In the very short term given Apple makes hardware I think it’s going to have some issues generating the same level of profit and sales volume in the next 12 months. They are facing a possible consumer led recession, supply chain issues, semiconductor shortage and cost inputs going through the roof. But all these items are one offs. In say 1-2 years they will all have been solved to one extent of another. Apple is such a unique and dominant brand that is well positioned to weather the economic storm ahead.
This may well present an excellent buying opportunity as many unusual factors come together at the same time to uniquely impact the stock.
The business model of the companies you invest in have never been more important. They are going to be tested by the difficult circumstances ahead. That context is important. How does the company and its business strategy hold up under pressure? How does it perform in a recession? With inflation? These are important questions that you should consider for not only every stock you buy going forward but for every stock currently in your portfolio.
General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.