When I want new ASX share ideas, I use this surprisingly simple stock picking formula.
If it sounds familiar, it should be.
It is the same formula used by two of the world's most revered investors, Warren Buffett and Charlie Munger, according to an interview Munger did with the BBC during the aftermath of the Global Financial Crisis.
1. You must be capable of understanding the business.
This is straightforward. If you are a shareholder, you are a business owner because a 'share' is just a 'share' of ownership in a business.
For example, if you are a shareholder of Commonwealth Bank of Australia (ASX: CBA) you are a part-owner of Australia's largest bank. It's simple, but many investors forget it.
Read the annual report and understand the business before you invest.
2. The business must have a durable competitive advantage.
This is the most difficult step in the stock picking formula. Your job is to determine what feature of the business will enable it to withstand intense competition and still grow profits. This may be a brand, size (e.g. BHP Billiton Limited (ASX: BHP)), unique physical characteristics (e.g. location) or a regulatory barrier (e.g. patent).
For example, APA Group (ASX: APA) is Australia's leading natural gas pipeline owner. It would be very difficult for a competitor to uproot APA Group's business by putting in their own pipes next door.
3. Management must have integrity and talent.
If you owned a business like a supermarket and you hired a manager to run it, you would do a lot of research on the person running your company. Chances are, you may also give them some equity in the business so their interests are aligned with yours.
I like CEOs and directors with a long tenure with the company (read: experience) and insider ownership (read: skin in the game). Preferably, a family-run or founder-run business.
4. No business is worth an infinite price.
There's a saying, everyone knows the price of everything but the value of nothing. Good investors focus on the value of an investment, like shares in a company. You should purchase a company's shares for less than they are worth.
For example, the Telstra Corporation Ltd (ASX: TLS) share price has fallen 23% in a year. However, that means nothing if you do not know what they are worth!
Foolish Takeaway
This formula is so simple that few people use it. What's more, it's super-easy to understand and put into practice.
It works for me.
I'm just surprised more long-term investors aren't using it.
