The ASX is home to over 2,000 listed companies, giving you a lot of choice when it comes to making an investment.
For many investors, however, there are a lot of companies which can be excluded straight off the bat. This is due to their size, illiquidity (infrequently traded) or speculative nature. But that still leaves a significant number to sift through.
That's where the below three checks come into play. Finding an answer to each of these can help you significantly narrow the field, and may leave you sleeping better at night.
Know your company
It sounds simple and obvious, but many people forget this check. Maybe this is because it's simply too obvious, or perhaps investors forget what buying ASX shares means – buying part of a company. But this is where your courtship with a company should begin, where all great love affairs start: getting to know each other. Buying a company just because a friend recommended it probably isn't going to work out. Much like a blind date.
However, in this case, it's a little one-sided. It's only you who has to do the 'get to knowing'. But it shouldn't be overstated, and may mean different things for different people.
Some people will want to know everything they can about a company before investing. Reading back over a few years of company reports and announcements. Combing through the balance sheet, checking fundamentals. Looking into the company's cash flow management and inventory cycles. It can be fairly endless how far you wish to go.
But many people don't have the time to do all of these checks, or simply are not sure how to perform some of them. And that's ok. That doesn't mean they shouldn't look to invest in ASX shares. A great start is just understanding what the business does. In its simplest form, it may mean asking yourself:
- What does the business make, or what is the service it provides?
- How does it plan to make a profit from this?
- Where does it operate?
- Who is its target audience?
Just knowing the answers to these few questions will tell you a lot. And if you find it hard to understand what the company does or how it does it, it may be best to steer clear. Investing in companies which are esoteric can be a recipe for disaster. Not just from a returns point of view, but also from a comfort level. It can be uncomfortable and stressful owning a company you don't understand. And we don't want to be losing sleep over it.
A great place to start might be with a company you're already familiar with, such as Woolworths Group Ltd (ASX: WOW), Telstra Corporation Ltd (ASX: TLS) or Commonwealth Bank of Australia (ASX: CBA), and learning a little more about it through a Google search or reading one of its results presentations.
Looking ahead
This check really builds on from the first point about knowing the company and is really about knowing the company's future. Well, having a thesis about it anyway.
I believe the best way to invest is for the long-term, looking at a minimum time frame of 2–3 years, but ideally greater than 10. That's when the true effects of compounding come to fruition. Also, over this time, you should get to know the company very well, staying up to date with its announcements and business decisions.
For this reason, before investing I think it's important for investors to believe the company to have a bright future, with its product or service still being relevant for many years to come, or at least capable to adapt to changes in market dynamics.
So, whether it is a growth company or a dividend payer, make sure you have a firm conviction that it can continue growing, or paying a steady stream of dividends. In my view, a company such as Rural Funds Group (ASX: RFF), which has a strong pipeline of future revenue to allow its continued dividend growth and payment, or ResMed Inc (ASX: RMD), which has a large addressable market, are examples of what to look for.
Management
One last check is to look at a company's management. These are the people who make the big decisions about the direction of the company, so it's important to make sure that their values are aligned with the company and its shareholders. After all, it is the management in charge that are in control of creating value for the shareholders.
Some simple checks are to make sure that management's compensation is in line with other companies in the same industry. Another good indicator is a founder-led company, or a management team with significant tenure. People who are willing to stick with the company over the long-term.
Additionally, having 'skin in the game' is a strong indicator. This involves looking to see if key management personnel personally own shares in the company and if so, whether this ownership stake is significant. After all, what greater incentive could there be to run a company well than having your own savings invested in it.
Foolish takeaway
Although the above checks by no means constitute an exhaustive list, I believe they are certainly a great place to start.
