Friday, 16 September 2016

How do you identify an exceptional company with a durable competitive advantage from the INCOME STATEMENT?

How do you identify an exceptional company with a durable competitive advantage?

Financial statements are where you can search for companies with a durable competitive advantage that is going to make one super rich.


Gross Profit

Gross Profit is a key number that helps determine whether or not the company has a long term competitive advantage.

Companies that have excellent long term economics working in their favour tend to have consistently higher gross profit margins than those that don't.

What creates a high gross profit margin is the company's durable competitive advantage, which allows it the freedom to price the products and services it sells well in excess of its cost of goods sold.

As a general rule (and there are exceptions):
Companies with gross profit margins of 40% or better tend to be companies with some sort of durable competitive advantage.

Companies with gross profit margins below 40% tend to be companies in highly competitive industries, where competition is hurting overall profit margins (there are exceptions here, too).

Any gross profit margin of 20% and below is usually a good indicator of a fiercely competitive industry, where no one company can create a sustainable competitive advantage over the competition.

The gross profit margin test is not fail-safe, it is one of the early indicators that the company in question has some kind of consistent durable competitive advantage.

You should track the annual gross profit margins for the last ten years to ensure that the consistency is there.

Operating Expenses

Selling, General and Administrative (SGA) expenses

In the search for a company with a durable competitive advantage the lower the company's Sales, General and Administrative (SGA) expenses, the better.

If they can stay consistently low, all the better.

Anything under 30% of Gross Profit is considered fantastic.

However, there are a number of companies with a durable competitive advantage that have SGA expenses  in the 30% to 80%range.

If you see a company that is repetitively showing SGA expenses close to, or in excess of 100%, the company is likely in a highly competitive industry where no one entity has a sustainable competitive advantage.

There are also companies with low to medium SGA expenses that destroy great long term business economics with high research and development costs, capital expenditures and/or interest expense on their debt load.

Steer clear of companies with consistently high SGA expenses.

The economics of companies with low SGA expenses can be destroyed by expensive research and development costs, high capital expenditures, and/or lots of debt because the inherent long-term economics are so poor that even a low asking price for the stock will not save investors from a lifetime of mediocre results.

Research &Development expenses

Companies that have to spend heavily on R&D have an inherent flaw in their competitive advantage that will always put their long term economics at risk, which means they are not a sure thing.


Depreciation is a very real expense and should always be included in any calculation of earnings.  It is a cost that cannot be ignored.

The companies that have a durable competitive advantage tend to have lower depreciation costs as a percentage of gross profit than companies that have to suffer the woes of intense competition.

Less depreciation always means more when it comes to increasing the bottom line.

Interest Expense

Interest expense is a financial cost, not an operating cost and it is isolated out on its own in the income statement because it is not tied to any production or sales process.

Interest is reflective of the total debt that the company is carrying on its books.

Companies with high interest payments relative to operating income (EBIT) tend to be in a fiercely competitive industry, where large capital expenditures are required for it to stay competitive, or a company with excellent business economics that acquired the debt when the company was bought in a leveraged buyout.

The companies with a durable competitive advantage often carry little or no interest expense.

Even in highly competitive businesses like the airline industry, the amount of the operating income paid out in interest can be used to identify companies with a competitive advantage.

Warren's favourite durable competitive advantage holders in the consumer products category all have interest payouts of less than 15% of operating income.

The percentage of interest payments to operating income varies greatly from industry to industry.

The investment banking business, the average interest payments are in the neighbourhood of 70% of its operating income.

The ratio of interest payments to operating income can also be very informative as to the level of economic danger that a company is in.

A simple rule:  In any given industry the company with the lowest ratio of interest payments to operating income is usually the company most likely to have a competitive advantage.

Investing in the company with a durable competitive advantage is the only way to ensure that we are going to to get rich over the long term.

Gain (or Loss) on Sale of Assets and Other

Non-recurring, non-operating, unusual and infrequent income and expense events (e.g. sale of assets) can significantly affect a company's bottom line.

Since these are nonrecurring events, they should be removed from any calculation of the company's net earnings in determining whether or not the company has a durable competitive advantage.

Income before tax (Pretax earnings)

Income before tax is also the number that Warren uses when he is calculating the return that he is getting when he buys a whole business or when he buys a partial interest in a company through the open-market purchase of its shares.

[With the exception of tax-free investments, all investment returns are marketed on a pre-tax basis.  And since all investments compete with each other, it is easier to think about them if they are thought about in equal terms.]

Warren has always discussed the earnings of a company in pre-tax terms.  This enables him to think about a business or investment in term relative to other investments.

It is also one of the cornerstones of his revelation that a company with a durable competitive advantage is actually a kind of "equity bond" with an expanding coupon or interest rate.

Income Tax paid

One of the ways to see if the company is telling the truth is to look at the documents they file and see what it is paying in income tax.  If this doesn't equal the amount according to the tax rate, better start asking some questions.

Companies that are busy misleading the IRS are usually hard at work misleading their shareholders as well.

The beauty of a company with a long-term competitive advantage is that it makes so much money it doesn't have to mislead anyone to look good.

Net Earnings

Net earnings that are consistent and showing a historical long term upward trend can be equated to durability of the competitive advantage.

The ride doesn't have to be smooth but it should be a historical upward trend.

A company's historical net earnings trend may be different from its historical per share earnings trend due to changes in the number of shares outstanding (e.g. share buyback programs will increase per share earnings even though actual net earnings haven't increased.)

Look at the business's net earnings to see what is actually going on.

Companies with a durable competitive advantage will report a higher percentage of net earnings to total revenues than their competitors will.

Net profit margins tell us a lot about the economics of the business compared with other businesses.

High net profit margins reflect the companies' superior underlying business economics.

Low net profit margins reflect the highly competitive nature of the business.

A simple rule (and there are exceptions) is that if a company is showing a net earnings history of more than 20% on total revenues, there is a real good chance that it is benefiting from some kind of long term competitive advantage.

If a company is consistently showing net earnings under 10% on total revenues it is - more likely than not - in a highly competitive business in which no one company holds a durable competitive advantage.

Those companies that earn between 10% to 20% on total revenue may also have companies with long term competitive advantage yet to be discovered.

One of the exceptions to this rule is banks and financial companies, where an abnormally high ratio of net earnings to total revenues usually means a slacking off in the risk management department.    In the game of lending money, this is usually a recipe for making quick money at the cost of long term disaster.

Per-Share Earnings

The more a company earns per share the higher its stock price is.

A per share earnings figure for a ten year period can give us a very clear picture of whether the company has a long term competitive advantage working in its favour.

Look for a per share earning picture over a ten year period that shows consistency and an upward trend - an excellent sign that the company in question has some kind of long term competitive advantage working in its favour.

Consistent earnings are usually a sign that the company is selling a product or mix of products that don't need to go through the expensive process of change.

The upward trend in earnings means that the company's economics are strong enough to allow it either to make the expenditures to increase market share through advertising or expansion, or to use financial engineering like stock buybacks.

Erratic earnings picture that shows a downward trend, punctuated by losses tells that this company is in a fiercely competitive industry prone to booms and busts.

There are thousands of companies like this and the wild price swings in shares, caused by each company's erratic earnings, create the illusion of buying opportunities for traditional value investors.  But what they are really buying is a long, slow boat ride to investor nowhere.

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