A Stocks and Shares ISA can be a nice little earner over the long term. Then again, I might put more money in than I end up getting out. How well I do depends on the investment choices I make.
Simply finding great businesses is not enough. I need to find great investments. Those are not necessarily the same thing.
Here are three things I consider when looking for great investments at bargain prices that I can add to my ISA.
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1. Is it a great business model?
The first question I have about a business is how big its potential customer market is likely to be and what it has that can set it apart in that market.
Rolls-Royce operates in a market where plane engines sell for millions of pounds each. So, even though there are likely to be a limited number of customers, the market is sizeable and set to stay that way. Its proprietary technology and installed customer base are both a competitive advantage for Rolls.
By contrast, one of the concerns I have about my holding in boohoo is that its competitive advantage seems to have shrunk. Its results published today (8 May) showed shrinking sales and a big loss. Boohoo indeed!
A strong competitive advantage, by contrast, ought to give a company pricing power even when sales revenues are in decline.
2. Do the finances look strong?
But earnings do not tell the full story.
One common mistake people make when they start investing is ignoring a company’s accounts. But they are important to understanding how a company is priced. The net debt (basically, debt minus assets) on a company’s balance sheet can turn an otherwise attractive business into an uninvestable one for me. Aston Martin is a case in point.
Debt is not always a bad thing for a business, but it does affect valuation.
Vodafone has a price-to-earnings (P/E) ratio of seven. On its own, that may sound like a bargain for my ISA. But it also has net debt of around £31bn.
Earnings matter when valuing a company – but so does its balance sheet.
3. Is the valuation attractive?
As it happens, I own Vodafone in my ISA too. I think it has risks (all companies do), but I like its valuation relative to the company’s business prospects.
The opposite is true for Intuitive Surgical (NASDAQ: ISRG).
Its business model seems fantastic. It builds, sells, and services robots that help perform medical surgery. The medical market is huge and resilient. Customers are often not price sensitive.
As some of the surgery tools need to be replaced after each procedure, Intuitive has an ongoing service revenue stream on top of product sales.
Plus, the more of its machines in use, the more Intuitive can build up best practice guidelines based on real world data. That helps make its offering even more compelling.
As to its balance sheet, Intuitive ended its most recently reported quarter with $7.3bn in cash, cash equivalents, and investments.
However, its market capitalisation is $138bn and the P/E ratio is 70. That leaves me no margin of safety if the business hits a bump, from a cyber attack to AI-enabled competitors eating into its market share.
For my ISA, I want to buy great companies – but at the right price!
