What Matters and What Doesn't

It is very easy for new stock investors to get started on the wrong track by focusing only on

• the mechanics of trading or 
• the overall direction of the market.

To get yourself in the proper mind-set, tune out the noise and focus on studying individual businesses and their ability to create future profits.

Begin to build the skills you will need to become a successful buyer of businesses.



1.  Investing does not equal trading

Investing is like a chess game, where thought, patience, and the ability to peer into the future are rewarded.

Making the right moves is much more important than moving quickly.



2.  Investing means owning businesses

If you are buying businesses, it makes sense to think like a business owner. 

This means

• learning how to read financial statements, 
• considering how companies actually make money, 
• spotting trends, and 
• figuring out which businesses have the best competitive positions.  

It also means coming up with appropriate prices to pay for the businesses you want to buy. 

Notice that none of this requires lightning-fast reflexes.

You should also buy stocks like you would any other large purchase:  with lots of research, care and the intention to hold as long as it makes sense.

Investing is an intellectual exercise, but one that can have a large payoff.



3.   You buy stocks, not the market

One thing to remember when listening to market premonitions is that stock investing is about buying individual stocks, not the market as a whole.

If you pick the right stocks, you can make money no matter what the broader market does.

Another reason to heavily discount what the prognosticators say is that correctly predicting market movements is nearly impossible.

• No one has done it consistently and accurately.  
• There are just too ma y moving parts, and too many unknowns.

By limiting the field to individual businesses of interest, you can focus on what you can actually own while dramatically cutting down on the unknowns.  

You can save a lot of energy by simply tuning out market predictions.

With so many predictions about the stock market floating around, simple statistics says there are bound to be a handful of them that come true.  When thinking about this, it is helpful to remember the saying: "A broken clock is correct twice a day."

Stocks are volatile.  Why is that?  Does the value of any given business really change up to 50% year-to-year?   "Mr. Market" tends to be a bit of an extremist in the short term, overreacting to both good and bad news.



4.  Competitive Positioning is most important

Future profits drive stock prices over the long term, so it makes sense to focus on how a business is going to generate those future earnings.

Competitive positioning or the ability of a business to keep competitors at bay, is the most important determinant factor of future profits.

Competitive positioning is

• more important than the economic outlook,
• more important than the near-term flows of news that jostles stock prices and 
• even more important than management quality at a company.

Time is a precious resource in investing.

Business economics trump management skill.

A company with the best competitive positioning is going to create the most value for its shareholders.




Summary:


Active traders have three things working against them:  the bid/ask spread, commissions and taxes.

Stocks are not just pieces of paper to be traded; they are pieces of businesses.

The stock market as a whole is nearly impossible to predict, but predicting the outcome of individual businesses is a more manageable exercise.

Mr. Market is highly temperamental, over-reacting to both good and bad news.

Future profits drive stock prices over the long term, and the competitive positioning of a business is the most important factor in its ability to generate future earnings.

Pat Dorsey Explains Economic Moats - Morningstar Video

Finding Firms with an Edge (Morningstar)

Scale = Scalable Mountain = Monopoly Buy = Brand Low = Low Cost Produce Sell = Secret (Patent) High = High Cost of Switching

Moats

Low cost producer
Switching costs
Economies of scale
Intangibles
Regulatory
IP (Intellectual Property)
Network effects


Note:  Most companies do not have moat.  They can only survive and compete through being more efficient.

What Warren Buffett says about Non-Commodity (Franchise) Companies

NON-COMMODITY COMPANIES

Warren Buffett prefers to invest in non-commodity companies - companies whose products or services are unique or special in some way.

Here customers either need the product, or there is no real competitor, or the reputation of the product is such that people will keep buying it. Suppliers and distributors have no choice but to stock the product or people will go elsewhere.

Generally, but not always, either the product will be a brand name (eg Coke, Gillette), the company will be a brand name (H & R Block) or the company will be in a monopoly situation or monopolistic cartel.

WHAT WARREN BUFFETT SAYS ABOUT NON-COMMODITY COMPANIES

Warren Buffett illustrated this difference in 1982:

‘[There is the] constant struggle of every vendor to establish special qualities of product or services. This works with candy bars (customers buy by brand name, not by asking for a "two-ounce candy bar") but doesn't work with sugar (how often do you hear, "I’ll have a cup of coffee with cream and C & H sugar, please").’

WHAT WARREN BUFFETT SAYS ABOUT GOOD BUSINESSES

Good businesses with that ‘protective moat’ that Warren Buffett likes have the ability to cope with inflation by raising prices. As he said in 1993:

‘The might of their brand names, the attributes of their products and the strength of their distribution systems gives them an enormous competitive advantage, setting up a protective moat around their economic activities. The average company, in contrast, does battle daily without any means of protection.’

BERKSHIRE HATHAWAY HOLDINGS

Stocks held by Berkshire Hathaway in 2002, as stated by Buffett in his letter to stockholders include:

• The Coca Cola Company
• American Express
• The Gillette Company
• H and R Block Inc
• Moody’s Corporation
• The Washington Post Company
• Wells Fargo and Company

These are all companies with a unique or special product, or with a company brand name, or in a market domination position. They or their products have a loyalty (voluntary or otherwise) that means customers want or must come back.

Another desirable quality in non-commodity companies is repeat business. Customers drink their Coke, wear out their razor blades, or finish reading their Washington Post, and then, eventually have to replace it.

Margin of Safety Concept as explained by Warren Buffett

The margin of safety has little to do with price but more to do with the quality of the business (durable competitive advantage and economic moat) and its management.

Buffett:   "In investing in securities, you can change your mind tomorrow and sell it if you feel you have made a mistake. When you buy a business, we buy businesses to keep. So .. our margin of safety is not in the price we pay .. it's in crossing the threshold of being virtually certain of buying into a business with durable competitive advantage, that is, one with good economics ... and we are buying in into people with a passion for the business and who are going to run it in the same way the year after they sold it to us the year that they run it the year before. So our margin of safety gets more into the qualitative characteristics than the quantitative aspects that you probably refer to in terms of the Ben Graham's standard of buying a business for .... he would say buy a stock .. if you think a stock is worth $10 .. don't pay $9.90 for it but $8.00 or something like that. When you are buying businesses, it's a different criteria, you are buying to keep and you better make sure that you are buying both the businesses that you like 10 or 20 years from now and the management that you are going to love 10 or 20 years from now.

We don't look for specific sectors, but we do look at businesses that I can understand. That means where I feel I have a high degree of confidence in my ability to see what they are going to look like 5, 10 and 20 years from now. It isn't that I don't understand, say the software product in general of the Microsoft but I don't know how that industry is going to develop 10 or 20 years. I didn't know that Google was going to come along in terms of search .. and all kind. So, anything that is rapidly developing, has lots of change embodied in it, by my definition, I won't understand. It may do wonders for society. It may have what appears to have a bright future, but I don't bring anything to that game that I know. Not only I don't know more that the other fellow, I do not know as much as the other fellow in evaluating what the industry will look like in 10 years. So, besides the things I look at businesses are reasonably easy to evaluate where the products .. how they will fit in with the economic picture .. how their economics will look in the 5, 10 or 20 years period. (2.40 minute)...Take an extreme example, I can understand Nestle ............................."

Focus on the companies with Economic Moats

Economic moats are long-term competitive advantages that allow companies to earn oversized profits over time.  These are the companies you should focus your attention on.

There are 4 main types of economic moats:

• Low-cost producer or Economies of Scale
• High switching costs
• Network effect
• Intangible assets

The more types of economic moats a company has, the better.

The longer a firm can sustain its competitive advantage, the wider its economic moat.


The Bottom Line

• While having these four types of of moats, or competitive advantages, as guidelines is helpful, there is still a lot of art to determining whether a firm has a moat. 
• At the heart of it, the harder it is for a firm's advantage to be imitated, the more likely it is to have a barrier to entry in its industry and a defensible source of profit.

Looking for the firm with an economic moat (Evaluating Profitability)

The first thing we need to do is look for hard evidence that a firm has an economic moat by examining its financial results. (Figuring out whether a company might have a moat in the FUTURE is much tougher.)

What we are looking for are firms that can earn profits (ROIC) in excess of their cost of capital (WACC) - companies that can generate substantial cash relative to the amount of investments they make.

Use the metrics in the following questions to evaluate profitability:

1. Does the firm generate free cash flow? If so, how much?
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.

FCF Margin:  Divide FCF by sales (or revenues). This tells what proportion of each dollar in revenue the firm is able to convert into excess profits.

If a firm's FCF/Sales is around 5% or better, you've found a cash machine.

Strong FCF is an excellent sign that a firm has an economic moat.

(FCF/Total Capital Employed or FCF/Enterprice Value are some measures.)


2. What are the firm's net margins?
Net margins look at probability from another angle.

Net margin = net income/ Sales

It tells how much profits the firm generates per dollar of sales.

In general, firms that can post net margins above 15% are doing something right.

3. What are the returns on equity?
ROE = net income/shareholders' equity
It measures profits per dollar of the capital shareholders have invested in a company.

Although ROE does have some flaws -it still works well as one tool for assessing overall profitability.

As a rule of thumb, firms that are able to consistently post ROEs above 15% are generating solid returns on shareholders' money, which means they're likely to have economic moats.

4. What are returns on assets?
ROA = (net income + Aftertax Interest Expense )/ firm's average assets
It measures how efficient a firm is at translating its assets into profits.

Use 6% to 7% 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.

The company's aftertax interest expense is added back to net income in the calculation.  Why is that?  ROA measures the profitability a company achieves on all of its assets, regardless if they are financed by equity holders or debtholders; therefore, we add back in what the debtholders are charging the company to borrow money.


Study these metrics over 5 or 10 years

When looking at all four of these metrics, look at more than just one year.

A firm that has consistently cranked out solid ROEs, ROA, good FCF, and decent net margins over a number of years is much more likely to truly have an economic moat than a firm with more erratic results.

Five years is the absolute minimum time period for evaluation, 10 years is even better, if you can.


Consistency is Important

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.



These benchmarks are rules of thumb, not hard-and-fast cut-offs.

Comparing firms with industry averages is always a good idea, as is examining the trend in profitability metrics - are they getting higher or lower?

There is a more sophisticated way of measuring a firm's profitability that involves calculating return on invested capital (ROIC), estimating a weighted average cost of capital (WACC), and then looking at the difference between the two.

Using a combination of FCF, ROE, ROE and net margins will steer you in the right direction.


Additional notes:

DuPont Equation

ROA = Net Profits / Average Assets
ROA = Asset Turnover x Net Profit Margin

ROA
= (Sales/Average Assets) x (Net Profits/Sales)
= Net Profits/Average Assets

ROE = Net Profits / Average Shareholder's Equity
ROE = Asset Turnover x Net Profit Margin x Asset/Equity Ratio*

ROE
= (Sales/Average Assets) x (Net Profits/Sales) x (Average Assets/Average Equity)
= Net Profits./ Average Equity

*Asset/Equity Ratio = Leverage