Investor's Checklist: Hard-Asset-Based Businesses

Companies in the hard asset based subsector depend on big investments in fixed assets to grow their businesses.  Airlines, waste haulers and expedited delivery companies all fall into this subsector.  In general, these companies aren't as attractive as technology-based businesses, but investors can still find some wide-moat stocks and good investments in this area.

Industry Structure

Growth for hard asset based businesses inevitably requires large incremental outlays for fixed assets.  After all, once an airline is flying full planes, the only way to get more passengers from point A to point B is to acquire an additional aircraft, which can cost US $35 million or more.

Because the incremental fixed investment occurs before asset deployment, companies in this sector generally finance their growth with external funding.  Debt can be used to finance almost all of the asset's cost, so lenders generally require the asset to provide collateral against the loan.  With this model, high leverage is not necessarily a bad thing, provided that the company can make enough money deploying the asset to cover the cost of debt financing and earn a reasonable return for shareholders.

Subsector:  Airlines


(With this in mind, airlines are generally the least attractive investment of all the companies in this subsector.  Airlines must bear enormous fixed costs to maintain their fleets and meet the demands of expensive labour contracts, yet they sell a commodity service that's difficult to differentiate.  As a result, price competition is intense, profit margins are razor-thin - and often non-existent - and operating leverage is so high that the firms can swing from being wildly profitable to nearly bankrupt in a short time.  If you don't think this sounds like a recipe for good long-term investments, you're right - airlines have lost a collective $11 billion (excluding the impact of recent government handouts) between deregulation in 1978 and 2002.  Over the same time period, 125 airlines had filed for Chapter 11 bankruptcy protection and 12 of them filed for Chapter 7 liquidation.)

Hallmarks of Success for Hard-Asset-Based Businesses

Cost leadership:  Because hard-asset based companies have large fixed costs, those that deliver their products most efficiently have a strong advantage and can achieve superior financial performance, such as Southwest in the airline industry.  To get an idea about how efficiently a company operates, look at its fixed asset turnover, operating margins and ROIC - and compare its numbers to industry peers.

Prudent financing:  Remember, having a load of debt is not itself a bad thing.  Having a load of debt that cannot be easily financed by the cash flow of the business is a recipe for disaster.  When analysing companies with high debt, always be sure that the debt can be serviced from free cash flow, even under a downside scenario.

Investor's Checklist:  Hard-Asset-Based Businesses

• Understand the business model.  Knowing a company leverages on hard assets will provide insight as to the kind of financial results the company may produce.
• Look for scale and operating leverage.  These characteristics can provide significant barriers to entry and lead to impressive financial performance.
• Look for recurring revenue.  Long-term customer contracts can guarantee certain levels of revenue for years into the future.  This can provide a degree of stability in financial results.
• Focus on cash flow.  Investors ultimately earn returns based on a company's cash-generating ability.  Avoid investments that aren't expected to generate adequate cash flow.
• Size the market opportunity.  Industries with big, untapped market opportunities provide an attractive environment for high growth.  In addition, companies chasing markets perceived to be big enough to accommodate growth for all industry participants are less likely to compete on price alone.
• Examine growth expectations.  Understand what kind of growth rates are incorporated into the share price.  If the rates of growth are unrealistic, avoid the stock.

The Five Rules for Successful Stock Investing

by Pat Dorsey

Investor's Checklist: Telecom Sector

The telecommunication sector is filled with the kinds of companies we love to hate:

• They earn mediocre (and declining) returns on capital, 
• economic moats are nonexistent or deteriorating, 
• their future depends on the whims of regulators, and 
• they constantly spend boatloads of money just to stay in place.  

Even companies that once boasted wide moats, such as those that control the local phone network, face increasing competition from newer players, such as cable and wireless networks.  Because telecom is fraught with risk, we typically look for a large margin of safety before considering any telecom stock.

Telecom Economics

Building and maintaining a telecom network, whether fixed line or wireless, is an extremely expensive endeavor that requires truckloads of upfront capital.  This requirement provides a substantial barrier to entry and usually protects the established players.  To raise capital, a new entrant must have a great story to tell investors.  The emergence of the Internet, the opening of local networks to competition, and rapid wireless growth during the 1990s gave numerous new players the yarns they needed, which is why the usual barrier provided by huge capital requirements came crumbling down as investors lined up to grab a piece of the action.

While the effects of this massive infusion of capital are still being felt in the industry, ongoing capital needs have sunk many new entrants.  Even a mature telecom firm will need to invest significant capital to maintain its network, meet changing customer demands, and respond to competitive pressures.

Because of the enormous cost to build a network, carriers typically have very low ratios of sales to assets (asset turnover ratios).  Even a mature carrier typically generates only around $1 per year in sales for each $1 of assets invested.  But building a business of ample size to support interest payments and ongoing capital needs is very important.  Because fixed costs are so high, it's imperative for carriers to have enough customers over which to spread the costs.

Squeezing as much profit from the sale as possible is also crucial.  While size again plays a role here, a telecom company must be able to send bills, provide customer service, maintain the network, and market services efficiently.  A mature company, either fixed line or wireless, should expect to earn operating margins between 20 percent and 30 percent.  Short of this level, it is extremely difficult to earn an attractive return on invested capital, given the slow pace at which assets turn over.

With so many companies raising money and building networks in the late 1990s, the volume of business needed to support all these huge investments never materialised.

Conclusion:

The telecom sector of tomorrow will look nothing like the sector of the past.  Competition is far greater throughout the industry and economic moats exceedingly difficult to come by.  The future of the industry will be shaped by regulatory and technological changes, which means that financial strength and flexibility are likely to be what separate successful firms from unsuccessful ones over the next few years.

Investor's Checklist:  Telecom

• Shifting regulations and new technologies have made the telecom industry far more competitive.  Though some areas are more stable than others, look for a wide margin of safety to any estimate of value before investing.
• Telecom is a capital-intensive business.  Having the resources to maintain and improve the network is critical to success.
• Telecom is high fixed-cost business.  Keeping an eye on margins is very important.
• Watching debt is also important.  Firms can easily overextend themselves as they build networks.
• The price of wireless airtime is plummeting. Carriers continue to compete primarily on price.

The Five Rules for Successful Stock Investing
by Pat Dorsey

The Five Rules for Successful Stock Investing

The Five Rules for Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market

02.28.2010 · Posted in Stock Market

Product Description
The Five Rules for Successful Stock Investing

“By resisting both the popular tendency to use gimmicks that oversimplify securities analysis and the academic tendency to use jargon that obfuscates common sense, Pat Dorsey has written a substantial and useful book. His methodology is sound, his examples clear, and his approach timeless.”

–Christopher C. Davis Portfolio Manager and Chairman, Davis Advisors

Over the years, people from around the world have turned to Morningstar for strong, independent, and reliable advice. The Five Rules for Successful Stock Investing provides the kind of savvy financial guidance only a company like Morningstar could offer. Based on the philosophy that “investing should be fun, but not a game,” this comprehensive guide will put even the most cautious investors back on the right track by helping them pick the right stocks, find great companies, and understand the driving forces behind different industries–without paying too much for their investments.

Written by Morningstar’s Director of Stock Analysis, Pat Dorsey, The Five Rules for Successful Stock Investing includes unparalleled stock research and investment strategies covering a wide range of stock-related topics. Investors will profit from such tips as:
* How to dig into a financial statement and find hidden gold . . . and deception
* How to find great companies that will create shareholder wealth
* How to analyze every corner of the market, from banks to health care

Informative and highly accessible, The Five Rules for Successful Stock Investing should be required reading for anyone looking for the right investment opportunities in today’s ever-changing market.

• ISBN13: 9780471686170

Our Stock-Picking Track Record by Pat Dorsey, Morningstar

By Pat Dorsey, CFA| 1-26-2010 12:20 PM

Our Stock-Picking Track Record
Pat Dorsey takes a look back at the performance of our calls through the downturn and recovery, plus how our star ratings on wide-, narrow-, and no-moat stocks have played out.

Related Links
How Our Stock Calls Have Performed

Pat Dorsey: Hi, I'm Pat Dorsey, director of equity research at Morningstar. At Morningstar's Equity Research Department, we're sometimes accused of taking a bit of an academic focus towards equity research. We spend a lot of time on competitive analysis and cash flow projections, but at the end of the day, the purpose is to pick stocks that go up.

So, the question is, did we do this? How has our performance been in 2009 and over the past few years? We recently published an article looking at our performance in '09 and in the past several years. I wanted to recap some of the highlights for you.

One of the first ways we can look at our performance in general is basically comparing how cheap we thought stocks were in aggregate to how the market has done. On that score, we've done OK.

In '07 and '08, we thought stocks were mildly overvalued. In hindsight, they were more overvalued then we had projected them to be, but at least we weren't pounding the table and saying, "Go out and put all your money into the equity markets."

What we did get right was calling the market as significantly undervalued in late '08 and early '09 when the median price-to-fair value of all the stocks that we cover reached as low as about 0.6, meaning that we thought the median stock in our coverage universe was about 40% undervalued in late '08 and early '09. Of course, that turned out to be a pretty good call.

Close Full Transcript

We can also look at our valuation of popular indexes like the S&P 500 because, since we cover every stock in the S&P 500, we can basically take all of our fair values and roll them up into an aggregate value for the index. Well, before things really rolled over, we had a fair value of the S&P of about 1,500-1,600. That was certainly, in hindsight, too high. (Food for thought:  even the expert got it wrong!)

We quickly adjusted that downward in late '08 to a level of about 1,200-1,250, and I'm very proud of the fact that we actually held our ground. Throughout most of '09, we held our fair value for the S&P at about 1, 200 even as the market was cratering down towards 800, 700 and down to the intra-day number of the beast low on March nine of 666.

We held our ground that whole time that the fair value for the S&P of 1,200. I'm fairly glad that we didn't succumb to the temptation to hide under the covers and not call anything a buy. In fact, we called quite a few things buys at that point in time.

Those are two big ways to look at the overall performance of our stock calls. Another way is basically have our 5-stars, our buy-rated stocks, outperformed our 1-stars, sell-rated stocks? One way we do this is sort of look at it by moat. Look at it by

• wide-moat, 
• narrow-moat and 
• no-moat stocks.

And here again, the story is pretty good. If you look at our wide-moat stocks over pretty much all time periods--trailing three years, five years and last year--our 5-star, buy-rated, wide-moat stocks have beaten our entire coverage universe of wide-moat stocks and, of course have done much better than our 1-star, sell-rated, wide-moat stocks.

Same story on the narrow-moat side. Of course, narrow-moat companies are the kinds of companies that don't have quite as strong an advantage as wide-moat businesses, and they are still good businesses. And those are businesses where, again, our 5-stars have out-performed narrow moats in general, as well as our sell-rated, 1-star, narrow-moat stocks.

Now, on the no-moat side of things, the story's a little bit more mixed, frankly. We cover about 900 no-moat stocks. These are typically sometimes smaller, less well competitively advantaged businesses. Businesses that we think are very prone to the vicissitudes of the economy and don't really have strong economic moats. And our performance here has been a bit more skewed, basically. We have not really done a very good job of sorting out the buy-rated ones from the 1-star, no-moat stocks. I think there's a couple reasons for this.

One is, well, frankly these are harder companies to value at the end of the day. They tend to be more volatile. They tend to be less predictable. They tend to be more easily buffeted by macroeconomic events, so they're just harder to value. They've also more volatile. They tend to be a little bit more levered and smaller, on average. They're just tougher companies to get you arms around. And our 1-star, no-moat stocks actually did incredibly well in 2009.

So, if you had owned this portfolio of beaten-down retailers, auto parts companies and media firms, you would have made a ton of money in 2009. You would have also needed a titanium-lined stomach to have held them from the beginning of the year through the March lows, and I'm not quite sure how many people would have had the fortitude to do this. If you did, more power to you. But I think the perhaps better risk-adjusted way is to think about the 5-star, narrow-moat and wide-moat stocks.

Finally, our strategies have done fairly well over time. These are kind of real money portfolios. Again, you're seeing more conservative strategies, like our Morningstar StockInvestor Tortoise Portfolio, didn't do quite as well in 2009, but it also didn't lose nearly as much money as the market in 2008, where as our more aggressive portfolios, like the Morningstar StockInvestor Hare, did quite well in 2009, as taking risk was rewarded by the market .

And our Wide Moat Focus Index, which basically takes the 20 cheapest of our wide-moat stocks, basically has been knocking the cover off the ball. It was up about 46% in 2009 and is beating the market by about 500 basis points annualized over the past five years. Again, it's a very simple, mechanical strategy. It's simply looking at our wide-moat universe of about 160 companies and looking for the 20 cheapest and then rebalancing quarterly.

I think what that really shows is the value of a disciplined approach and having a watch-list sorting out a group of companies you think that have the economic sticking power to be around for the long haul and waiting and buying them when they're cheap. That's essentially all this strategy does.

So, that's a pretty comprehensive look at our performance in 2009 and over the past several years. Overall, pretty good. We could have done a better job with the no-moat stocks but again, these are just frankly harder companies to get your arms around. They tend to be a little bit riskier and those were some missed opportunities, but overall, I'm pretty pleased with the performance.

I'm Pat Dorsey and thanks for watching.
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