The Five Rules for Successful Stock Investing 4

Economic Moats

Investors often judge companies by looking at which ones have increased profits the most and assuming the trend will persist in the future. But more often than not, the firms that look great in the rearview mirror wind up performing poorly in the future, simply because success attracts competition as surely as night follows day. And the bigger the profits, the stronger the competition. That's the basic nature of any (reasonably) free market – capital always seeks the areas of highest expected return. Therefore, most highly profitable firms tend to become less profitable over time as competitors chip away at their franchises.

To analyze a company's economic moat, follow these four steps:

• Evaluate the firm's historical profitability. Has the firm been able to generate a solid return on its assets and on shareholders' equity? This is the true litmus test of whether a firm has built an economic moat around itself.
• If the firm has solid returns on capital and consistent profitability, assess the sources of the firm's profits. Why is the company able to keep competitors at bay? What keeps competitors from stealing its profits?
• Estimate how long a firm will be able to hold off competitors, which is the company's competitive advantage period. Some firms can fend off competitors for just a few years, and some firms may be able to do it for decades.
• Analyze the industry's competitive structure. How do firms in this industry compete with one another? Is it an attractive industry with many profitable firms or a hypercompetitive one in which participants struggle just to stay afloat?

Firms that generate free cash flow essentially have money left over after reinvesting whatever they need to keep their businesses humming along. In a sense, free cash flow is money that could be extracted from the firm every year without damaging the core business.

If a firm's free cash flow as a percentage of sales is around 5 percent or better, you've found a cash machine [...]. Strong free cash flow is an excellent sign that a firm has an economic moat.

Net margin is simply net income as a percentage of sales, and it tells you how much profit the firm generates per dollar of sales. In general, firms that can post net margins above 15 percent are doing something right.

Return on equity (ROE) is net income as a percentage of shareholders' equity, and it measures profits per dollar of the capital shareholders have invested in a company. [...] As a rule of thumb, firms that are able to consistently post ROEs above 15 percent are generating solid returns on shareholders' money, which means they're likely to have economic moats.

Return on assets (ROA) is net income as a percentage of a firm's assets, and it measures how efficient a firm is translating its assets into profits. Use 6 percent to 7 percent as a rough benchmark – if a firm is able to consistently post ROAs above these rates, it may have some competitive advantage over its peers.

Consistency is important when evaluating companies, because it's the ability to keep competitors at bay for an extended period of time – not just for a year or two – that really makes a firm valuable. Five years is the absolute minimum time period for evaluation, and I'd strongly encourage you to go back 10 years if you can.

When you're examining the sources of a firm's economic moat, the key thing is to never stop asking, "Why?" Why aren't competitors stealing the firm's customers? Why can't a competitor charge a lower price for a similar product or service? Why do customers accept annual price increases? When possible, look at the situation from the customer's perspective. What values does the product or service bring to the customer? How does it help them run their own business better? Why do they use one firm's product or service instead of a competitor's?

In general, there are five ways that an individual firm can build sustainable competitive advantage:

1. Creating real product differentiation through superior technology or features
2. Creating perceived product differentiation through a trusted brand or reputation
3. Driving costs down and offering a similar product or service at a lower price
4. Locking in customers by creating high switching costs
5. Locking out competitors by creating high barriers to entry or high barriers to success

[...] although firms can occasionally generate enormous excess profits – and enormous stock returns – by staying one step ahead of the technological curve, these profits are usually short-lived. Unless you are familiar enough with the inner workings of an industry to know when a firm's products are being supplanted by better ones, be wary of firms that rely solely on innovation to sustain their competitive advantage.

[...] a strong brand can constitute a very wide economic moat. The wonderful thing about a brand is that as long as customers perceive your product or service as better than everyone else's, it makes relatively little difference whether it actually is different.

In general, firms can create cost advantages by either inventing a better process or achieving a larger scale.

If you can make it difficult – in terms of either money or time – for a customer to switch to a competing product, you can charge your customers more and make more money – simple in theory, but difficult in practice.

When you're looking for evidence of high customer switching costs, these questions should help:

• Does the firm's product require a significant amount of client training? If so, customers will be reluctant to switch and incur lost productivity during the training period.
• Is the firm's product or service tightly integrated into customers' businesses? Firms don't change vendors of mission-critical products often because the costs of a botched switch may far outweigh the benefits of using the new product or service.
• Is the firm's product or service an industry standard? Customers may feel pressure from their own clients – or their peers – to continue using a well-known and well-respected product or service.
• Is the benefit to be gained from switching small relative to the cost of switching?
• Does the firm tend to sign long-term contracts with clients? This is often a sign that the client does not want to frequently switch vendors.

Although patents and licenses can do a great job of keeping competitors at bay and maintaining high profit margins, they can also be ephemeral. If you're investigating a firm whose economic moat depends solely on a single patent or other regulatory approval, don't forget to investigate the likelihood of that approval disappearing unexpectedly.

Think about an economic moat in two dimensions. There's depth – how much money the firm can make – and there's width – how long the firm can sustain above-average profits.

Although the attractiveness of an industry doesn't tell the whole story, it's important to get a feel for the competitive landscape. Some industries are just easier to make money in than others.

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