‘What makes a good investment?’ is a question that I have been asked a number of times and that I will try and answer in this short post. For a starter, I would like to differentiate between investment and speculation as defined by Ben Graham. The main difference between the two is risk. With speculation, you are making a bet on the future stock movement of a given company, for which you may or may not know anything about (high risk). With investment, you make a calculated analysis of the company’s growth prospect, irrespectively of its stock price (for a starter) (low risk c.f. below).

In order for an investment to give you a satisfactory return, you thus want to purchase a company (or part thereof) at a discounted price to its current or future value (as calculated during your analysis). This is when the stock price comes in… with a publicly-trading company, the price at which you will purchase the stock of the said company will be determined by the market. The key is thus to buy the stock when it is trading at a significant discount to what you have calculated previously.

Finding companies matching these criteria is surprisingly easy since it depends on the analysis you have carried out and how you interpret a ‘significant discount’. Here are a few examples:

• Ben Graham (and many other value investors) define this criteria as to when the stock is trading below the company’s net working capital
• Venture Capitalists and Private Equity-st understand a similar concept as they are investing with the assurance that the company’s present value is below the company’s future value

Because the market is not perfect (otherwise arbitrage companies would never make money), companies’ stock will sometimes match the above criteria on several occasions that do not change the company’s value (significantly). For instance:

• If the whole market is depressed like in a bear market
• If the company recently received some bad news (for instance, it missed its quarterly targets)
• If the company is currently considered ‘uncool’ by investors (c.f. IT bubble of 2000)
• Any other reason you could think of…

Obviously, this kind of investment assumes that the company’s ‘cheap’ stock price will eventually reflect (and surpass) the valuation that you have made above. This part of the theory is backed by empirical data and analysis provided by Ben Graham, Warren Buffet and many other value investors.

The question thus remains: how would you define a company that you think will make a good investment… and that will be left for another post.