I. Business
The key in stock picking is not to lose your principal amount. This can be achieved investing only in sound businesses at sensible prices. The first part of the dilemma is distinguishing good business from mediocre and the second one is valuation. When you get a grasp on business quality, you can delve into “average” businesses having full knowledge of the situation and what you are doing.
Micro economy or bottom-up approach is what leads to the overall macro picture because macro is a sum of micro units. Some industries are doing better and some units are doing better than others inside an industry. This is common sense. How to distinguish a good from bad?
A quick way to filter is looking at the return on invested capital (profit / capital needed to run the business) (10-year numbers). High profit margins (profit / sales) could be another hint [NB: a very distant break-even point can also very a powerful competitive advantage; e.g. think of Coca Cola making 1c from every serving…]. High values in both parameters should lead you to good businesses. It sounds simple but really common sense – if you can charge high margins, you must be doing something great for you customer (they still buy from you) and are better than competitor (they cannot offer anything better), and if you can pay back invested capital quickly and reinvest generated money at high return rates, this means that you have a lot of invisible / unquantifiable capital and value. Now you just have to make sense of those invisible things. [NB this does not mean that high capital requiring industries are bad investments – they are of a different kind, like financial companies, and could be very profitable investments]
The trick is to find out what is invisible and determine if it is sustainable (i.e. cannot be destructed by capital and creativeness). In other words, profits are protected by moats (Buffett’s vocabulary) or competitive advantages (Michael Porter), which are continuously under assault of creative destruction.
Moats or Competitive Advantage
“[What counts is] competition from the new commodity, the new technology, the new source of supply, the new type of organization... competition which... strikes not at the margins of the profits and the outputs of the existing firms, but at their foundations and their very lives.” Capitalism, Socialism and Democracy by Joseph Schumpeter
The topic of business moats / competitive advantages is one of the most interesting in business studies. The basic concept is easy to grasp (I will try to make some sense of it below), however, life is a dynamic process and new moats are emerging while old, supposedly sustainable ones, are becoming must-haves and ubiquitous elements of businesses. And really, the key concept here is sustainability.
It is important to remember that if the best possible management meets the worst industry / business, the latter will prevail. Think about textiles – does it make a difference if you can buy a 2-times more efficient machine, which can be bought by anybody? Such a “first mover” (or machine buyer) advantage can last for a few months, which does not bode well for sustainability.
So, what can make a firm unique and having capacity to take money profitably from its customers for long time? There are 2 aspects: a) industry structure; and b) business specific features.
If we still remember that industry is stronger than management, industry structure becomes crucial for determining predictability of profits. It is common sense that if you have fewer competitors, profits can be larger. When there are 2 or 3 remaining, nice things can happen to profits, especially if those remaining in action can demonstrate pricing discipline or, in other words, agree on pricing without discussing the subject, which is illegal.
Without going into great detail, I will give you reference where you can dig further. First of all, Michael Porter developed a useful chart of 5 forces (all charts are borrowed from M. Mauboussine & K. Bartholdson paper “Measuring the Moat”).
After practicing this chart on a few businesses, you should develop a useful habit of running any industry fundamentals through such lenses. One of the key concepts to discuss is barriers of entry. Obviously, if they are high, there will be less competition.
There are different layers and twists, some concepts are dependent on each other or complimentary but I think that the list provided below is a useful checklist:
== cost advantage (think about: economies of scale, location, process, access to unique resource, proprietary process, quick learning curve, etc.)
== proprietary product / service and / or technology / process (think about: patents, brands, regulatory licenses, contracts; the key test for brand strength is if it can charge a higher price; in other words – captivity induced by habit; yes, business can create habits)
== switching cost (key word here again is captivity; changing vendor is always a hassle – psychological, monetary, time, training, very important component and low % of total cost, etc.)
== network effects (value of products and services increases with the number of users – build a critical mass and let the snowball grow by itself)
== capital requirements (apart of obvious, think also about advertising spending)
== access to distribution / selling channel (best is if the channel is created in-house – think of multi layer marketing, Coca Cola sign is usually max 50m from you on the street, etc.)
== government regulation (government is famous and very capable of creating monopoly monsters but the best thing is to have many small concessions than one big and easy removable)
== expected retaliation (balance sheet strength is very important here)
Please let me know if you know how to improve the list.
Note that efficiency and differentiation are absolutely essential in any business.
Finally, company specific moats (in addition to industry situation) and the strongest moats are usually combinations of many smaller moats and factors. In value investing slang it is called lollapalooza effect. You will definitely be a better person if you read these 2 pieces:
Elementary Wordly Wisdom or Artof Stock Picking by Charlie Munger (there are only about 100 models worth studying which cover almost all life tricks)
Practical Thought AboutPractical Thought by Charlie Munger (Coca Cola case study) (email me for a photocopy from Of Permanent Value)
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