The Five Rules for Successful Stock Investing, by Pat Dorsey

Pat Dorsey is the founder of Dorsey Asset Management, the former director of equity research at Morningstar and Sanibel Captiva Trust, and the author of several investment books.

Below are the key insights from his book The Five Rules for Successful Investing:

Picking great stocks is tough:

• The bad news is that picking individual stocks requires hard work, discipline, and an investment of time (as well as money).
• The good news is that the basic principles of successful stock-picking aren’t difficult to understand, and the tools for finding great stocks are available to everyone at a very low cost.
• All you need are patience, an understanding of accounting and competitive strategy, and a healthy dose of skepticism.
• The basic investment process is simple: Analyze the company and value the stock.
• Remember that buying a stock means becoming part owner in a business.
• Great companies create wealth, and as the value of the business grows, so should the stock price in time.
• In the short term, the market can be capricious, but over the long haul, stock prices tend to track the value of the business. As the short-term price movement of a stock is completely unpredictable, you should focus on the long-term performance of businesses.
• Your goal as an investor should be to find wonderful businesses and purchase them at reasonable prices.
• It is not worth devoting any time to predicting Mr. Market’s actions. None of the truly exceptional managers do. Instead, they all focus on finding undervalued stocks that can be held for an extended time. Betting on short-term price movements means doing a large amount of trading, which drives up taxes and transaction costs.
• Successful stock-picking means having the courage to take a stance that’s different from the crowd.

The five rules for successful stock investing:

1. Do your homework. The most common mistake that investors make is failing to thoroughly investigate the stocks they purchase. Unless you know the business inside and out, you shouldn’t buy the stock. That means sitting down and reading the annual report cover to cover, checking out industry competitors, and going through past financial statements. Think of the time you spend on research as a cooling-off period. It’s always tempting when you hear about a great investment idea to think you have to act now, before the stock starts moving. But your research process might very well uncover less attractive facts. And if it is a winner, missing out on the first couple of points of upside won’t make a big difference.
2. Find economic moats. Focus on companies with wide economic moats that can help them fend off competitors. In any competitive economy, capital seeks the areas of highest expected return, the most profitable firms find themselves beset by competitors, and profits have a strong tendency to regress to the mean. Economic moats allow a relatively small number of companies to retain above-average levels of profitability for many years, and these companies are often the most superior long-term investments. The key to identifying wide economic moats can be found in the answer to the question “How does a company manage to keep competitors at bay and earn consistently fat profits?”.
3. Have a margin of safety. Finding great companies is only half of the investment process—the other half is assessing what the company is worth. The goal of any investor should be to buy stocks for less than they’re really worth. This difference between the market’s price and our estimate of value is the margin of safety. The margin of safety should be larger for shakier firms with uncertain futures and smaller for solid firms with reasonably predictable earnings. If you later realize you overestimated the company’s prospects, you’ll have a built-in cushion that will mitigate your investment losses. Sticking to a valuation discipline is tough for many people because they’re worried that if they don’t buy today, they might miss the boat forever on the stock.
4. Hold for the long-haul. Buying a stock is a major purchase and should be treated like one. Short-term trading means that you’re playing a loser’s game: the taxes and brokerage costs really begin to add up, and create an almost insurmountable hurdle to good performance.
5. Know when to sell. Knowing when it’s appropriate to bail out of a stock is at least as important as knowing when to buy one, yet we often sell our winners too early and hang on to our losers for too long. The key is to constantly monitor the companies you own, rather than the stocks you own. Don’t sell just because the price has gone up or down, but give it some serious thought if: (1) You made a mistake buying it in the first place, (2) the fundamentals have deteriorated, (3) the stock has risen well above its intrinsic value, (4) you can find better opportunities, or (5) it takes up too much space in your portfolio.

Seven mistakes to avoid:

1. Swinging for the fences. Loading up your portfolio with risky, all-or-nothing stocks is a sure route to investment disaster. Instead, focus on finding solid companies with shares selling at low valuations. Making up large losses is a very difficult proposition (a stock that drops 50 percent needs to double just to break even). Many smaller firms never do anything but muddle along as small firms, assuming they don’t go belly up, which many do.
2. Believing that it’s different this time. The four most expensive words on Wall Street are “It’s different this time.” History does repeat itself, and bubbles do burst. Understanding the market’s history can help you avoid repeated pitfalls.
3. Falling in love with products. Great products do not necessarily translate into great profits. Although great products and innovative technologies do matter when you’re assessing companies, neither matters nearly as much as economics. When you look at a stock, ask yourself, “Is this an attractive business? Would I buy the whole company if I could?”. If the answer is no, give the stock a pass—no matter how much you might like the firm’s products.
4. Panicking when the market is down. Stocks are generally more attractive when no one else wants to buy them, not when barbers are giving stock tips. It is very tempting to look for validation (other people doing the same thing) when you are investing, but history has shown that assets are cheap when everyone else is avoiding them. Going against the grain takes courage, but pays off: you will do better if you think for yourself and seek out bargains in parts of the market that everyone else has forsaken, rather than buying the flavor of the month.
5. Trying to time the market. Market timing is one of the all-time great myths of investing. There is no strategy that consistently tells you when to be in the market and when to be out of it.
6. Ignoring valuation. The only reason you should ever buy a stock is that you think the business is worth more than it’s selling for—not because you think a greater fool will pay more for the shares a few months down the road. Although it’s certainly possible that another investor will pay you 50 times earnings down the road for the company you just bought for 30 times earnings, that’s a very risky bet to make.
7. Relying on earnings for the whole story. At the end of the day, cash flow is the true measure of a company’s financial performance, not earnings. Accounting-based EPS can be made to say just about whatever a company’s management wants them to, but cash flow is much harder to fiddle with.

Economic moats:

• Investors often judge companies by looking at which ones have increased profits the most and assuming the trend will persist in the future. But more often than not, the firms that look great in the rearview mirror wind up performing poorly in the future, simply because success attracts competition. In free markets, capital always seeks the areas of highest expected return, so the bigger the profits, the stronger the competition. Therefore, most highly profitable firms tend to become less profitable over time as competitors chip away at their franchises.
• To analyze a company’s economic moat, follow these four steps.
  • 1. Evaluate the firm’s historical profitability. Has the firm been able to generate a solid return on its assets and on shareholders’ equity? This is the true litmus test of whether a firm has built an economic moat around itself. What you are looking for are firms that can earn profits in excess of their cost of capital. Firms that consistently post FCF/sales above 5%, net margins above 15%, ROE above 15%, or ROA above 6% are more likely to have an economic moat than firms with more erratic results.
  • 2. If the firm has solid returns on capital and consistent profitability, assess the sources of the firm’s profits. Why is the company able to keep competitors at bay? What keeps competitors from stealing its profits?When you’re examining the sources of a firm’s economic moat, the key thing is to never stop asking, “Why?”. When possible, look at the situation from the customer’s perspective. In general, there are five ways that an individual firm can build sustainable competitive advantage: (1) Creating real product differentiation through superior technology or features, (2) Creating perceived product differentiation through a trusted brand or reputation, (3) Driving costs down (better process, larger scale) and offering a similar product or service at a lower price, (4) Locking in customers by creating high switching costs (training, integration with customers’ business, industry standard, limited benefit of switching, long-term contracts), (5) Locking out competitors by creating high barriers to entry (patents, licenses) or high barriers to success (network effects).
  • 3. Estimate how long a firm will be able to hold off competitors, which is the company’s competitive advantage period. Some firms can fend off competitors for just a few years, and some firms may be able to do it for decades. Think about an economic moat in two dimensions: (1) depth: how much money the firm can make, and (2) width: how long the firm can sustain above-average profits. Technology firms often have deep but narrow moats (very profitable but only for a relatively short period of time), while niche players often have shallow but wide moats (lower but more persistent excess returns). In general, any competitive advantage based on technological superiority is likely to be fairly short. Cost leadership, brands (perceived product differentiation), customer lock-ins, and competitor lockouts can each confer competitive advantage periods of varying lengths.
  • 4. Analyze the industry’s competitive structure. Some industries are just easier to make money in than others. How do firms in this industry compete with one another? Is it an attractive industry with many profitable firms or a hypercompetitive one in which participants struggle just to stay afloat? Start by getting et a rough sense of the industry so you can classify it. Are sales for firms in the industry generally increasing or shrinking? Are firms consistently profitable or does the industry go through periodic cycles when most firms lose money? Is the industry dominated by a few large players, or is it full of firms that are roughly the same size? How profitable is the average firm—are operating margins fairly high (more than 25%) or fairly low (less than 15%)? You can look at aggregate industry statistics, but be sure to examine a dozen of individual companies, over 10 years. You don’t need to do detailed analysis at this point: just glance over sales and earnings growth rates and margins.

The language of investing:

The balance sheet

The balance sheet is like a company’s credit report because it tells you how much the company owns (assets) relative to what it owes (liabilities), and the difference between the two (equity, which represents the value of the money that shareholders have invested in the firm).

• Current assets are assets that are likely to be used or converted into cash within one business cycle, usually defined as one year. The major portions of this category are cash and equivalents (money market funds), short-term investments (bonds), accounts receivable (bills that the company hasn’t yet collected), and inventories (raw materials that have not yet been made into a finished product, partially finished products, and finished products that have not yet been sold). Accounts receivables rising much faster than sales can be a sign of trouble. “Allowance for doubtful accounts” is the company’s estimate of how much money it’s owed by deadbeat customers, and which it’s consequently unlikely to collect. Inventories are especially important to watch in manufacturing and retail firms, and their value on the balance sheet should be taken with a grain of salt. More importantly, inventories soak up capital. The speed at which a company turns over its inventory can have a huge impact on profitability because the less time cash is tied up in inventory, the more time it’s available for use elsewhere. You can calculate inventory turnover by dividing a company’s cost of goods sold by its inventory level.

• Noncurrent assets are assets that are not expected to be converted into cash or used up within the reporting period. The big parts of this section are property, plant, and equipment or “PP&E” (land, buildings, factories, furniture, equipment), investments (stocks, bonds), and intangible assets (notably goodwill, which is the difference between the price the acquiring company pays and the tangible value of the target company). PP&E as a % of total assets can give a feel for how capital-intensive firms are. You should dig into investments to see what is in this account and with how much skepticism you should view its value. You should view goodwill with extreme skepticism as most companies overpay for their targets,

• Current liabilities is money the company expects to pay out within a year. They include accounts payable (bills the company owes to somebody else and are due to be paid within a year), and short-term borrowings (money the company has borrowed for a term of less than a year). Large companies that have a lot of leverage over their suppliers can push out some of their payables. Short-term borrowings becomes especially important for companies in financial distress.
• Noncurrent liabilities is money the company owes one year or more in the future (bonds, bank debt). Remember that debt is a fixed cost: a big chunk of long-term debt can be risky because the interest has to be paid no matter how business is doing.

• • Stockholders’ equity is equal to total assets minus total liabilities, and represents the part of the company owned by shareholders. Retained earnings records the profits generated by the company over its lifetime, minus funds that have been returned to shareholders (dividends and stock buybacks).

The income statement

The income statement shows how much the company made or lost in accounting profits during a year or a quarter. Unlike the balance sheet, which is a snapshot of the company’s financial health at a precise moment, the income statement records revenues and expenses during a set period, such as a fiscal year.

• Revenue records how much money the company has brought in during the period. Be sure to check the revenue recognition policies.
• Cost of sales represents the expenses most directly involved in creating revenue, such as labor costs, raw materials (for manufacturers), or the wholesale price of goods (for retailers).
• Gross profit is revenue minus cost of sales. Gross margin is gross profit as a percentage of revenue, which tells you how much the company is able to mark up its goods.
• Selling, general, and administrative expenses (SG&A) includes items such as marketing, administrative salaries, and, sometimes, R&D. You can get a feel for how efficient a firm is by looking at SG&A as a percentage of revenues.
• Nonrecurring charges and gains is the catch-all area where companies put all the one-time charges or gains that aren’t part of their regular, ongoing operations, such as the cost of closing a factory or the gain from selling a division. Serial chargers have a habit of rolling many costs that are part of doing business in nonrecurring charges.
• Operating income is equal to revenues minus cost of sales and all operating expenses. You can use it to calculate an operating margin, which is fairly comparable across firms and industries.
• Interest income and expense: this represents interest the company has paid on bonds it has issued or received on bonds or cash that it owns. You can get some insight into the financial health of a firm by looking at its EBIT relative to its interest expense (interest coverage ratio).
• Taxes: If the tax rate for a company is much lower than the satndard rate, find out why, and whether that tax advantage is likely to be permanent or temporary. Aslo look at the tax rate over time: if it bounces around, the firm may be generating earnings by playing with tax loopholes rather than selling more goods or services.
• Net income represents the company’s profit after all expenses have been paid. It may or may not be a good representation of the amount of cash the company has generated, and can be wildly distorted by one-time charges and/or investment income.
• Number of shares: basic shares inclue only actual shares of stock, while diluted shares include securities that could potentially be converted into shares of stock, such as stock options and convertible bonds. It is the diluted number you want to look at.
• EPS usually gets the most attention when a company reports its results. It is mostly meaningless. When you read that a firm beat or missed EPS estimates, find out why.

The statement of cash flows

The statement of cash flows records all the cash that comes into a company and all of the cash that goes out.

• Net cash provided by operating activities is the result of adding or subtracting the following items from net income.
  • Depreciation and amortization is not a cash charge so must be added back.
  • Tax benefit from employee stock plans: when an employee exercises stock options, the employer gets to deduct the gain received by the employee against its corporate income, leading to a lower tax bill. This item may not be sustainable.
  • Changes in working capital: if a company is owed more money by customers, cash flow decreases; if it owes more money to suppliers, cash flow increases; if it pumps more money into inventory that doesn’t sell, cash flow decreases.
  • One-time charges: noncash charges need to be added back.
• Cash flow from investing activities involve acquiring or disposing of PP&E, corporate acquisitions, and any sales or purchases of investments.
  • Capital expenditures represents money spent on items that last a long time. Operating cash flow minus capital expenditures equals free cash flow.
  • Investment proceeds tells us how much money the company has made or lost on investments in bonds or stocks to get a better return than in a basic savings account.
• Cash flow from financing activities includes any transactions with the company’s owners or creditors.
  • Dividends paid
  • Issuance / purchase of common stock: this number indicates how a company is financing its activities. Rapidly growing companies often issue large amounts of new stock, which can dilute the value of existing shares but which also give the company cash for expansion. Slower growing companies that generate a lot of free cash flow tend to buy back significant amounts of their own stock, though companies that issue many stock options to their employees also buy back stock to minimize dilution.
  • Issuance / repayment of debt tells you whether the company has borrowed money or repaid money it previously borrowed.
• Accrual accounting is a key concept for understanding financial statements. The income statement matches sales with the corresponding expenses when a service or a good is provided to the buyer, but the cash flow statement is concerned only with when cash is received and when it goes out the door.
• The income statement and cash flow statement can tell different stories about a business because they’re constructed using different sets of rules. To get the most complete picture, be sure to look at both.

Analyzing a company

Break down the process into five areas

1. Growth: How fast has the company grown, what are the sources of its growth, and how sustainable is that growth likely to be?
2. Profitability: What kind of a return does the company generate on the capital it invests?
3. Financial health: How solid is the firm’s financial footing?
4. Risks / bear case: What are the risks to your investment case?
5. Management: Who’s running the show? Are they running the company for the benefit of shareholders or themselves?

Growth

Historical vs future growth

• A track record of high earnings growth does not necessarily lead to high earnings growth in the future.
• Because the total economic pie is growing only so fast, strong and rapidly growing profits attract intense competition.

Sources of growth

It is critical to investigate the sources of a company’s growth rate:

• Selling more goods or services. This can stem from market growth or from market share growth.
• Raising prices. It takes a strong brand or a captive market to do it successfully for very long.
• Selling new goods or services.
• Buying another company. Be wary of companies that have relied on acquisitions to boost growth. The historical track record of acquisitions is mixed as (a) firms have to keep buying bigger and bigger targets to keep growing at the same rate, (b) it takes time and money, which steals resources from running the core business, (c) it makes true underlying growth and profitability difficult to figure out.

Quality of growth

It is also critical to investigate the quality of growth:

• Big differences between sales growth, earnings growth, and cash flow from operations can hint at something unsustainable.
• Earnings growth can be manufactured through:
  • Changing tax rates.
  • Changing share counts.
  • Pension gains.
    • One-time gains.
    • Rampant cost cutting (at some point there won’t be any more costs to cut).

Profitability

• Companies take shareholders’ money and invest it in their own business to create wealth, just like mutual fund managers take investors’ money and earn a return on it.
• By measuring the return that a company’s management has achieved through this investment process, we know how good they are at efficiently transforming capital into profits.

ROA

• ROA is the amount of profits that a company is able to generate per dollar of assets.
• It is net margin (net income divided by sales) multiplied by asset turnover (sales divided by assets).
• ROA is a measure of efficiency.
• It helps us understand that there are two routes to excellent operational efficiency: you can charge high prices for your products (high margins) or you can turn over your assets quickly.

ROE

• ROE is the amount of profits that a company is able to generate per dollar of shareholders’ capital.
• It is ROA (net margin multiplied by asset turnover) multiplied by financial leverage (assets divided by shareholders’ equity). As with any kind of debt, a judicious amount can boost returns, but too much can lead to disaster.
• There are three levers that can boost ROE: net margins, asset turnover, and financial leverage.
• Any nonfinancial firm that can generate consistent ROEs above 10% without excessive leverage is at least worth investigating.
• Banks have enormous financial leverage, so you should raise the bar (ROEs above 12%).
• ROEs above 40% are often meaningless due to distortions by the financial structure (spinoffs, buybacks, massive charges that depressed the equity base).

Free Cash Flow

• Free Cash Flow is cash flow from operations minus capital expenditures.
• Free cash flow gives financial flexibility: (1) firms with positive FCF are not relying on the capital markets to fund their expansion, (2) firms with negative FCF have to take out loans or sell shares to keep things going, which can become risky if the market becomes unsettled at a critical time for the company.
• A firm able to convert more than 5% of sales to FCF is worth investigating.

Profitability Matrix

• The profitability matrix looks at a company’s ROE relative to the amount of free cash flow it is generating.
• The upper right-hand corner is the sweet spot: excess cash and the ability to earn a high return on it.
• On the bottom right are companies that are reinvesting all of their cash in expansion but are still able to generate a high return on shareholders’ money.
• In the bottom left are young companies growing like weeds, but which haven’t yet proven that they can earn a decent ROE—they’re spending tons of money, but they’re not yet making it pay off very well.

ROIC

• Return on invested capital (ROIC) is equal to Net operating profit after tax (NOPAT) divided by Invested capital (total assets minus non-interest-bearing liabilities minus excess cash).
• It is the best measure of the true operating performance of a firm.

Financial health

Financial leverage

• Be wary of companies with too much financial leverage.
• Because debt is a fixed cost, it magnifies earnings volatility and leads to more risk.
• In years when business is good, a company with high fixed costs can be extremely profitable because once those costs are covered, any additional sales the company makes fall straight to the bottom line.
• When business is bad, however, the fixed costs of debt push earnings even lower.

Credit statistics

Common measures of leverage include:

• Financial leverage: assets divided by equity.
• Debt to equity: long-term debt per dollar of equity.
• Interest cover or “times interest earned”: EBIT divided by interest expense.
• Current ratio: current assets divided by current liabilities. A low ratio (<1.5x) means the company may not be able to source enough cash to meet near-term liabilities, which would force it to seek outside financing or to divert operating income to pay off those liabilities. A high ratio (>1.5x) means it should be able to meet operating needs without much trouble.
• Quick ratio: current assets less inventories, divided by current liabilities. In general, a quick ratio above 1.0x puts a company in fine shape.

Risks / Bear case

• List all of the potential negatives, from the most obvious to the least likely. What could go wrong with your investment thesis? Why might someone prefer to be a seller of the stock than a buyer?
• Your bear case will be a great reference point even if you do decide to buy the stock. You’ll know in advance what signs of trouble to watch for, which will help you make better decisions when bad news comes down the pike in the future. Having already investigated the negatives, you’ll have the confidence to hang on to the stock during a temporary rough patch as well as the savvy to know when the rough patch might really be a serious turn for the worse.

Management

• Excellent management can make the difference between a mediocre business and an outstanding one, and poor management can run even a great business into the ground.
• Your goal is to find management teams that think like shareholders: executives that treat the business as if they owned a piece of it, rather than as hired hands.
• No one can run a public company without leaving a trail of pretty strong objective evidence behind.
• Divide the management-assessment process into three parts: Compensation, Character, and Operations

Compensation

Check out:

• How much management is paid (if a pay package makes you cringe, it’s too high).
• Whether pay varies with the company’s performance.
• Whether there are red flags, e.g. loans to executives that are subsequently forgiven, unjustified perks, inequitable sharing or excessive use of stock options, stock options granted to large owners, lack of skin in the game.

Character

Compensation is often a good litmus test for character, but there are other areas to watch:

• Related-party transactions (reasonable and limited or egregious pattern of abuse?).
• Board of directors (hard-nosed or stacked with family members and former managers?).
• Letters to shareholders (candid assessment of successes and failures or fluff piece?).
• Degree of self-promotion (simple rallying of troops or self-cult and complaints about undervalued stock).
• Turnover rate of officers (long tenure is a signal of motivation and confidence in the business, whereas high turnover is the opposite or a sign that the CEO spends too much time on power struggles).
• Ability to take decisions that hurt reported results.

Operations

In addition to managers who are paid reasonably and are honest, you also want folks who can run the business well. Things to look for include:

• Performance: Look for high and increasing ROEs and ROAs, driven by improved profitability and asset efficiency, reasonable acquisition prices, stable share count).
• Follow-through: When management identifies a problem and promises a solution, does it actually implement the plan, or does it hope you forget about it?
• Candor: Does the firm provide enough information to properly analyze the business, or does it clam up about certain issues?
• Self-confidence: passing on a hot consulting fad, buying a beaten-down competitor, or maintaining R&D during a downturn are examples of self-confidence showing concern for winning in the long-run
• Flexibility: Has management made decisions that will give the firm flexibility in the future, e.g. not taking on too much debt, controlling fixed costs, issuing equity when the stock is high, buying back stock when the price is low, retiring high-rate debt.

Avoiding financial fakery

You need to know how to identify what’s known as aggressive accounting so you can avoid the companies that practice it.

Major red flags

There are six major red flags to watch out for:

1. Declining cash flow: If you see cash from operations decline or increase at a slower pace than net income, it usually means that the company is generating sales without necessarily collecting the cash.
2. Serial chargers: Be wary of firms that take frequent one-time charges and write-downs. When a firm takes a big restructuring charge, it’s essentially improving future results by pulling future expenses into the present.
3. Serial acquirers: Aside from muddying the waters, acquisitions icnrease the risk of a nasty surprise in the future, as acquisitve firms that want to beat competitors often do not spend as much time checking out their targets as they should.
4. The CFO or auditors leave the company: When it comes to financial reporting, the watchmen are the CFO and the corporate auditors. A sudden departure or change is something to watch.
5. The bills aren’t being paid: One of the sneakier ways for a company to pump up its growth rate is to loosen customers’ credit terms, which induces them to buy more products or services. You should track how fast A/R are increasing relative to sales, and how fast the allowance for doubtful accounts is moving up relative to A/R.
6. Changes in credit terms and accounts receivable: Look for any mentions of changes in credit terms for customers, as well as for any explanation by management as to why A/R has jumped.

Other pitfalls

There are seven other pitfalls to watch out for:

1. Gains from investments: The problem arises when companies use invetsment gains or asset sales to boost operating income or reduce expenses.
2. Pension pitfalls: See whether the company has an overfunded or underfunded pension plan.
3. Pension padding: When stocks and bonds do really well, and annual returns exceed annual pension costs, the excess can be counted as profit. You should subtract it from net income when trying to figure out just how profitable a company really is.
4. Vanishing cash flow: You can’t count on cash flow generated by employees exercising options.
5. Overstuffed warehouses: When inventories rise faster than sales, there’s likely to be trouble on the horizon.
6. Accounting changes: You should look skeptically on any optional accounting change that improves reported results (e.g. depreciation period, allowance for doubtful accounts, expensing of costs, revenue recognition) as the firm is probably trying to cover up deteriorating results.
7. Capitalized costs: The basis of accrual accounting is that benefits have to be matched with expenses on the income statement. operating costs are expensed because they produce a short-term benefit, while machinery is capitalized because it produces long-term benefits. The tricky part is that certain types of costs, such as marketing and some kinds of software development, can be treated either way.

Valuation: the basics

Why valuation matters

• Even the most wonderful business is a poor investment if purchased for too high a price.
• To invest successfully means you need to buy great companies at attractive prices.

Sources of returns

• Over time, the stock market’s returns come from two key components:
  • Investment return (appreciation of a stock because of its dividend yield and subsequent earnings growth).
  • Speculative return (impact of changes in the P/E ratio).
• Over a long time span, the impact of investment returns trump the impact of speculative returns.
• By paying close attention to the price you pay, you minimize your speculative risk, which helps maximize your total return.

Valuation metrics

• Don’t rely on a single valuation metric as no individual ratio tells the whole story.

Price to sales (P/S)

• Sales are typically cleaner (less prone to accounting tricks) and less volatile than earnings (e.g. cyclicals, one-time charges), making the P/S ratio useful for valuing companies with variable earnings.
• However, the P/S ratio has one big flaw: sales may be worth a little or a lot, depending on a company’s profitability, so companies in different industries should not be compared.

Price to book (P/B)

• Although P/B isn’t terribly useful for service firms, it’s very good for valuing financial services firms (as long as the firm does not have a large number of bad loans) because most financial firms have considerable liquid assets on their balance sheets.
• When you’re looking at P/B, make sure you relate it to ROE.

Price to earnings (P/E)

• Accounting earnings are a much better proxy for cash flow than sales, are more up-to-date than book value.
• Moreover, earnings per share results and estimates are easily available.
• P/E can be compared to industry peers or the entire market (with limitations due to different risks, growth, and capital needs ), or the same company at a different point in time (for stable, established firms, that haven’t undergone major shifts in their business).
• P/E can be distorted in the following cases: (a) the firm has sold a business or asset recently (artificially inflated E), (b) the firm took a big charge (artificially depressed E), (c) the firm is cyclical, (d) the firm uses different expense vs. capitalization policies than peers, (e) the consensus forecast is too optimistic.

Price to earnings growth (PEG)

• The PEG is calculated by dividing the company’s P/E by its growth rate.
• The problem is that risk and growth often go hand in glove.

Earnings yield

• This is the inverse of the P/E ratio.
• The nice thing about yields, as opposed to P/Es, is that we can compare them with alternative investments, such as bonds, to see what kind of a return we can expect from each investment.

Cash return

• This is FCF divided by enterprise value.

Valuation: intrinsic value

Intrinsic value

• The ratios discussed above are all based on price, but do not tell you about value, which is what a stock is really worth.
• Stocks should be purchased because they’re trading at some discount to their intrinsic value, not simply because they’re priced at a higher or lower point than similar companies.
• The value of a stock is equal to the present value of its future cash flows.
  • The present value adjusts for the fact that money we plan to receive in the future is worth less than money we receive today, because of (1) the time value of money (opportunity cost) and (2) the risk premium (we may never receive these cash flows).
  • Forecast free cash flow (“FCF”) for the next 10 years.
    • Estimate FCF for the next four quarters.
    • Estimate how fast you think FCF will grow over the next 10 years. Only firms with very strong competitive advantages and low capital needs are able to sustain above-average growth rates for very long. If the firm is cyclical, don’t forget to throw in some bad years.
  • Discount these FCFs to reflect the present value:
    • Estimate a discount rate (“R”). Morningstar uses 10.5% as the discount rate for an average company, with variations based on (1) Size, (2) Financial leverage, (3) Cyclicality, (4) Management and corporate governance, (5) Economic moat, (6) Complexity.
    • Discounted FCF = FCF / (1+R)^n
  • Calculate the perpetuity value and discount it:
    • Estimate a long-run growth rate (“g”).
    • Perpetuity value= FCF10 x (1+g) / (R-g)
    • Discounted Perpetuity Value = Perpetuity Value / (1+R)^10
  • Calculate per share value
    • Total Equity Value = Discounted Perpetuity Value + Discounted FCFs
    • Per share value = Total Equity Value / Shares outstanding

Margin of safety

• If you really want to succeed as an investor, you should seek to buy companies at a discount to your estimate of their intrinsic value.
• Having a margin of safety is like an insurance policy that helps prevent us from overpaying: it mitigates the damage caused by overoptimistic estimates.
• Morningstar requires a 30-40% margin of safety for most firms, with ranges from 20% for stable firms with wide moats to 60% for high-risk stocks with no competitive advantages.

The 10-minute test

• With thousands of companies available to invest in, one of the toughest challenges for any investor is figuring out which ones are worth detailed examination and which ones aren’t.
• The author suggests the following 10-minute test:
  1. Does the firm pass a minimum quality hurdle? Avoid companies with minuscule market caps, that trade on the bulletin boards, that do not file regular financials, or recent IPOs (except spin-offs).
  2. Has the company ever made an operating profit? Companies that are still in the money-losing stage sound the most exciting, but will blow up your portfolio more often than not.
  3. Does the company generate consistent cash flow from operations? Companies with negative cash flow from operations will eventually have to seek additional financing by selling bonds or issuing more shares.
  4. Are returns on equity consistently above 10%, with reasonable leverage? use 10% as a minimum hurdle for nonfinancials, and 12% for financials. Check leverage to make sure it is in line with industry norms. Beware of cyclicals which have wildly varying results from year to year.
  5. Is earnings growth consistent or erratic? The best companies post reasonably consistent growth rates. If a firm’s earnings bounce all over the place, it’s either in an extremely volatile industry or it’s regularly getting hit by competitors.
  6. How clean is the balance sheet? Firms with a lot of debt require extra care because their capital structures are often very complicated. If nonfinancial firms have a financial leverage ratio above 4x or a debt to equity ratio above 1x, make sure: (a) the firm is in a stable business, (b) debt has been going down as a % of total assets, (c) you understand the debt instruments.
  7. Does the firm generate FCF? You should prefer firms that create free cash to ones that don’t. The one exception is that it’s fine for a firm to be generating negative FCF if it’s investing that cash wisely in projects that are likely to pay off well in the future.
  8. How much “other is there”? Companies can hide many bad decisions in supposedly one-time charges, so if a firm is already questionable on some other front and has a history of taking big charges, take a pass.
  9. Has the number of shares increased markedly over the past years? If shares outstanding are consistently increasing by more than around 2% per year, think long and hard before investing, as the firm is either issuing new shares to buy other companies or granting numerous options to employees and executives.
• Beyond the 10 minutes:
  1. Look at the 10-year summary balance sheet, income statement and statement of cash flows. Look for trends, and make notes of anything that raises an eyebrow and deserves further investigation.
  2. Read the most recent 10-K front to back. Pay special attention to the sections that describe the company, its industry, risks, competition, legal issues, and the management discussion and analysis. Write down anything that you don’t understand or that you want to investigate further.
  3. Read the two most recent proxies. Look for reasonable compensation that varies with performance.
  4. Read the past three annual reports. Is the letter to shareholders candid and frank?
  5. Look at the two most recent quarterly earnings report to see if anything has changed recently.
  6. Start valuing the stock. Look at the stock’s valuation multiples relative to the market, the industry and historical ranges. Do a rough DCF valuation.

Industry primers

Health care

Overview

• The sector includes drug companies, biotechs, medical device firms, and health care service organizations.
• Health care companies are often highly profitable (especially drug companies and medical devices firms), with strong FCF and returns on capital.
• Health care benefits from powerful growth trends, consistent demand, high ROE, and economic moats in the form of
  1. High start-up costs (developing a single drug can take 15-20 years).
  2. Patent protection (prevents direct competition).
  3. Limited price sensitivity for the end consumer (most costs are paid by insurance plans).
  4. Significant product differentiation.
  5. Economies of scale.

Big pharma

• Big pharmaceutical companies typically have wide moats and some of the most attractive financial characteristics of any industry: gross margins near 80%, operating margins between 25-35%, and ROICs in the mid-20s.
• But there is budgetary pressure to reduce health care costs.
• Drugs typically go through the following stages:
  1. Preclinical testing: the drug is tested on animals to evaluate toxicity.
  2. Phase I: the drug is tested on <100 healthy volunteers, to check safety and efficacy (1-2 years, cost of a few $ million, 20% chance of eventual approval).
  3. Phase II: the drug is tested on 300-500 sick patients (2-3 years, costs >$5 million, 29% chance of eventual approval), (4) Phase III: the drug is tested on 5,000+ patients to ensure long-term safety and efficacy (2-4 years, costs of c$800 million, 60% chance of eventual approval).
  4. FDA review: the company files a new drug application with the FDA (17 months, 70% chance of approval).
  5. Marketing: drugs enjoy patent protection for 20 years after patent filing, which generally means 8-10 years after they are launched in the marketplace.
  6. Generic drug competition: after a drug goes off patent or loses market exclusivity, the field is open to competition from generic drugs, which have the same chemical composition but usually cost 40-60% less. Drugs can lose as much as 80% of their sales in the first 6 months after going off patent.
• Things to look for:
  1. Blockbuster drugs (with more than $1 billion in sales).
  2. Patent protection.
  3. A full pipeline of drugs in clinical trials, with a big market potential.
  4. Strong sales and marketing capabilities.

Generic drug makers

• Generic drug makers usually have 40-50% gross margins, 15-20% operating margins, and ROICs in the teens.
• The first company to file a patent challenge enjoys 180 days of marketing exclusivity, which provides a temporary 10% point increase in operating margins.
• Once other players are allowed to join, the only company that comes out ahead is the low-cost manufacturer.
• Generic companies have gained market share.
• Given the crucial importance of manufacturing scale, you’re usually better off with an established player.

Biotechnology

• They seek to discover new drug therapies using biologic (cellular and molecular) processes rather than the chemical processes used by big pharma.
• Although the best biotech companies can generate significant FCF, most are too speculative:
  • Established players:
    • These have revenues above $1 billion, and generate positive earnings and cash flow.
    • Look for:
      1. A large number of drugs in late-stage clinical trials.
      2. Plenty of cash on hand.
      3. A salesforce of their own.
      4. A margin of safety of 30-40%.
  • Up and coming players:
    • Cash is king during this stage.
    • Look for:
      1. Enough cash to get through the final stages of testing.
      2. Larger biotech or pharma companies willing to join forces.
      3. A 50% margin of safety.
  • Speculative players: These stocks are more like lottery tickets than anything else.

Medical device companies

• These are the companies that make the hardware for medical procedures.
• There are two main types of device firms:
  • Cardiovascular (e.g. pacemakers).
  • Orthopedic (e.g. artificial hips).
• Demand is driven by:
  1. Aging population and increase in life expectancy.
  2. Reduced cost of some procedures.
• Medical device companies also typically boast wide economic moats and high margins: economies of scale, switching costs, long-term clinical histories (in excess of 30 years for some orthopedic devices), patent protection, and switching costs serve as high barriers to new entrants.
• Medical device companies hold a great deal of pricing power, and face less risk than pharmaceutical firms because product improvements tend to be evolutionary rather than revolutionary.
• Look for:
  1. Salesforce penetration.
  2. Product diversification.
  3. Product innovation.
• Risks include:
  1. Short product cycles with heavy R&D spend.
  2. Litigation.

Insurance and managed care firms

• These are subject to intense regulatory pressure, widespread litigation, and narrow moats.
• Look for:
  1. Effective medical cost management and underwriting.
  2. Minimal dual-option business.
  3. Large mix of fee-based business.
  4. Minimal exposure to government accounts.

Consumer services

Overview

• The sector contains discount stores, drugstores, clothing stores, home improvement shops, restaurants, and scores of other well-known names.
• The consumer services sector has seen strong growth, however, most economic moats are extremely narrow.
• The few consumer service firms that have established a wide economic moat developed distinctive store prototypes that set them apart from their competitors, and now enjoy vast economies of scale that make it tough for competitors to earn consistent profits.
• Although you can also do well buying high-quality specialty and clothing retailers when the industry sees one of its periodic sell-offs, very few of these kinds of firms make great long-term holdings.
• Because many consumer purchases other than food are discretionary, retail stocks generally outperform during periods of economic strength and underperform during times of economic weakness.

Restaurants

• The restaurant industry can be split into quick-service restaurants (“QSR” or “fast food”), where patrons pay and receive their meals at a counter, and full-service restaurants, where customers are seated at a table and place orders with a wait staff.
• Demographic shifts drive demand for restaurants (with both parents working in many households, there’s little time to cook and even less for grocery shopping and cleanup, families are getting smaller).
• Look for:
  1. A successful concept.
  2. The ability to replicate the concept in other areas.
  3. Frequent remodeling.
• Risks:
  1. Many new concepts fail.
  2. Others become aggressive growth companies and must be profitable on a per unit basis to support opening new stores.
  3. One of the dangers is that a restaurant company outgrows its funding.
• As expansion opportunities dry up, profits from existing operations and same-store sales increases become increasingly important.
• Restaurants in the slow-growth stage manage to have their concept ingrained in customers (familiarity, consistent advertising and service); they typically have strong FCF, solid returns on capital, and usually start to pay out dividends.

Retail

• Retail is generally a very low-return business with low barriers to entry and strong competition.
• The primary way a firm can build a moat is to be the low-cost leader.
• The retail industry has undergone major shifts:
  • Development of category killers.
  • Move off the mall.
• Look for:
  1. A fast cash conversion cycle: A retailer with increasing DIO is likely stocking its shelves with merchandise that is out of favor, leading to excess inventory, clearance sales, and, usually, declining sales and stock prices. DPO shows how well a retailer negotiates with suppliers.
  2. Clean and fresh stores (retail is a fickle business and shoppers have plenty of alternatives).
  3. Adequate store traffic (no lines at the checkout counter, but no empty parking lots either).
  4. Positive employee culture (retail is about customer service).
• Pitfalls include:
  1. Inaccurate same-store sales figures.
  2. Understated financial obligations (leases kept off balance sheet).

Business services

Overview

• The business services sector is home to a large number of firms with wide moats, which can be divided into technology-based, people-based, and hard-asset-based subsectors.
• Growth has been driven by increased outsourcing (saves time and money, removes the hassle of noncore tasks, allows management to focus).
• Many industries have significant barriers to entry, but companies still need to differentiate themselves to fend off competition from established players.
• Understand the business model (technology, people, or hard-asset-based), and look for:
  1. Scale and operating leverage (size matters given fixed-cost networks and the importance of branding in a business outsourcing purchase decision).
  2. Recurring revenue.
  3. Adequate cash flow.
  4. Big untapped opportunities.
  5. Realistic growth expectations embedded in the stock price.

Technology-based businesses

• Technology-based businesses include data processors, database providers, and other companies that leverage technology to deliver their services.
• Due to their sizeable and defensible competitive advantages, they’ve often generated better-than-average long-term returns, and can be a great opportunity for investors when they get cheap.
• They often offer the strongest cases for outsourcing (high initial investments in infrastructure that can be leveraged across many customers), have low ongoing capital investment required to maintain their systems, and often benefit from economies of scale and operating leverage.
• Price competition is often less intense than might be expected given the large potential.
• Look for:
  1. Strong cash generation.
  2. Economies of scale.
  3. Stable revenues.
  4. Exposure to fast-growing or underpenetrated markets.
  5. Complete range of services.
  6. Strong sales capabilities and access to distribution channels.

People-based businesses

• People-based businesses include consultants and professional advisors, temporary staffing companies, advertising agencies, and other companies relying heavily on people to deliver their services.
• Investments can be attractive at the right price.
• These businesses make a spread on their employee’s billed time: training ensures a standard level of service quality, salaries are a big fixed cost, and growth comes from finding and hiring more skilled workers to deploy.
• Relationships are important as it is difficult to differentiate offerings.
• When the economy slows, customers tend to cut back on people-based services.
• While brands, longstanding relationships with customers, and geographic scope can provide some advantages, there are usually many competitors in each area, and moats are generally narrow.
• Look for:
  1. Differentiation of offering.
  2. Necessary and/or low-cost service.
  3. Organic growth (signals healthy demand, acquisitions don’t integrate as smoothly as planned).

Hard-asset-based businesses

• Hard-asset-based businesses include airlines, waste haulers, expedited delivery companies.
• Growth requires large incremental outlays for fixed assets, generally financed with external funding.
• Most companies have either narrow or nonexistent moats, requiring a steep discount to fair value.
• Airlines are the least attractive segment (fixed costs, commodity service, intense competition, razor-thin margins, high operating leverage), though a few carriers have fared well.
• Look for:
  1. Cost leadership.
  2. Unique assets.
  3. Prudent financing.

Banks

• Banks receive money from depositors and the capital markets and lend to borrowers, profiting from the difference (spread), and also make money from basic fees and other services (noninterest income).
• Because the service they provide is vital to economic growth, the industry should grow in line with total output.
• By assembling large, diverse portfolios of loans, banks reduce their risks and pass some of the resulting savings along to all borrowers.
• Implicit subsidies from the FDIC and the Federal Reserve allow banks to borrow at below-market rates.
• The heart and soul of banking is centered on risk management.
• Banks accept three types of risk:
  1. Credit risk. This risk can be reduced by (a) Portfolio diversity (assembling large, diverse portfolios of loans), (b) Conservative underwriting and account management (avoiding bad loans), and (c) Aggressive collection procedures (chasing the deadbeats). One of the biggest challenges to investing in banks is spotting credit quality problems before they blow up: investors can get a sense of a bank’s credit quality by (a) examining its balance sheet, loan categories, trends in nonperforming loans and charge-off rates, and (b) looking look for evidence that the credit culture and lending philosophy is sound, conservative, and has been tested. Beware of super-fast growth (which can lead to big troubles).
  2. Liquidity risk. Banks offer liquidity management services via backup lines of credit, factoring, and deposit handling. Investors must pay close attention to (a) deposit levels (are they increasing, especially the low-cost ones), and (b) the bank’s balance sheet (seek firms with a diverse stable of loans).
  3. Interest rate risk. The impact of rates on banks is often oversimplified to “Higher rates, good; Lower rates, bad”, but the reality is more nuanced: (a) at any point, banks can be either asset sensitive or liability sensitive, (b) banks aren’t as interest rate sensitive as they used to be (cushion linked to noninterest income, cues communicated by the Fed before rate cuts, ability to reposition the balance sheet or to sell loans to investors while keeping servicing, matching of asset and liability duration).
• Economic moats include:
  1. Huge balance sheet requirements (capital intensive).
  2. Large economies of scale (big banks generate more revenues per dollar of asset, and their employees manage more assets).
  3. Regional oligopolies.
  4. Customer switching costs (branding, desire to stick to a trustworthy bank, inertia).
• Look for:
  1. A strong capital base (high equity to assets ratio, high level of loan loss reserves relative to nonperforming assets).
  2. High ROA (1.2-1.4%) and ROE (mid-to-high-teens).
  3. Low efficiency ratios (noninterest expense < 55% of revenues).
  4. Net interest margins trends (net interest income as a % of average earning assets).
  5. Steady revenue growth.
  6. Low price to book (<2x for a solid bank)

Asset management and insurance

Overview

• Asset managers and insurance companies make profits from other people’s money, the former by charging a fee for investing clients’ money in stocks or bonds, and the latter by investing insurance premiums on top of their core underwriting businesses.
• While asset managers are lucrative, the insurance industry is highly competitive.

Asset management

• Asset management firms run money for their customers and demand a small chunk of the assets as a fee in return.
• This is lucrative work (30-40% operating margin), which requires very little capital investment.
• The real assets of the firm are its investment managers, so compensation is the firm’s main expense, and since it doesn’t take twice as many people to run twice as much money, economies of scale are excellent.
• With huge margins and constant streams of fee income, asset managers are profit machines, but their stock price often reflect oversized optimism or pessimism on the economy.
• The best asset managers can present truly outstanding investment opportunities when they are selling at the right price.
• Gathering assets takes time, and gaining significant scale (at least $10 billion in assets under management) takes a track record.
• The most important competitive advantages are:
  1. Diversification (to overcome market fluctuations).
  2. Stickiness of assets.
• Metrics to watch include:
  1. The level of AUM.
  2. The mix of AUM (higher fees on specialized funds and stocks than on bonds or money market funds, higher fees for retail investors than for institutions and large investors).
  3. The sources of AUM growth (net inflows, market movements).
• Look for:
  1. Diversity of products and investors (stability).
  2. Sticky assets (revolving doors can be volatile).
  3. Niche market (more control over pricing and less competition for investor assets).
  4. Market leadership (economies of scale, long-term track record, name recognition).

Custody and asset servicing

• Custodians keep track of the securities that their customers buy and sell, collect dividends, calculate an accurate value at the end of the day, and offer additional services such as performance analytics, risk management, and pension consulting.
• Revenues are primarily driven by the level of assets under custody: fees for custody are generally below 0.05% of assets under custody, making scale essential to support technology investments.
• This has led to consolidation and higher entry barriers.
• Most custodians also lend money to their clients as part of their overall service relationship, and bad loans can easily eat into profits.

Life insurance

• Life insurance companies offer products that allow people to protect themselves or their loved ones from catastrophic events such as death or disability or to provide greater financial protection and flexibility for situations such as retirement.
• A life insurer pools the individual risks of many policyholders, and strives to earn a profit by taking in and/or earning more money than it is required to eventually pay out to its policyholders.
• Life insurance is a mature, slow-growth business that offers commodity products, which are easily substituted.
• Barriers to entry are modest (regulatory and capital requirements), barriers to exit are high (the firm owes life insurance benefits to its customers, who may still have many years to live), and successful growth above nominal GDP is rare.
• Financial statements are very different from those of other businesses.
• On the asset side are (a) investments (accumulated premiums and fees), (b) deferred acquisition costs (capitalized value of selling insurance or annuities policies), and (c) separate account assets (funds invested by variable annuity owners). On the liability side are (a) actuarially estimated future benefits that need to be paid to policyholders and (b) separate account liabilities (funds owed to variable annuity owners).
• The main sources of revenues are (a) recurring premiums and fees and (b) earned investment income. The main expenses are (a) benefits and dividends paid to policyholders and (b) amortization of the deferred acquisition costs. Examining the mix of insurance products is critical to assess revenue and profit growth, as well as risk (annuities produce greater exposure to the equity markets).
• Life insurers often operate on a thin margin between their ROE (12% on average, 15% for best performers) and their cost of equity (10-11%).
• Tangible book value (adjusted by excluding marked-to-market gains or losses on on available-for-sales securities) is the other key valuation metric.
• Look for:
  1. Prudent premium growth rates (beware of underpricing to win sales).
  2. ROE consistently above the cost of equity (10-11%).
  3. High credit rating (AA or above).
  4. A diverse investment portfolio and proven risk management culture (e.g. low exposure to junk bonds).

Property and casualty insurance

• When an insurer sells a policy, it accepts financial risk in exchange for a premium payment.
• By transferring many individual risks to a common pool, an insurer is able to create a diversified risk portfolio.
• Because most risks aren’t realized, insurers expect to earn a small profit margin. Insurers receive premiums well in advance of the firm’s requirement to pay claims, and earn investment income in the meantime form this “float”.
• How much money they can make this way depends on market performance, the insurer’s asset allocation, and how long the insurer holds premiums before making claim payments (“long tail” insurance hold premiums longer and can invest more in equities).
• Premium revenue (or “earned premium”) is used to fund claim payments (“loss expense”), sales commissions for insurance agents (“commission expense”), and operating expenses (“opex”).
• Insurers express each of these expenses as ratios to earned premiums: adding these three ratios produces the combined ratio, a figure under 100 indicating an underwriting profit.
• Companies with combined ratios exceeding 105 for more than a short time have a difficult time recouping their losses via investment earnings, and this type of poor underwriting track record suggests that an insurer’s competitive position is unusually weak.
• Insurers also make money from investment income, often a key profit determinant because it offsets underwriting losses.
• Adding the investment ratio to the combined ratio yields the operating profit ratio.
• The key asset for most insurers is investments: in addition to float, most insurers invest a large portion of their own retained earnings as well.
• Unearned premiums represent premiums received but not yet considered revenue.
• The economics of PC insurers are difficult: (a) insurance products are difficult to distinguish, except by price, (b) claims expense (which generally consume more than 70% of premiums) are uncontrollable and unpredictable, (c) if one insurer prices too low, profits for other insurers can be wiped out, (d) insurance is a mature and cyclical business: when market returns are high, premium rates decline (“soft market”), when market returns decline or severe losses occur, premium rates rise to restore profitability (“hard market”), (e) insurers face considerable regulation (rates must be approved in every state, insurers may be required to insure less profitable customers at no extra charge or to fund the losses of insolvent competitors) and consumer lobbying.
• Look for:
  1. Low-cost operators (usually enjoy the highest profits in a commodity business).
  2. Strategic acquirers (who can acquire and turnaround underperforming competitors).
  3. Specialty insurers (more leeway to set prices).
  4. A record of financial strength (to survive a disaster).
  5. A rational management team with a significant portion of its financial wealth invested in the business.

Software

• The software industry is highly competitive but has great economics: excellent growth prospects (reduction of time-consuming tasks), huge upfront costs to create software, but high free cash flow thereafter (low production costs, low inventory, A/R, and capital).
• License revenue is the best indication of current demand because it represents how much new software was sold during a given time.
• Service revenue, which is the other major type of revenue that many software firms report, is less profitable because it’s expensive to employ consultants to install software.
• Deferred revenue represents cash the company has received before some services have been performed. Rising deferred revenue indicates a healthy backlog of business.
• In an industry where demand can change quickly, rising DSOs are often the first signal that a firm’s products are no longer as hot as they once were.
• Accounting red flags include (a) revenue recognition changes, and (b) questionable transactions (swap deal, product sale and investment).
• Most segments are oligopolies, with only a few players controlling the majority of sales:
  • Operating systems run all the other programs on a computer; there are limited investment opportunities (Windows owns 90% of the market).
  • Database software collects data so it can be easily accessed and updated; high switching costs make this market attractive (it’s tough to move data from one database to another) but it’s also mature (growth unlikely to exceed the high single digits because most firms already have databases in place).
  • Enterprise resource planning (ERP) software aims to improve back-office tasks; the market is mature (most large companies already have some type of ERP system).
  • Customer relationship management (CRM) software keeps track of client data.
  • Security software firms provide firewalls, virtual private networks, antivirus, and intrusion detection products; demand growth is driven by hackers, viruses, and credit card number theft.
  • Video game publishers create games for hardware platforms; the industry is cyclical and has low entry barriers (costs to support various platforms).
  • Miscellaneous includes niches such as tax preparation, graphic design, etc.; companies that dominate a niche are often more attractive investments than household names that serve larger markets.
• Wide moats are tough to build in software due to the rapid pace of technological change. Look for companies that have gone beyond superior technology and that enjoy:
  1. High customer switching costs (make it tough to use competing products without significant hassle).
  2. Network effect.
  3. Brand names.
• Look for:
  1. Increasing sales (at least 10% p.a.).
  2. Good economics throughout cycles.
  3. Expanding profit margins (economies of scale).
  4. Large installed customer bases.
  5. Great management (watch out for egregious stock options).
• Risks include:
  1. High cyclicality (economic conditions and it spending).
  2. Seasonality (back-end loaded quarters).
  3. High P/E ratios.

Hardware

• The hardware sector is characterized by rapid innovation, cyclical demand, periods of inventory imbalances (demand bubbles followed by excess capacity), and intense rivalry.
• Technology itself is not a moat and leads rarely last long.
• Examples of moats include:
  1. High switching costs (telecom equipment with conservative buyers and complex networks).
  2. Low-cost production (scale).
  3. Network effects (compatibility, maintenance).
  4. Knowledge and experience.
• Look for:
  1. Durable market share and consistent profitability (wide moat).
  2. Strategic focus.
  3. Flexible economics (outsourced manufacturing, low capex, workforces on variable schedules or in low-cost markets).

Media

Overview

• Media can be divided into publishing, broadcast and cable television, and entertainment production.
• Media companies generate cash by producing or delivering a message to the public (video, audio, print) via varied methods of delivery (TV, movies, radio, internet, books, magazines, newspapers).
• Revenues stem from one-time user fees, subscriptions, or advertising.
• The most prevalent moats include:
  1. Economies of scale.
  2. Monopolies.
  3. Unique intangible assets.
• Look for:
  1. High free cash flow (margins of 8-10%+, which indicate that customers are willing to pay a premium, that the company is efficient or that the business does not require much ongoing capital investment).
  2. High market shares.
  3. A track record of sensible acquisitions (small, profitable, which can be easily integrated and financed without stretching the balance sheet).
  4. A strong balance sheet.
  5. Candid management teams.
• Risks include:
  1. Governance (family control, cross holdings).
  2. Excessive compensations.
  3. Chasing hits.

Publishing

• Many publishing companies enjoy monopolies on their markets, giving them power to raise prices and profits to expand into other areas via acquisitions, and economies of scale (fixed costs).

Broadcasting and cable TV

• Companies in the radio, broadcast television, and cable television industries also tend to have some solid competitive advantages, which often lead to above-average and sustainable profitability.
• Broadcasters have a solid business model (fixed cost of programming which can be shared among stations and lead to economies of scale) so investing in this segment is mostly a matter of valuation.
• Cable companies enjoyed local monopolies but are challenged by satellite TV providers and price competition.

Entertainment

• The film, TV, and music industries largely revolve around creating and distributing feature films, television series, and musical recordings.
• While most businesses have large libraries of content, a large portion of revenues comes from one-time user fees (often volatile hits), barriers to entry in distribution have been weakened by the internet, and the bulk of entertainment firms’ profits go to high-profile actors, directors, and executives, which leaves little for shareholders.

Telecom

• Despite high entry barriers (upfront capital), telecom players usually earn mediocre returns on capital, have nonexistent or deteriorating moats, suffer from intense competition, depend on regulators, and require significant capital to stay in place.
• Carriers typically have low asset turnover ratios, and high fixed costs, requiring a significant number of customers and efficient operations to earn an attractive ROIC.
• Look for:
  1. Strong financial health.
  2. A wide margin of safety.
• Pitfalls include:
  • Focus on EBITDA obscuring growing A/R.
  • Bloated debt levels leading to financial distress.

Consumer goods

• The consumer goods sector is composed of industries such as food, beverages, household and personal products, and tobacco. Consumer goods companies make products and sell them to retailers (supermarkets, mass merchandisers, warehouse clubs, and convenience stores), or in the case of beverage makers to bottlers and distributors.
• Because of their maturity, most consumer goods industries have gone through periods of consolidation, and are dominated by a handful of huge companies.
• Firms tend to grow by:
  • Stealing market share from competitors, usually by introducing new products.
  • Acquiring other consumer goods companies.
  • Reducing operating costs.
  • Selling products overseas.
• Companies often have wide moats, such as:
  • Economies of scale.
  • Powerful brands.
  • Exclusive distribution networks (beverage).
• Look for:
  1. Dominant market shares.
  2. Shareholder-friendly capital allocation.
  3. Focus on brand building.
  4. A successful track-record of innovation.
  5. A 20-30% margin of safety.
• Risks include:
  1. The increasing power of retailers.
  2. Litigation risk (tobacco).
  3. FX risk.
  4. Premium valuation.

Industrial materials

• Industrial materials companies buy raw materials and facilities to produce the inputs and machinery that other firms use to meet their customers’ expected demand for goods.
• The sector includes commodities (steel, aluminum, and chemicals) and value-added goods (electrical equipment, heavy machinery, and specialty chemicals). Commodity producers have little influence on the price, while value-added players may charge a premium price. Demand is cyclical (with added volatility compared to GDP, notably for big-ticket items, compounded at the earnings level by operating leverage) and some sectors face deflation. Although basic materials firms are protected by significant barriers to entry (steep upfront cost), the commodity nature of products and related stiff price competition, along with the cyclical swings, makes for mediocre profits and poor returns on capital.
• Very few industrial materials companies have any competitive advantages; the exceptions are those in concentrated industries (e.g., defense), those with a specialized niche product and, above all, those that can produce their goods at the lowest cost.
• Look for:
  1. Industries having already undergone significant consolidation.
  2. The low-cost producer.
  3. Excellent financial health.
  4. Additional revenue streams from value-added products or services.
  5. Highly efficient operations (high fixed assets and working capital turnover).
  6. Regular and growing dividends.
  7. A fair margin of safety.
• Red flags include:
  1. Unreasonable debt levels.
  2. Large unfunded pension plans.
  3. Big acquisitions that distract management.
  4. Market share chasing by cutting prices.

Energy

Overview

• The profitability of the energy sector is highly dependent on commodity prices. Commodity prices are cyclical, as are the sector’s profits. It’s better to buy when prices are at a cyclical low than when they’re high and hitting the headlines.
• Working in a commodity market, economies of scale are just about the only way to achieve a competitive advantage.
• Look for:
  1. A strong financial track record over a complete cycle.
  2. A strong balance sheet (to weather cyclical lows better).
  3. A reserve replacement ratio above 1.0x.
  4. Shareholders-friendly uses of cash flow.
• Risks include:
  1. Threats to the OPEC cartel.
  2. Political instability (expropriation, taxation).
  3. Being faked out by the cycle.
  4. Cleaner and cheaper sources of energy.

Exploration and production

• Roughly two-thirds of the world’s energy needs are supplied by oil and gas.
• Most of the energy we use starts out under the ground, locked up in the hydrocarbons of dead plants and animals.
• Finding and mining this oil and gas is known as exploration and production or upstream.
• Technology has done an excellent job of making oil available that was previously thought to be inaccessible, such as deep under the ocean.

Transportation

• Once petroleum is lifted from the ground, it must be transported to refineries, through ships or pipelines.

Refining

• Once oil and gas makes it to the refineries, it is said to be downstream.
• Refineries break apart crude oil into its component parts and refine it into end products, such as gasoline, jet fuel, and heavy lubricants.
• Over the long term, refining is typically a less profitable business than getting oil out of the ground because there is no refining cartel maintaining profits.
• Refining profit margins are less dependent on commodity prices: high crude prices raise the cost of the refiners’ raw goods, but some of this can be passed along to consumers.

Marketing

• The other portion of downstream operations is called marketing, which includes operating convenience stations, as well as marketing fuels for industrial uses and electricity production.

Services

• Typical services that the oil companies tend to outsource include seismic studies to find the oil as well as services related to drilling and maintaining wells.
• Profitability tends to be only mediocre in the boom years when oil prices are high, but bottom lines have tended to dip into the red when prices were low.
• The industry tends to be extremely cyclical, with short-term demand for drilling services and equipment highly volatile and dependent on commodity oil and gas prices.
• Long-run demand for advanced oil services should however increase as oil companies have to dig in more far-flung places and at deeper depths to find and produce from fresh oil fields.

Utilities

Overview

• The sector includes electric utilities (and to a lesser extent gas and water utilities).
• Most utilities carry a great deal of leverage, both operationally and financially. On the operations side, most of the costs are fixed, with fuel being the only significant variable cost. The financial component of their leverage is much more important, as a way to increase ROE. Unfortunately, many utilities are today struggling with their legacy of high debt.
• Look for:
  1. A stable, favorable regulatory structure.
  2. A strong balance sheet.
  3. A focus on the core business.
• Risks include:
  1. Changing regulation.
  2. Environmental costs.
  3. Liquidity risk.

Electric utilities

• The electric utility business can be divided into essentially three parts: generation, transmission, and distribution.
• Generation covers operations that run the power plants themselves, and turn coal/natural gas/uranium into electricity. It is the area with the greatest competition because electricity is a pure commodity, the barriers to entry are comparatively low and falling, and deregulation is far along.
• Transmission is the business of transporting electricity over long distances. Transmission operations typically have fairly wide economic moats (huge barriers to entry due to large upfront costs as well as the “not in my back yard” effect), however, with rates and returns regulated, companies have a difficult time creating excess value.
• Distribution-related companies own and service the final mile of cable that brings power to the individual homes and businesses, and handle the customer service and billing. Distribution is where utilities have their widest economic moat (monopolies) but also the most government control, meaning rates are regulated and ROIC is capped, making it difficult for utilities to earn excess returns.