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.
Cost Advantage
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.
Legal Protection
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.
Brand Loyalty
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 Innovation
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 Cost
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
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
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
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.
