Whether you pick a low PE stock or a high dividend paying stock, it is summarised to the fundamentals of the company that you are investing. In Warren Buffett’s term, we need to see beyond the numbers, we need to look for companies with economic moats.
An “economic moat” is a competitive advantage that is unique to an individual company which is difficult for rivals to imitate. It acts as a barrier-to-entry for competing firms aspiring to capture market share, and it protects the long-term viability of a company.
There are a few types of economic moats or competitive advantages that firms can strive to acquire.
Warren Buffett once referred to his auto insurance business as having an “economic moat” because of its low cost. The company’s cost advantage is that it sells direct to the consumer, via the internet and phone, rather than employing an army of costly agents, which adds a huge layer of operating expense. Warren Buffet said, “If prices are set by its competitors with all their expensive agents, the business will consistently enjoy higher margins and returns than its competitors, and will earn a return in excess of its cost of capital”.
A company that can produce a quality good or service and deliver it to the consumer cheaper than its competitors has a cost advantage. Cost advantages are typically industry-specific and can be attributed to lower cost inputs, process efficiency, superior technology or location. A cost advantage is often the first type of competitive advantage sought by a company entering the marketplace.
A company who owns a trademark or has patented technology unique to that industry has a natural barrier-to-entry and prevent potential rival firms from entering into the market. For example, Biotech and software companies depend on patents for their medicine and information systems technology to create their economic moats. Media companies will copyright intellectual property and works of art in an effort to protect exclusive content from competitors and establish an economic moat based upon product differentiation.
In Malaysia, the best example of a legal barrier that gives rise to a monopoly is the Genting Berhad’s casino license.
In certain cases, brand loyalty can be the most valuable asset to a company and provide a formidable economic moat. An illustration of brand loyalty is Coca-Cola, which has been one of Warren Buffett’s largest investments over the years. Berkshire Hathaway owns 400 million shares which accounts for more than 9% of the company.
Coca-Cola is a long-time favourite stock of the Oracle of Omaha. Not only is Coca-Cola the favourite drink of Warren Buffett, from an investment perspective, the company has one of the world's strongest brand names, which allows it to charge more than rivals for essentially the same product, and to sell even more of its products all over the world.
Warren Buffett even said, "If you gave me $100 billion and said to take away the soft drink leadership of Coca-Cola in the world, I'd give it back to you and say it can't be done."
Technology giants like Microsoft, Google and Apple have proprietary technological know-how that are usually legally protected. These tech giants also have the knowledge, capabilities and skills that are difficult to duplicate. And amazingly, the market power that these firms enjoyed is closely link to their ability to innovate and to further protect their market position.
According to the great economist, Schumpeter, there is a close relationship between innovation and market structure. Once a company, through innovation, achieves a monopoly position, tends to reinforce this position by controlling and extending the period of benefit due to patents. At the same time, with the premium profits, the company can support the costs related to innovation, and it is the innovation itself that determines or reinforces the company’s market position further, creating economic moats for the company. Hence, these technology giants are usually cash-rich due to their premium profits arising from their market structures.
Switching costs are the costs associated with switching suppliers or brands by a consumer. Switching costs involve the expenses, inconvenience, and new learning that consumers would be required to make if they were to start purchasing another product. For example, the mobile telecommunication companies in Malaysia offer mobile phone plans that comes in a lock-in periods of 12 months to 24 months. This is to prevent customers from switching to other mobile telecommunication providers by imposing hefty penalty fees for early break of agreements.
Another example is Apple. The Apple ecosystem, which involves products such as the iPad, MacBook, iPhone, iTunes and iPod, is intricately related. All of these products operate on Apple's iOS operating system, which differs greatly from the operating systems of competitors' products and all of these products and their respective files can be managed with Apple's iCloud. As a result, existing Apple users are often so invested in the company's products that competitors would need to offer crazy discounts for Apple users to consider changing products. As a results, Apple has created high switching costs in an attempt to create its own economic moats.
As a general rule, the more substantial the moat, the more stable the company. Economic moats can protect companies from competition, helping them to earn premium profit over the long run, and therefore making them more valuable to an investor.
Return On Capital
While “economic moats” are the qualitative aspects of stock selection, we still need to look at numbers again to confirm if the company is profitable. One way to measure whether the company is profitable or not is to look at their Return on Capital which is comprised of the following three financial ratios:
ROA is calculated by dividing a company’s operating profit (earnings before interest expense and incomes taxes, or EBIT) by average total assets.
ROA is in fact the product of two other ratios: total asset turnover and operating margin, calculated as follows:
Sales X EBIT
Average Total Assets Sales
The first ratio, total asset turnover, is a measure of a firm's productivity, i.e., how much revenue does one dollar of assets generate? The second ratio, operating margin, is a measure of a firm's profitability, i.e., what percentage of these revenue dollars remains as operating profits? Putting the two ratios together becomes a high-level summary measure of operating performance.
ROE on the other hand is calculated by dividing a company’s net income by its shareholders fund (equity).
ROE = Net Income / Shareholders’ Funds
It measures the rate of return of shareholders of a company receive on their shareholdings. In other words, ROE signifies how good the company is in generating returns on the investment it received from its shareholders.
The denominator – shareholders’ funds is the difference of a company's assets and liabilities. It is the amount left over if an organisation decides to settle its liabilities at a given time.
So if a firm has an ROE of say 10%, it means for RM1 of common shareholding generates a net income of RM0.10. This metric is especially important from an investor's perspective, as he/she uses it to judge whether the firm is efficient enough to generate income for its shareholders.
Investors generally prefer firms with higher ROEs. However ROE can be manipulated by share buybacks and debt leverage as the formula itself does not include the “debt” component of the balance sheet. Hence, smart investors should learn how to look at another similar financial ratio called the ROCE – Return on Capital Employed.
ROCE is calculated by dividing a company’s Earnings Before Interest and Taxes (EBIT) by its Capital Employed, where Capital Employed is the Total Assets less its Current Liabilities.
ROCE = Earnings Before Interest and Tax (EBITA) / Capital Employed
The ROCE indicates the amount of capital investment that is needed for a particular business to operate successfully. Since ROCE considers a company’s long term debt obligations, the figures takes a longer view of the firm’s continued financial viability.
ROCE measures the overall profitability of the company’s operations while ROE focuses on the return generated by its shareholders on their investment in the business. Investors should look at various return on capital ratios in order to gauge the overall profitability of a company.
Is Investing An Art or A Science?
Finally, I believe investing is a combination of both art and science, but more weight is on the ‘science’ part. It is science because when it comes to which stocks to buy, we need to look at the fundamental analysis and technical analysis of a stock which are the technical aspects of investing and can be laborious.
On the other hand, investing is not as simple as one plus one equals to two! It requires an investor to have his or her own investment philosophy which depends on an individual’s investment style and risk preference, which is the ‘art’ component. Simply because what is suitable for one investor may not be suitable for another. You may see one investor become successful by investing in Technology stocks but others may not be so successful.
To do well in this field one has to take strong calls on investments, stick to one’ beliefs, learn from past mistakes and have a focused approach to investing without the noise of others.
Last but not least, one should treat investing as a business or a hobby that requires your attention. Remember, the more time you spend on your investment, the more you will be rewarded from it.