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.
BALANCE SHEET
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 Liabilities
Account Payable, Accrued Expenses and Other Current Liabilities
Accounts payable is money owed to suppliers that have provided goods and services to the company on credit.
Accrued expenses are liabilities that the company has incurred but has yet to be invoiced for.
These expenses include sales tax payable, wages payable and accrued rent payable.
Other Liabilities is a slush fund for all short term debts that didn’t qualify to be included in the above categories.
Account payable, accrued expenses and other debts can tell us a lot about the current situation of a business but as stand alone entries they tell us little about the long term economic nature of the business and whether or not it has a durable competitive advantage.
However, the amount of short and long term debt that a company carries can tell a great deal about the long term economics of a business and whether or not it has a durable competitive advantage.
Short Term Debt
This includes commercial paper and short term bank loans.
Short term money is cheaper than long term money.
It is possible to make money borrowing short term and lending it long term.
We just borrow more money short-term to pay back the short term debt that is coming due (rolling over the debt).
The problem works well until the short term rates jump above what you lent the money long at.
You have to refinance your short term debt at a rate in excess of what you loaned it out at.
Another problem of borrowing short term to lend this money long term is when your creditors decide not to loan you any more money short term.
Suddenly you have to pay back all that money you borrowed short term and lent long term (e.g. Bear Stearns).
The smartest and safest way to make money in banking is to borrow it long term and lend it long term.
When it comes to investing in financial institutions, you should shy away from companies that are bigger borrowers of short-term money than of long-term money.
While being aggressive can mean making lots of money over the short term, it has often led to financial disasters over the long term.
In troubled financial times, it is the stable conservative banks that have the competitive advantage over the aggressive banks that have gotten themselves into trouble.
The durability equates with the stability that comes with being conservative.
It has money when the others have losses, which creates opportunity.
Aggressive borrowers of short term money are often at the mercy of sudden shifts in the credit markets, which puts their entire operation at risk and equates with a loss of any kind of durability in their business model.
Long Term Debt Coming Due in current year
As a rule, companies with a durable competitive advantage require little or no long-term debt to maintain their business operations and therefore have little or no long term debt ever coming due.
A company that has a lot of long term debt coming due, we probably are not dealing with a company that has a long term competitive advantage.
Buying a company that has a durable competitive advantage going through troubled times due to a one time solvable event, it is best to check how much of the company’s long term debt is due in the years ahead.
Too much debt coming due in a single year can spook investors, which will give us a lower price to buy in at.
With mediocre company that is experiencing serious problems, too much debt coming due in a current year can lead to cash flow problems and certain bankruptcy.
Total Current Liabilities and the Current Ratio
A current ratio of over one is considered good and anything below one, bad.
But, as previously discussed, companies with a durable competitive advantage often have current ratios under one.
Current ratio is of great importance in determining the liquidity of a marginal to average business, it is of little use in telling us whether or not a company has a durable competitive advantage.
Long Term Debt
Long term debts are debts that mature anytime out past a year.
The amount of long term debt a company carries on its books tells a lot about the economic nature of the business.
Companies that have a durable competitive advantage often carry little or no long term debt on their balance sheets.
This is because these companies are so profitable that they are self financing when they need to expand the business or make acquisitions, so there is never a need to borrow large sums of money.
Take a look at the long term debt load that the company has been carrying for the last ten years and not just in the current year.
If there have been ten years of operations with little or no long term debt on the company’s balance sheet it is a good bet that the company has some kind of strong competitive advantage working in its favour.
The company should have sufficient yearly net earnings to pay off all of its long term debt within a three or four year earnings period.
Companies that have enough earning power to pay off their long term debt in under three or four years are good candidates in the search for the excellent business with a long term competitive advantage.
These companies are so profitable and carrying little or no debt, they are often the targets of leveraged buyouts.
This is where the buyer borrows huge amounts of money against the cash flow of the company to finance the purchase.
After the leveraged buyout, the business is then saddled with large amounts of debts.
In cases like these, the company’s bonds are often the better bet, in that the company’s earning power will be focused on paying off the debt and not growing the company.
Deferred Income Tax, Minority Interest and Other Liabilities
Deferred Income Tax is tax that is due but hasn’t been paid.
This figure tells us little about whether or not the company has a durable competitive advantage.
When a company acquires the stock of another, it books the price it paid for the stock as an asset under long term investments.
When it acquires more than 80% of the stock of a company, it can shift the acquired company’s entire balance sheet onto its balance sheet.
The same applies to the income statement.
The Minority Interest entry represents the value of the acquired company that the acquirer does not own.
This shows up as a liability to balance the equation, since the acquirer booked 100% of the acquired company’s assets and liabilities, even though it owns from 80% to less than 100%.
What does Minority Interests have to do with identifying a company with a durable competitive advantage?
Not much.
Other Liabilities: This is a catchall category that includes such liabilities as judgments against the company, non-current benefits, interest on tax liabilities, unpaid fines and derivative instruments.
None of these helps us in our search for the durable competitive advantage.
Total Liabilities and the Debt to Shareholders’ Equity Ratio
The debt to shareholders’ equity ratio can be used to help us identify whether or not a business has a durable competitive advantage.
The debt to shareholder’s equity ratio helps us identify whether or not a company is using debt to finance its operations or equity (which includes retained earnings).
The company with a durable competitive advantage will be using its earning power to finance its operations and therefore, in theory, should show a higher level of shareholders’ equity and a lower level of total liabilities.
The company without a competitive advantage will be using debt to finance its operations and therefore should show just the opposite, a lower level of shareholders’ equity and a higher level of total liabilities.
Debt to Shareholders’ Equity Ratio = Total Liabilities / Shareholders’ Equity
The problem with using the debt to equity ratio as an identifier is that the economics of companies with a durable competitive advantage are so great that they don’t need to maintain any shareholders’ equity.
Because of their great earning power, they will often spend their built-up equity/retained earnings on buying back their stock, which decreases their equity/retained earnings base.
That in turn, increases their debt to equity ratio, often to the point that their debt to equity ratio looks like that of a mediocre business – one without a durable competitive advantage.
It is easy to see the contrast between companies with a durable competitive advantage and those without it when we look at the treasury share-adjusted debt to shareholders’ equity ratio.
If we add back into the equity the value of all the treasury stock acquired through stock buybacks, then the debt to equity ratio of these companies with durable competitive advantage can be clearly noticed.
With financial institutions like banks, the ratios, on average tend to be much higher than those of their manufacturing cousins.
Banks borrow tremendous amounts of money and then loan it all back out, making money on the spread between what they paid for the money and what they can loan it out for.
This leads to an enormous amount of liabilities which are offset by a tremendous amount of assets.
On average, the big banks have $10 in liabilities for every dollar of shareholders’ equity they keep on their book.
That is, banks are highly leveraged operations.
The simple rule: unless we are looking at a financial institution, any time we see an adjusted debt to shareholders’ equity ratio below 0.8 (the lower the better), there is a good chance that the company in question has the coveted durable competitive advantage we are looking for.
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