Why This Book?

We have all heard about Warren Buffett and Charlie Munger’s approach to value investing. A fundamental premise of that style of investing is that you need to find undervalued companies whose prices fall below their intrinsic value and that will do great in the long run. I have long wondered how to do that, and some of my recent finance studies have given me an idea; this book is one piece of the puzzle.

The logic goes as follows: First, we need to figure out how to calculate the intrinsic value of a company — a topic covered in my separate valuation notes (either using Discounted Cash Flow analysis or relative valuation). Second, we need to find undervalued companies that will do well in the long run — and this is what Pat Dorsey argues in the book: “do well in the long run” means having an “Economic Moat”. This is why I am reading this book: if I can learn how to value a company and can tell with high certainty that it will do well in the long run, those are the companies to keep.

Introduction

Value Investing

Investors can choose from a variety of stock market strategies, but many are flawed. The best strategy is to buy great companies at good prices and hold them for the long term. This approach works well for investment guru Warren Buffett. To make it work for you, follow a four-step process:

  1. Identify firms that have sustainable competitive advantages and are likely to be profitable year after year
  2. Wait until their stock prices fall below their intrinsic value before buying them
  3. Hold these stocks as long as they continue to meet your criteria
  4. Consider selling if they no longer fit your definition of a great company

Talk on the same material

When You Buy a Stock, What Do You Really Get?

When you buy a stock, the money ultimately goes back to the company that issued the shares, and the company uses that money to generate more value for its shareholders. I think most people forget that because they focus only on the “trading game” — I did too.

Economic Moat

Competitors can’t take over a profitable company’s business because they lack the advantages that make it successful. These are called moats, and they protect companies from outside competition. If you want to invest in a good company with strong competitive advantages, then look for these factors so you can find great opportunities.

Economic moats are invaluable assets for companies. For investors, they protect their money by making the company more resilient to competition and market downturns. They can weather those storms much better than other companies without them. Coca-Cola is a good example of that because it has a primary competitive moat in its core brand, which made up for the failure of New Coke. Your job as an investor is to learn how to spot good undervalued companies with strong economic moats and invest in them quickly before others do.

Signs of Good Economic Moats

1. Intangible Assets

In general, there are three types of intangible assets — brand, patent, and regulatory advantages:

  • Brand: people are willing to pay a price premium for a similar product with similar features because of its brand. The biggest risk to a great brand is that people are no longer willing to pay a higher price for your product. Popular brands are not necessarily profitable brands.
  • Patent: intellectual property allows firms to prevent other companies from duplicating a good or service. It is a way to block competitors from selling similar goods; pharmaceutical companies and their patents on drugs are good examples. The biggest risk of patents is that they are not permanent, and legal battles can be costly.
  • Ability to operate at a regulated market that is not regulated economically: Moody’s and educational accreditation are good examples. If a company cannot generate economic returns in a regulated market, it isn’t a moat. It’s far better to have a set of smaller regulations in favor of your business than a big one, because they are harder to change. If you can find a company that can price like a monopoly without being regulated like one, you’ve probably found a company with a wide economic moat.

2. Customer Switching Cost

Michael E. Porter defines switching costs as a barrier to entry that involves the one-time inconvenience or expense a buyer incurs to change over from one product or service to another. In certain industries, customers find it easy to switch from one company to another.

  • Low switching cost: For example, a customer who normally buys Shell gasoline can start buying Mobil gas immediately if a new, more convenient station opens. The customer has no switching cost and can easily change companies.
  • High switching cost: This is not true for banking customers. Switching from one bank to another means ordering new checks, filling out numerous forms and doing all sorts of paperwork. Due to relatively high switching costs, most people stay with the same bank for six or seven years (or longer).

Switching cost can come in different flavors: retraining cost, monetary cost, or even loyalty to brand. One has to figure out how to create a switching cost. Firms with high switching costs can charge more for their products and services than those with low switching costs because they’re less likely to lose clients due to competition between firms offering similar goods or services.

In general, consumer goods have much lower switching costs than other businesses. Examples of high switching cost businesses: propane, banks, turbines, and other businesses where either replacement is very tedious or the risk of operational disruption is way too high. Be nervous when companies that used to be able to raise prices easily begin receiving pushback from customers.

3. Network Effect

Companies with a large network of users have an advantage over their competitors. Take American Express, for example. The more retailers accept its card, the more valuable it becomes to consumers and businesses that use the card.

4. Cost Advantages

In some industries such as retail clothing or technology products (like cell phones), price is a very important factor in determining which product people will buy. Companies that offer cheaper alternatives for relatively expensive products or services have a competitive advantage over other companies because they’re able to charge less than those who don’t offer cheaper substitutes. The absolute size of a company matters much less than its size relative to its rivals. In general, there are 4 types of reasons for cost advantages:

  • Processes: A company can have better processes to deliver the goods and services they ship to customers (e.g. Southwest, Dell, etc). This competitive advantage is often something to pay attention to, but it doesn’t last as long as we think, as others can copy it.
  • Location: Companies that are in a good location can often deliver goods at a cheaper cost. Think of businesses that deliver gravel, cement, etc.
  • Unique Access to Resources: This often applies to businesses that have access to some natural resources that can grow faster or better.
  • Scale: The hallmark of cost advantages. In general, there are three types of scale advantages, and they usually involve spreading the fixed cost of providing those goods and services into economies of scale. Generally speaking, businesses that require large start-up fixed costs will only have a few consolidated conglomerates.
    • Distribution: Setting up a distribution network is costly and has high fixed costs. However, once the distribution channels are set up, there isn’t that much variable cost. Examples are delivery networks, telecom networks, and the internet.
    • Manufacturing: This is the classic economies of scale, where the upfront cost of setting up the manufacturing facilities is spread out to more customers because more people are paying and the firm is earning more returns.
    • Niche: Occasionally, the market is so niche that the high fixed cost becomes a disadvantage, and this lack of profitability opportunity prevents big players from entering, effectively creating a local monopoly for those operating in that space.

Signs of Bad Economic Moats

Mistaken Moats

There are many factors that lead to success, but not all of them actually have a competitive advantage. For example:

  • In the business world “bet on the jockey, not on the horse” does not apply: No matter how good a manager is, the fact is that many companies operate in unattractive environments. If you asked a world class chef to serve superb dishes profitably by placing him in a small local diner along the highway, it would be quite a hurdle. There are some exceptions, but we should consider the norm rather than convince ourselves that the exception is the norm.
  • Great products do not create moats: Remember vinyl discs, cassette tapes, CDs, video tape recorders, muscle cars, film cameras, Tommy Hilfiger, Netscape? All were great products but none of them lasted. Who knows what will replace the iPod or the AeroGarden. Or what about Krispy Kreme? They have some fantastic tasting donuts but nothing to lure me back when I decide to go on a diet. Unless a company can leverage its product to create an economic moat, profits will probably be reaped for a short time.
  • High market share: In highly competitive industries, high market share is not equivalent to a competitive advantage. Kodak (film), IBM (PCs), Netscape (internet browsers), GM (automobiles), and Corel (word processors) were big companies but they failed to maintain their moat which led to either a demise or a sale. Size can help a company create a moat but it is rarely the source of an economic moat by itself.
  • Operational efficiency: If a company succeeds by being leaner and meaner than its competition, it is probably because the company operates in a very tough and competitive industry where cutting costs is the only way to profit. You can cut and carve a fat cow but once you get to the bone, where is the meat going to come from?

Fleeting Economic Moats

Be very mindful of when a company loses its moat.

  • Disruptive technologies can hurt moats of businesses that are enabled by technology even more than businesses that sell technology.
  • Also, watch out for a consolidation of a once-fragmented group of customers.
  • Be wary of companies that pursue growth in areas where they have no moat.
  • Companies that provide services to businesses have more moats than most because they are often able to integrate themselves into their customers’ business processes, creating high switching costs.

Picking Investments

Primer: Intrinsic Value

One of the ways to value a company is to use Discounted Cash Flow (DCF). A stock is worth the present value of all the cash it will generate in the future. Some of the most important factors that drive the DCF are:

  • Growth: How large those cash flows will likely be
  • Risk: How likely the estimated future FCF will actually materialize
  • ROIC: How much investment will be needed to keep the business going
  • Moat: How long the business can generate excess profits

Over time, only two things can push a stock’s price — the investment return (earnings + dividend) and speculative return (change in P/E ratio, which represents how bullish people are about the company).

Valuation Tools

Profitability Measures

You can use profitability as a proxy for whether a company has sustained an economic moat. (Note: It gives you an indication of whether it has a moat, but it will not tell you why. For the WHY, you have to use the framework above to reason yourself.) Here are some of the common measures for profitability.

  • Return on Assets (ROA): an indicator of how profitable a company is relative to its total assets. ROA gives a manager, investor, or analyst an idea as to how efficient a company’s management is at using its assets to generate earnings.
  • Return on Equity (ROE): a measure of financial performance calculated by dividing net income by shareholders’ equity. Because shareholders’ equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets.
  • Return on Invested Capital (ROIC): a calculation used to assess a company’s efficiency at allocating the capital under its control to profitable investments.

Some rules of thumb:

  • ROA of 7%+ is a good sign of a competitive advantage
  • ROE of 15%+ is a healthy sign
  • Moat process:
    • Has the firm historically generated solid ROE, ROA, ROIC?
    • (If step 1 is a Yes) Does the firm have one or more of the competitive advantages discussed?
    • (If step 2 is a Yes) How strong is the company’s competitive advantage? Is it likely to last a long or short time? Short = narrow moat, Long = wide moat

Earnings Multiples

  • Price-to-Sales (P/S Ratio): calculated by dividing the company’s market capitalization by its total sales over a designated period (usually twelve months). Most useful for companies that have temporarily depressed margins.
  • Price-to-Book (P/B Ratio): compares a firm’s market capitalization to its book value. It’s calculated by dividing the company’s stock price per share by its book value per share (BVPS). Extremely useful for valuing financial services companies.
  • Price-to-Earnings (P/E Ratio): measures its current share price relative to its per-share earnings (EPS). Look at how a company’s P/E has fared in good times and bad and think about how the company’s future looks.
  • Price-to-Cash Flow (P/CF Ratio): measures the value of a stock’s price relative to its operating cash flow per share.

Earnings Yields

We can use earnings yields as an objective tool, like bond yields.

  • Earnings-per-Share / Stock-Price-per-Share (1 / PE ratio): This can be used to calculate the yield. If a company has a P/E ratio of 10, then the yield is about 10%; this means you will “earn” about 10% of what you paid for each year, and that’s a lot more attractive than a typical government bond. Obviously, you are not guaranteed to receive those earnings, but they will be reflected in the re-investments that the company will do, and the long-term payout will continue to grow.
  • Cash Returns: (Free Cash Flow + Net Interest Expense) / (Enterprise Value). The goal of the cash return metric is to measure how efficiently the business is using its capital — both equity and debt — to generate free cash flow. In other words, cash return tells you how much free cash flow a company generates as a percentage of how much it would cost an investor to buy out the entire business.

Knowing When to Sell

Ask the following questions before you sell:

  • Did I make a mistake?
  • Has the company changed for the worse?
  • Is there a better place for my money?
  • Has the stock become too large a portion of my portfolio?

Be cautious or at least mindful of when you anchor on a price:

  • Write down why you bought a stock and roughly what you expect to happen with the company’s financial results (increasing sales, profit margins up / down…)
  • If the company does worse, look at what you wrote down; if something has changed, selling is likely your best option regardless of whether you’ve made or lost money
  • The trick is to always stay focused on the future performance of the business, not the past performance of the shares

References