Sunday, 18 September 2016
How do you identify an exceptional company with a durable competitive advantage from the ASSETS OF THE BALANCE SHEET?
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.
The balance sheet is a snapshot of the company's financial condition on the particular date that the balance sheet is generated.
Assets minus Liabilities = Net worth or Shareholders' Equity
Current Assets: Cash and cash equivalents, short-term investments, net receivables, inventory and other assets.
Non Current Assets: Long Term investments, Property Plant and Equipment, Goodwill, Intangible Assets, Accumulated Amortization, Other Assets and Deferred Long Term Asset Charges.
Individually and collectively, via their quality and quantity, tell a great many things about the economic character of a business and whether or not it possesses the coveted durable competitive advantage that will make an investor super rich.
Current Asset Cycle
Cash --> Inventory --> Accounts Receivable --> Cash.
This cycle repeats itself over and over again and it is how a business makes money.
Cash and Cash Equivalent
Companies traditionally keep a hoard of cash to support business operations.
A company basically has three ways of creating a large stockpile of cash.
· It can sell new bonds or equity to the public, which creates a stockpile of cash before it is put to use.
· It can also sell an existing business or other assets that the company owns, which can also create a stockpile of cash before the company finds other uses for it.
· Or it has an ongoing business that generates more cash than the business burns.
Look at the past seven years of balance sheets.
This will reveal whether the cash hoard was created by a one-time event, such as the sale of new bonds or shares, or the sale of an asset or an existing business, or whether it was created by ongoing business operations.
If we see lots of debts, we probably are not dealing with an exceptional business.
But if we see a ton of cash piling up and little or no debt and no sales of new shares or assets and we also note a history of consistent earnings, we are probably seeing an excellent business with a durable competitive advantage - the kind of company that will make us rich over the long term.
A company that is suffering a short-term business problem may see its shares sold down in the stock market.
Look at its cash or marketable securities that the company has hoarded away to gain an idea whether it has the financial strength to weather the troubles it has gotten itself into.
If we see a lot of cash and marketable securities and little or no debt, chances are very good that the business will sail on through the troubled times.
But if the company is hurting for cash and is sitting on a mountain of debt, it probably is a sinking ship that not even the most skilled manager can save.
With a lot of businesses, there is a risk of inventory becoming obsolete.
Manufacturing companies with a durable competitive advantage have an advantage, in that the products they sell never change and therefore never become obsolete.
To identify a manufacturing company with a durable competitive advantage, look for an inventory and net earnings that are on a corresponding rise.
This indicates that the company is finding profitable ways to increase sales and that the increase in sales has called for an increase in inventory, so the company can fulfill orders on time.
Manufacturing companies with inventories that rapidly ramp up for a few years and then, just as rapidly, ramp down are more likely than not companies caught in highly competitive industries subject to booms and busts.
And no one ever got rich going bust.
Receivables - Bad Debts = Net Receivables
If a company is consistently showing a lower percentage of Net Receivables to Gross Sales than its competitors, it usually has some kind of competitive advantage working in its favour that the others don't have.
Prepaid Expenses/Other Current Assets
Insurance premiums for the year ahead, which are paid in advance is an example of prepaid expense.
Prepaid expenses offer us little information about the nature of the business or about whether it is benefiting from having a durable competitive advantage.
Total Current Assets and the Current ratio
The higher the current ratio, the more liquid the company is.
A current ratio of over one is considered, good and anything below one, bad.
If it is below one, it is believed that the company may have a hard time meeting its short term obligations to creditors.
A lot of companies with a durable competitive advantage often have current ratios below one.
Their earning power is so strong they can easily cover their current liabilities.
Also, as a result of their tremendous earning power, these companies have no problem tapping into the cheap, short-term commercial paper market if they need any additional short term cash.
Because of their great earning power, they can also pay out generous dividends and make stock repurchases, both of which diminish cash reserves and help pull their current ratios below one.
There are many companies with a durable competitive advantage that have current ratios less than one.
Such companies create an anomaly that renders the current ratio almost useless in helping us identify whether or not a company has a durable competitive advantage.
Property, Plant and Equipment
These are carried at their original cost, less accumulated depreciation.
Depreciation is what occurs as the plant and equipment wear out little by little; every year, a charge is taken against the plant and equipment.
The company that has a durable competitive advantage replaces its plant and equipment as they wear out, while the company that doesn’t have a durable competitive advantage has to replace its plants and equipment to keep pace with the competition.
A company with a durable competitive advantage will be able to finance any new plants and equipment internally.
But a company that doesn’t have a competitive advantage will be forced to turn to debt to finance its constant need to retool its plants to keep up with the competition.
Producing a consistent product that doesn’t have to change equates to consistent profits.
The consistent product means there is no need to spend tons of money upgrading the plant and equipment just to stay competitive which frees up tons of money for other money-making ventures.
The FASB (Financial Accounting Standards Board) decided that goodwill wouldn’t have to be amortized unless the company that the goodwill was attached to was actually depreciating in value.
Whenever we see an increase in goodwill of a company over a number of years, we can assume that it is because the company is out buying other businesses.
This can be a good thing if the company is buying businesses that also have a durable competitive advantage.
If the goodwill account stays the same year after year, that is because either the company is paying under book value for a business or the company isn’t making any acquisitions.
Businesses that benefit from some kind of durable competitive advantage almost never sell for below their book value.
Occasionally it does happen and when it does, it can be the buying opportunity of a lifetime.
Intangible assets are assets we can’t physically touch: patents, copyrights, trademarks, franchises, brand names and the like.
Companies are not allowed to carry internally developed intangible assets in their balance sheets.
Intangible assets that are acquired from a third party are carried on the balance sheet at their fair value.
If the asset has a finite life – as a patent does – it is amortized over the course of its useful life with a yearly charge made to the income statement and the balance sheet.
The real value of some companies that benefit from durable competitive advantage may be understated.
For example, its strong brand name is worth a lot and yet because it is an internally developed brand name, its real value as an intangible asset is not reflected in its balance sheets.
Coke’s brand name is worth a lot. The intangible asset of Coke is its brand that gives it durable competitive advantage and the long term earning power that came with it.
Short of comparing ten years’ worth of income statements, investors have had no way of knowing it was there or knowing of its potential for making them super rich.
Long Term Investments
This records the value of long term investments (longer than a year): stocks, bonds and real estate, investments in the company’s affiliates and subsidiaries.
This asset class is carried on the books at their cost or market price, whichever is lower.
It cannot be market to a price above cost even if the investments have appreciated in value.
This means that a company can have a very valuable asset that is carrying on its books at a valuation considerably below its market price.
A company’s long-term investments can tell us a lot about the investment mind set of top management.
Do they invest in other businesses that have durable competitive advantages or do they invest in businesses that are in highly competitive markets (mediocre businesses)?
Watch out for management of a wonderful company buying mediocre companies.
Also search for and love the management of a mediocre company buying companies with durable competitive advantage e.g. Berkshire Hathaway.
Other Long Term Assets
Examples are paid expenses and tax recoveries that are due to be received in the coming years.
These tell us little about whether or not the company in question has a durable competitive advantage.
Total Assets and the Return on Total Assets
Return on total asset ratio is found by dividing net earnings by total assets.
It tells us how efficient the company is in putting its assets to use.
Capital is always a barrier to entry into any industry.
One of the things that helps make a company’s competitive advantage durable is the cost of the assets one needs to get into the game.
The really high returns on assets may indicate vulnerability in the durability of the company’s competitive advantage.
Moody’s (total assets $ 1.7 billion, ROA 43%)
Coca Cola’s (total assets $ 43 billion, ROA 12%)
While Moody’s underlying economics is far superior to Coca Cola’s, the durability of Moody’s competitive advantage is far weaker because of the lower cost of entry into its business.