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Archive for February, 2010

A sustainable competitive advantage is the ability for a business to do something that its (potential) rivals cannot. It means being able to:

  1. Keep the business’s current customers;[1] and,
  2. (Possibly) grow by attracting new customers;
  3. On terms which are more profitable than the business’s competitors;
  4. For a reasonably long-time (it is sustainable not temporary).

 I think the best competitive advantages in achieving this are, in descending order:

  1. Economies of Scale combined with Customer Captivity;
  2. A Network Effect;
  3. A Government Licence;
  4. Patent Protection; and,
  5. Customer Captivity.[2] [3]

How a business gets a competitive advantage

A business usually gets a competitive advantage from deliberately trying to gain a competitive advantage, or simply by good luck.[4]

Where do you find businesses with sustainable competitive advantages? 

I agree with Greenwald and Kahn’s conclusion that a business with a competitive advantage is much more likely to be ‘local’ and operate:

a)     In a limited geographical area (Wal-Mart in the US south); or,

b)     In a limited product space (Microsoft with its operating systems).[5] 

 This usually applies irrespective of the type of competitive advantage. For example, a business with an economies of scale competitive advantage is more likely to be ‘local’ for two reasons. Firstly, operating in a small market makes it is more difficult for a new entrant to capture enough market share off the incumbent to reach economies of scale. Secondly, high fixed costs, the linchpin of economies of scale, are fixed only within the region or product space in question.[6]

 A business with a customer captivity advantage is also more likely to be ‘local’ because it is often selling a customised product or service to its customers. Providing this customised product or service usually needs the business to specialise in a limited geographical area or product space.

 The restricted nature of a government licence or patent also means that businesses with these competitive advantages are often in a limited geographical area or product space.

A competitive advantage is limited to the product

If a business has a competitive advantage with a particular product that does not mean it has a competitive advantage with its other products. For example, Pepsi drinkers have no particular attachment to KFC.

I will discuss each of these different types of competitive advantage, and how strong I think they are, soon.


[1] Other than customers that naturally die or age out of the market.

[2] Customer captivity refers to how a business has ‘captured’ a customer. This can be because the customer will have high costs in ‘switching’ to an alternative product or an alternative service provider, or high costs in ‘searching’ for this alternative, or simply because the customer has developed a strong ‘habit’. I will discuss this form of competitive advantage in much greater detail in a later post.

[3] I think customer captivity is not as powerful as the other competitive advantages because it only allows a business to profitably grow from its current customer base. It does not allow the business to grow by attracting new customers on the same profitable terms.

[4] A business may have a competitive advantage simply because of good luck. As Denrell points out: “(it) is often argued that a strong performance record by a business cannot be because of good luck but indicates superior practices. The underlying idea is that sustained high performance is less likely to be the result of chance events. In other words, high performance during a number of years will filter out random noise and better reveal average tendencies, perhaps determined by capabilities. The reasoning assumes that the performance of an organisation is the sum of independent and random variables. If the random variables are not independent, high performance during the whole period may not be very impressive. An analogy makes the point. It a runner wins 10 independent races, she is probably a good runner. Suppose the races are dependent, however. That is, if a runner won by one minute, she starts one minute before the second runner in the next race. Clearly winning 10 such races is less impressive because if you won the first, you should have a higher chance of winning a second… Many industries consist of such dependent races.” See, P 295, Should we be impressed with high performance, J. Denrell, Journal of Management Inquiry, September 2005.

[5] See ‘All Strategy Is Local’, Bruce Greenwald and Judd Kahn, Harvard Business Review, 2005.

[6] Ibid at P3.

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I think the main reasons for why a business can have a high return on invested capital (ROIC) [1] [2] are:

  1. The business has had good luck;
  2. The business has been more operationally efficient than its competitors[3];
  3. The business has a sustainable competitive advantage;
  4. The business has a temporary competitive advantage; 
  5. The business’s earnings are high because the industry or the economy is at a cyclical peak; or,
  6. The business is in a new industry and competitors have only started to enter the industry.

The problem is that most of these reasons are likely to be unsustainable. This is because:

  1. The business’s good luck can easily run out;
  2. Competitors can become more operationally efficient, or the business becomes less efficient[4];
  3. The business’s temporary competitive advantage disappears;
  4. The business’s earnings falls because the industry, or economic, cycle turns; or,
  5. Competitors enter the new industry.

This is why I want a business, which has a high ROIC, to have a sustainable competitive advantage.[5] I think is far more likely that a business will be able to sustain a high ROIC if the high ROIC is due to a sustainable competitive advantage and not because of one of these other reasons. If is far more likely because it will be unprofitable for other businesses to compete against them.[6]

I will discuss what I think is a sustainable competitive advantage in my next post.


[1] A business’s ROIC is its Return on Invested Capital. It tells you how profitable a business has been. It does this by telling you the amount of capital the business needed to produce its profit. 

[2] A high ROIC is defined as a ROIC significantly above my discount rate.

[3] See, ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

[4] I believe that most businesses with good operational efficiency only have a temporary competitive advantage (there are exceptions). I think it is usually only temporary because this operational efficiency can naturally decline, or a competitor can reproduce it.

 A business’s good operational efficiency can naturally decline because:

  1. Management dies, or retires, or is poached by other businesses; or,
  2. Management becomes sidetracked by some major internal or external issue (for example they make a takeover offer, or are involved in a major lawsuit); or,
  3. Management simply loses its drive.

 A competitor can reproduce another business’s good operational efficiency by copying the successful business’s operational practices, or by recruiting better management.

[5] However, the closer my valuation assumes a business’s ROIC is to my discount rate the less sustainable the business’s competitive advantage will need to be.

[6] However, as Greenwald and Kahn point out, if competitors are not rational and do enter, or expand within the industry, I must never assume that they will then realise their error and just as quickly exit the industry, or reduce capacity. These two processes are not symmetrical. Competitors with patient capital and an emotional commitment to the business may not exit the industry for a long time. Greenwald uses the analogy that it is much easier to buy kittens and puppies then to drown them later. This will impair the profitability of those businesses in the industry that have a sustainable competitive advantage for years. See P25, ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

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I value a business using its Return on Invested Capital (ROIC) [1] because this profitability measure is independent of the business’s capital structure (the proportion of debt and equity). [2] A business’s Return on Equity (ROE) is not. I think the valuation of a business should be independent of its capital structure because the business’s value rests on the earnings it makes on the assets it uses, not on how it finances those assets. 

For example, a business can increase its ROE by using debt to buy assets. This will most likely increase the risk for the business’s equity holders. Increasing a business’s ROE, by increasing its debt, does not necessarily make the business more valuable because the return required for the equity holders must be higher to compensate for this greater risk. By comparison, if a business increases its ROIC it is undeniably more valuable.[3]  

Costantini explains this much better than I do when he says:  

 “Clouded thinking over debt and equity, assets and liabilities, of which the heavy use the ROE ratio is a prime example, is ubiquitous…

Suppose that an investor wanted to buy a property for rental income. Surely, he would wish to visit the property a few times, assess the surroundings, the amenities, the neighbours. He would make up his mind about a likely rent, the amount by which he could increase it every year, and then decide on a price that would make this investment worthwhile. Next would come haggling with the seller, and finally he would arrange financing. It would never occur to him to do it any other way especially not in the reverse of our suggested order. That is because the main object of this property buyer is to assess the growth and return prospects of an economic object, which demands an investigation of the asset side of the balance sheet. To this end, there is no relevant information on the liability side. On the other hand, suppose that our investor now wanted to investigate the market value of an economic object. The asset side is now not so useful.” [4]  

   


 [1] A business’s ROIC is its Return on Invested Capital. It tells you how profitable a business has been. It does this by telling you the amount of capital the business needed to produce its profit. 

 [2] Joel Greenblatt determines a business’s profitability by its return on tangible assets (ROTA). See, The Little Book That Beats the Market’, Joel Greenblatt, 2005. I measure a business’s profitability by its return on invested capital (ROIC). I prefer this measure because it shows you the business’s earnings as a proportion of all the assets of the business. The ROTA shows you the business’s earnings as a proportion of only the tangible assets of the business. 

[3] On a sustainable basis. 

[4] P57, Cash Return On Capital Invested: Ten Years Of Investment Analysis With The CROCI Economic Profit Model’, Pascal Costantini, 2006.

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In my last post I said that if a business’s ROIC has been, or is, greater than my discount rate, I think the business is likely to be viable. I also said it means that any growth by the business is likely to be profitable for me. In this post I am going to explain why a business’s ROIC tells me if its earnings growth will be profitable.  

How a business grows its earnings

Earnings growth by a business normally needs the business to grow its assets (for example inventory, receivables, plant and equipment and intangibles). The business usually has to pay for most of these new assets by using new capital.[1] This new capital must come from either retained earnings or new capital raised from shareholders (that’s me if I am an investor) or new borrowings. The owners of this new capital will have to be paid a return for providing the capital.[2]  

How a business’s ROIC tells me if its earnings growth will be profitable

A business’s earnings growth will only be profitable to me if the business earns more on these new assets than the minimum return I need to provide the capital (my discount rate). For example, when a business’s ROIC is equal to my discount rate, asset growth by the business will have no value to me because the return the business will earn on the new capital will just equal the opportunity cost to me for letting the business use my capital. Thus, while the business has increased in size, simply because it has more assets, the net return to me is zero.

When a business’s ROIC is lower than my discount rate, asset growth by the business will actually destroy value for me. This is because the business earns less on the new assets than the opportunity cost to me for letting the business use my capital.

Only when a business’s ROIC is higher than my discount rate is asset growth by a business profitable to me. It will be profitable because the business earns more on the new assets than the opportunity cost to me for letting the business use my capital. As a shareholder, I will receive these additional earnings. I will receive these additional earnings directly, either by dividends, or indirectly, by the business increasing in value because it has retained all or part of these earnings.[3]  

This is a very important point for investors to understand. Many investors think earnings growth by a business is unambiguously good. It is not. In many cases earnings growth will reduce the business’s value.  


[1] Some of the asset growth will usually be funded by a growth in spontaneous liabilities. Spontaneous liabilities are liabilities such as accounts payable, wages payable, accrued expenses, and accrued taxes. 

[2] For an excellent discussion of this process see, ‘Value Investing: From Graham To Buffett And Beyond’, Bruce Greenwald et al, 2001.  

[3] For an excellent discussion of this issue see, ‘Value Investing: From Graham To Buffett And Beyond’, Bruce Greenwald et al, 2001.

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My Discount Rate

I will usually only buy a business if its Return on Invested Capital (ROIC) [1] is greater than my discount rate (except for the last year).[2] I adopt this approach because if a business’s ROIC has been, or is, greater than my discount rate, I think the business could be viable. It also means that any growth by the business could be profitable for me.

What is my discount rate?

My discount rate is the real 10 year bond yield plus 4% (with a minimum of 7%)[3].

Why I use this discount rate

Buying a business is risky. I use this discount rate because it is the minimum return I will accept to take this risk.[4]

Why I use a real discount rate

My next comment is contentious and is the kind of issue that causes punch ups at equity analyst conventions… I use a real discount rate because I believe that the yield from a business is (over the long run) largely a real yield. This is because a business’s assets, and its earnings, are both likely to rise (in the long run) by a similar rate to the inflation rate. If the yield from a business is largely a real yield than my opportunity cost (discount rate) must also be a real yield.

Costantini’s research provides convincing evidence that business earnings are largely real.[5] He summarised his research by saying:

 “Unlike bondholders, shareholders possess a claim on the earnings (of a business) by the dividend and have ownership of the underlying assets, whose replacement value will rise and fall with the level of inflation. Furthermore, the feed through effect of inflation in the profit and loss account has to be taken into account. Faced with rising input prices, businesses will initially accept a certain amount of margin compression, but will eventually pass on this cost inflation to their customers, and all the way to the bottom line. Indeed, our research suggests that there is a 93% pass-through of CPI inflation to earnings growth in the long run.”[6] 

Why I use only one discount rate for different businesses

I only use one discount rate to value all businesses because my valuation process deals with the different risks that businesses face by changing the upside, central case and downside scenarios for each business. I think this a conceptually easier and more accurate way for me to adjust for these risks. I also think that this process will make me closely examine the risks of buying a particular business and, thus, more accurately value it.

Why I do not use a business’s WACC as my discount rate

I think a business’s ‘discount rate’ should simply be the opportunity cost to me for letting the business use my capital. Many equity analysts use a business’s WACC (Weighted Average Cost of Capital) as their discount rate. I do not use this as my discount rate because I do not agree with its calculation. One of the variables used to calculate the WACC of a business is the business’s cost of equity. In turn, a variable used to calculate the business’s cost of equity is the business’s beta. Beta supposedly measures the risk of investing in a business by increasing when the market price volatility of a business increases, and falling when the price volatility of a business falls. I do not think you should estimate how risky it is to invest in a business based on the price volatility of that business. As Warren Buffet explains, it was riskier to buy the Washington Post when its market price was $80 million, even though it had lower price volatility, (a lower Beta) than when its market price was $40 million and it had higher price volatility (a higher Beta).[7] It was riskier because you had to pay a much higher price to buy equity in the business. I think Buffett explained this well when he said:

“If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.

One quick example: The Washington Post Company in 1973 was selling for $80 million in the market… Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million.”[8]

  


[1] A business’s ROIC is its Return on Invested Capital. It tells you how profitable a business has been. It does this by telling you the amount of capital the business needed to produce its profit. I will discuss why I prefer this measure of profitability over other measures, such as ROE, later in this blog.

[2] I make the exception for the last year because the business may be suffering from what I think is only temporary problems. That is usually why it is ‘cheap’. I also make an exception to this rule for businesses that are likely to be liquidated or are in run off.

[3] This also matches the long term (since 1900) CPI deflated returns from world equities of roughly 7%. Thus, if I assume long-term inflation is 3%, a reasonable nominal expected return from a business should be a minimum pre tax return of 10%. See ‘Triumph of the Optimists’, Elroy Dimson, London Business School, October 2003. I use a post-tax real discount rate for Australian companies that have franked dividends.

[4] This includes the risk that part of the business’s earnings do not rise at the same rate as the inflation rate.

[5] P41: ‘Cash Return On Capital Invested: Ten Years Of Investment Analysis With The CROCI Economic Profit Model’, Pascal Costantini, 2006.

[6] P41: ‘Cash Return On Capital Invested: Ten Years Of Investment Analysis With The CROCI Economic Profit Model’, Pascal Costantini, 2006.

[7]The Superinvestors of Graham-and-Doddsville’, Speech given by Warren Buffett on May 17, 1984 at Columbia University.

[8] Ibid.

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If a business has not been operating profitably for at least five years I will usually not buy them

Young businesses are seductive. I often want to buy them because many of them sell great new products or services and have strong profitable growth. However, the problem with buying such businesses is that they have too short a history for me to value them properly.[1] For example, it is very difficult for me to predict if they will be able to sustain a high Return on Invested Capital (ROIC). This makes them risky investments. While I could increase the downside risk when valuing them, I think it is too difficult to decide what that risk is. Thus, I do not usually buy them.[2] 

Huhne explains the problem with investing in young businesses well when he says: 

 “The real problem is that investors fall in love. They fall in love with new things, with innovations, and the important thing about new things is that it is very difficult to assess the real riskiness of them because you do not have a history by definition”.[3] 

The business must be highly likely to still exist in 10 years time[4]

This rule applies irrespective of how old the business is! The reason for this rule is simple. If the business does not exist in 10 years time it is likely to be a very poor investment. However, it is hard for me predict whether a business will be around in 10 years time. Therefore, I simply assume that businesses in industries that change the least are the most likely to last. The industries that change the least are usually low technology product or service industries. However, I do think that some well entrenched high technology companies (think Microsoft) are likely to last. 

The graphs below show how risky it is to assume that a business in a fast changing technology industry will still exist in 10 years. The number of businesses in both of these technology industries rose and fell dramatically over a short period. 

  

[Click on the image for a better view] 

Source Michael Mauboussin[5] 


 

[1] This problem also exists for young businesses in established industries because it will be too difficult for me to estimate how well the business will compete against established industry members in the medium to long run. 

[2] I make an exception to this rule for young businesses that I think are ‘cheap’ compared to the value they will realize in liquidation or in run off. 

[3] ‘Comments on credit rating agencies and the US credit crunch’, Huhne, C, World Business Review, BBC World Service, September 1, 2007. 

[4] I also make an exception to this rule for businesses that I think are ‘cheap’ compared to the value they will realize in liquidation  or in run off. 

[5] P108, ‘More Than You Know: Finding Financial Wisdom in Unconventional Places’, Michael Mauboussin, 2007.

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What information I use to value a business

I think Montier is right when he says you should value a business by focusing on its key elements:

“…Studies suggest that rather than obsessing with the bewildering informational fusion of news and noise we should concentrate on a few key elements of a business i.e. what are the five most important things that we should know about any business in which we are about to invest.” [3]

I value a business by focussing on the following key elements:

  1. Its assets;
  2. Its historical profitability (its historical ROIC);
  3. Its historical asset growth;
  4. Whether the business has a sustainable competitive advantage (if relevant);
  5. The upside, central case and downside scenarios for the business; and,
  6. Its enterprise value (price).

I have designed my entire investment process to analyse these six elements. I will discuss each of these elements in more detail later.

How long do I spend on valuing a business?

I usually spend at least one week valuing a business before I buy the business. Some of you may be surprised that I consider a week’s analysis sufficient. However, I think valuing a business is different to finding out everything that I can about a business. I do not try to understand everything about a business because buying a business, while not knowing everything about it (being uncertain), may mean I can buy it at a big enough discount to offset this risk. As Klarman explains:

“Uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.”[1] [2]

This is a crucial point. Why value investing works is that businesses can become ‘cheap’ because other investors, usually for behavioural reasons, can overreact and sell the business when they should not. Those same behavioural reasons can cause investors to ‘underreact’ on the upside. That is, they need to see a lot of positive information about the business before they will invest. By that time the price of the business has usually increased significantly. If you are willing to buy a business, while there is still a lot of uncertainty, I think, to use Klarman’s terminology, you can be ‘well rewarded’.

This approach also means I often have to react fairly quickly. I think this one of my comparative advantages. Only one person (me) is making the investment decision. If I see a business which I think is ‘cheap’ I can drop everything and focus solely on valuing that business. I do not have the constraints that many institutional investors do. I do not need to wait until the ‘asset allocation’ committee meets, or the ‘investing committee’ meets, or one of the analysts returns from meeting with the company! I can focus solely on valuing the business and make a decision on whether to buy it within a week.


[1] P157, ‘Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor’, Seth Klarman, 1991.

[2] In addition, having too much information about a business can be harmful to decision-making. I can suffer from information overload, and fall into the trap of attaching too much confidence to my estimate of its value. See P133, ‘Behavioural Investing’, James Montier, 2007. .

[3] P134, ‘Behavioural Investing’, James Montier, 2007.

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