There are many companies listed on stock markets in Australia and worldwide so when it comes to deciding what companies to research first, it can seem like a daunting proposition.
The good news is that although there are over 2,000 stocks listed on the ASX, there is a vast array of companies, representing different earnings profiles, sectors, and sizes.
That’s why understanding your investment universe is important. Simply put, your investing universe is the basket of companies you believe are a good fit for your knowledge, investment goals and risk profile.
Once you start to narrow down the list of stocks, you’ll find your watchlist is much more manageable.
Download the entire company list
First of all, how are you going to define your investment universe is you don’t know what it contained in the entire ASX universe?
Go the ASX website and download the CSV file of the Official Company List.
Alternatively, I’ve prepared an Excel file with a bit more sector information to help with narrowing it down.
Work out your risk profile
A risk profile is a very personal thing. It indicates your propensity to take on risk based on the expected reward. If you have a high risk tolerance you might be more prepared to take on higher risk investments. For example, small cap companies are generally considered higher risk as they are less established businesses and there is more reliance on management.
Another example might be companies that are currently not making a profit but are growing rapidly and investing heavily in the product with an aim to be profitable in the medium term. If you have a lower propensity to risk you might go for larger, more established companies – such as those in the ASX200 – with more stable and predictable earnings, but less likely to shoot the lights out.
Work out your circle of competence
Warren Buffett is famous for avoiding technology companies for most of his investing career. Of course, that is until Berkshire Hathaway’s recent investment in Apple (NAS:AAPL). The reason for this is that Buffett is the first to admit that he doesn’t understand tech companies.
To be able to make an investment that you are comfortable with, you need to be able to understand the company. Firstly, what business models do you understand? And what are the risks specific to these companies?
Buffett said in his 1996 letter to shareholders:
“You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
If you can’t understand the risks, you can’t understand or analyse the company.
A part of this is finding sectors that also interest you. You are far more likely to research sectors you find compelling than something that bores you.
So, using the list of companies, filter out the companies in the sectors that you either don’t understand or aren’t interested in.
Think about investing like buying a small business
This is good advice regardless of what investment you are making. Rather than thinking about buying a small portion of a large business, which feels like just a fluctuating ticker on a page, compare it to purchasing 100% of a local business using all of your net worth.
Would you purchase a small business in an industry you didn’t understand? In most cases the answer would be “no” because you want to give the business every chance to succeed.
While the small business scenario might imply you take managerial responsibility as well, I think the illustration is relevant.
If you don’t understand the industry, you can’t effectively analyse the risks.
Granted, it might be an excellent business with good management, but part of investing is being able to accept that you will miss opportunities.
Warren Buffett discussed this at the 1998 Berkshire Hathaway AGM (NYS:BRK).
Defining your investment universe is important because there are many thousands of companies vying for your attention, so rather than spreading yourself thin by learning a little about a lot, focus on knowing a smaller number of companies really well.
Once you’ve defined your investment universe you can start narrowing down even further based on quantitative factors such as earnings profile, valuation, and growth prospects.
Farnam owns Berkshire Hathaway in the International Opportunities Portfolio.
This document has been prepared by Farnam Investment Management Pty Ltd (Farnam) ABN 15 149 971 808 AFS Licence 430574. Australian Unity Funds Management Limited ABN 60 071 497 115 AFS Licence 234454 is the responsible entity of Farnam Managed Accounts. While every care has been taken in the preparation of this document it does not contain any recommendations to buy or sell any particular stock(s) noted. Farnam makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.