Many moons ago — long before your mate’s dad’s cousin was buying Afterpay Touch Ltd (ASX: APT) shares — I received a piece of investment advice that stuck with me:

“Successful investing might have more to do with avoiding poor quality businesses than identifying great quality businesses.”

Nearly every day I’m reminded how true this is. Even in the hottest sectors today, such as technology, lesser quality companies can be a ticking time bomb.

Take Citadel Group (ASX: CGL), the Canberra-based technology small cap. Its shares fell 35% on Friday. It’s a company I’ve followed for months.

Why have I followed for so long?

It’s one of the few Australian/ASX technology companies which appeared to be growing in a virtual no-growth economy.

However, relative to other high-quality Software-as-a-Service (SaaS) businesses like WiseTech Global Ltd (ASX: WTC) and Pro Medicus Ltd (ASX: PME), I think Citadel is lower quality.

I’ve avoided buying shares of Citadel for the Rask Invest model portfolio because it’s lower quality than some other tech businesses I could buy (on the ASX or globally) and it’s slightly outside of my circle of competence.

So although I’ve invested a great deal of time and effort into researching Citadel, I’m still a long way from pulling the trigger.

(Having said that, my opinion could change at any time. Especially, if the company can deliver on its ‘Citadel 2.0‘ strategy.)

What Makes A Low Quality Company?

Rather than blow my own trumpet, it’s probably worth sharing some tricks and tips for identifying what makes a company ‘lower quality’ and how you might avoid the next ASX blow-up.

First, it’s important to know how your company grows, or at least plans to grow.

I almost always avoid companies attempting to grow via acquisition.

Why?

Look at the share price charts of G8 Education Ltd (ASX: GEM), Slater & Gordon (ASX: SGH) and BWX Ltd (ASX: BWX) and I reckon you’ll notice one thing:

You can buy them for a good time, not a long time.

In other words, some companies can pull off an acquisitive growth strategy and it’s usually a good ride for the first one-to-two years. However, sooner or later, chances are, shareholders end up paying the piper.

If that sounds a bit confusing, think about it like this:

If the company’s current products or services are so fruitful, why do they need to buy other companies?

Far and away I prefer to buy shares of companies that can grow organically. That is, by expanding their current product or service in new and exciting ways.

Companies which can grow organically tend to be higher quality companies because they often have a premium product (think Tiffany’s versus Zamel’s), great management, a net cash position and years of untapped growth potential.

Simple. Not Easy.

The thing about investing in the highest quality companies is there are few of them available in Australia — or even overseas. Moreover, even fewer have shares trading at sensible valuations.

Nonetheless, even the best companies can be found trading at fair or even bargain prices from time-to-time. But there is a catch…

You need patience.

And in more ways than one.

For example, patience in holding onto the shares you own is one thing.

But where many Aussie investors get it wrong is in the buying.

Some investors think that because they spend a week, month or even a year researching a company’s shares that they must then buy the shares. After all, if you work hard you should be rewarded with better returns, right?

Wrong.

Investing doesn’t work that way.

Take, for example, the work we’ve been doing for Rask Invest members on the entertainment software industry. I’ve been looking at this sector since 2018 and I still haven’t bought one share. Not one.

And investing is my full-time job!

Sure, it’s been painful to see shares in some of these software companies rise 20%, 40% or 60% since then. However, it’s also meant that we’ve avoided the blow-ups, much like BWX and Citadel.

Everyone Has Some Losers

To be sure, I’ve got my fair share of battle scars.

For example, I bought Slater & Gordon shares before they tanked. I overlooked its Work In Progress accounting trick and my family’s portfolio, which I was running at the time, suffered deeply.

Fortunately, I ‘downgraded’ management to the lowest quality when they expanded aggressively overseas. I avoided much of the fallout.

I also recommended Locality Planning Holdings (ASX: LPE) shares to Rask Invest members late last year. It is, by far, Rask Invest’s worst loser. I have investing PTSD just thinking about it.

From the date of my ‘Buy’ recommendation to the date of my ‘Sell’ recommendation, the Rask Invest model portfolio incurred a loss of 28% in shares of this small energy company.

Fortunately, I find comfort in knowing that, thanks to our research, Rask Invest members who followed our share ideas are still likely to be sitting on returns well in excess of the market’s return.

That’s not bad if you consider we launched Rask Invest to the public in June 2018 — less than one year ago — and we run a very concentrated model portfolio service which currently includes just 9 of our best investment ideas.

Why We’re Sitting On 40% Cash

Some Rask Invest members ask me — and rightly so — why our model portfolio has more than 40% cash despite our average returns being so good, so far.

My answer is simple: when a company meets our high standards of research and its shares trade at a reasonable valuation, we’ll act. I’ll buy in, in a big way.

Until then, a hefty cash balance will enable us to capitalise on the best opportunities, usually during times of heightened market uncertainty.

Again, the tricky part is remaining patient and trusting in the fact that around once per year the share market can be expected to fall materially. Sooner or later, patient investors like us will get an opportunity they can’t resist.

Cheers to our financial futures!

Owen 

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Disclaimer: Any information contained in this article is limited to general financial/investment advice only. The information has not taken into account your specific needs, goals or objectives, so please consider consulting a licenced and trusted adviser before acting on the information. Please read The Rask Group’s Financial Services Guide (FSG) for more information. This article is authorised by Owen Raszkiewicz of The Rask Group, which is a corporate authorised representative No. 1264179 of Strawman Pty Ltd (ACN: 610 908 211) (AFSL: 501 223).

Disclosure: At the time of writing, Owen owns shares of Pro Medicus. They have a ‘Hold’ rating inside Rask Invest.