Every investor will have their own criteria appraisal techniques but there are basic fundamentals which form part of most investors’ selection analysis.
One method is to apply the old fashioned stress tests as used by the Banks in considering Loan applications. To this day the criteria are still as relevant to Investment selection as Loan applications. The tests were known as the “Three Cs of Banking.”
The First Test Was “Character”
- Who are we dealing with? Who are the people involved?
- What have they got to lose if this project fails?
- What is the reputational risk to the people involved if the project fails to meet expectations?
- Are there any skeletons in the Key Personnel’s previous ventures?
- What is the performance of previous company projects?
- Above all, Are they people of integrity?
Unless the conclusion reached was favourable the matter seldom proceeded beyond this point.
The Second Test Was “Capability”
Assuming the key personnel are judged to be of good character the next step is to assess the underlying basis of the investment and the prospects of success of the project. This assessment may include considerations such as:
- Reality checks on growth and profit assumptions.
- What market research has been carried out?
- How much competition is there?
- Is the capital requirement sufficient to meet the companies’ objectives?
- Do the projections include for unforeseen challenges?
- What margins for error have been built into the forecasts?
- Will the time horizon for the anticipated returns fit into my portfolio objectives?
The Third Test Was Collateral
In the context of investment this test is designed to explore the potential outcome if the investment fails.
- What protection exists if the company fails to meet its targets or in the worst case scenario ceases to trade?
- What is the likelihood of the company entering into administration?
- What assets do the company own in the event of Liquidation of the company?
- What is the tax position on the investor losses?
The conclusion is investment risk can be managed by applying the above considerations to the potential investment. Very few investors get it right every time but a significant number build balanced portfolios that ensure the gains exceed the losses.