Checklist series, Part 1: Keep it simple

What are the elements that go into selecting companies to invest in

One of the more valid criticisms I’ve received from readers of Low Risk Rules is that the book stops short of instructing investors on how to identify the “low risk” investments it talks about.

There are a number of reasons for this, but first and foremost was that I did not intend to write the book for DIY investors. The book’s primary target was the high net worth investor looking for a third party to implement an investment strategy on their behalf.

I thought it would be a useful exercise to outline what I mean when I talk about the kind of companies that might form the backbone of your low-risk investment portfolio. I’m going to outline the many factors that I examine when looking at a potential investment. I’m going to try to keep it high level and not too technical, aimed at a general audience. I’ll be honest - I don’t have a lot of time to spend on these pieces, only because my writing is confined to spare evenings and weekends. So they will tend to be general and any specific references could very well be wrong. But I would gladly accept any feedback on factors I might have missed, or things I might be looking at the wrong way.

The first key element to consider is that the company’s business should be relatively simple.

Ask yourself:

• How does the company make money?

• Who do they sell to?

• What factors impact sales growth?

• Is there significant technological or regulatory change that might impact the company’s future prospects?

• Is management straightforward and forthcoming with shareholders about challenges and failures?

Early in my career I had a client who was interested in a direct private investment in a very complicated entity. Nothing about this investment was simple. From the technology, to the financial statements, to the inscrutable capitalization table.

True to form, the convertible preferred shares through which we were being offered our investment came with a huge number of conditions and exclusions which would impact the conversion price. In trying to map out an estimated value for the shares, my head was swimming.

I spent hours on the phone with the CFO asking questions about the documentation. At one point, on a call with the CEO, I asked why everything had to be so complicated.

He surprised me by answering so honestly.

“Simple costs money.” He told me.

Maybe for him! But for us, simple would save a hell of a lot of money and headache.

From the perspective of the investor, complexity costs money.

My instinct was to walk away from the deal, but my client insisted on investing. No surprise - it turned out to be a disaster.

Prefer simplicity. That’s my first rule. As I work through this project, you’ll see this theme return time and time again.

This is a lesson I’ve learned over decades of hard experience. There is no situation when I have not looked back on an investment and been thankful for the complexity and fine print.

That doesn’t mean you can’t own companies that swim in complex waters, be they technological or regulatory, but it does mean that you should demand a premium for doing so, because the devil, as they say, is in the details, and the more complexity, the more places for that little bugger to hide.