For Summary of Chapter 1 to Chapter 6 click on this link: https://thefundamentalmindset.finance.blog/2020/05/10/book-summary-of-the-five-rules-for-successful-stock-investing/
Chapter 7: Analyzing a Company – Management
Analyzing management of business can be a good step for investors. Management team should be like who thinks as shareholders. Management can be a difference between a good and a bad business. There are three ways in which management can be assessed – compensation, character and operations.
Compensation is easy to assess because majority data is available on a single document. One should check that in which way the management is paying itself i.e. bonuses, share grants, big salaries etc. Compensation of competing firms can also be checked to see what competitors are paying. It also depends on company to company i.e. big companies can give higher salaries, bonuses etc. Many companies pay according to the performance delivered by manager. If a firm is changing targets without changing compensation then this can be a red flag. Basically compensation of managers should be decided according to the performance of the company. There are some points which could be a red flag like if the company is paying for expenses which were to be paid by manager or is company giving loans to managers and then forgiving it or executives having too much skin in the game etc.
To determine whether a firm’s management deserve investor’s trust, few questions can be useful like checking related party transaction, checking board members (whether it comprise more of family members or not), whether company is able to retain talent, whether management is taking decisions that can hurt financial statements but gives more clear picture of company.
Compensation and trusting the management is ok but the main sign is that whether the business is running properly is not. It can be checked through – analyzing numbers such as ROE’s, ROA’s etc. focus should also be on mergers and acquisitions, by analyzing steps decided by management (whether they are followed or just renewed every year), is proper information is provided or not for analysis, decisions which make firm flexible etc.
These things if analyzed properly can give a good picture about company’s management.
Chapter-8: Avoiding Financial Fakery
Company’s can use accounting to their advantage by employing dozens of techniques that, though are legal, may provide an observer a false picture of a company’s performance. This is known as Aggressive Accounting.
An outright fraud is worst than aggressive accounting detecting the signs of a potential fraud can save from a loss. Although Professional assistance may be required to understand how is a company exaggerating it’s result, it’s not difficult to recognize the warning signals for the same.
Six Red Flags
There are six major red flags to watch out for before giving a firm a clean check:
Declining Cash Flow: The most simple thing one can do to analyze a company’s health is to watch the cash flow. A company’s cash flow from operation should follow the same path as its net income. If cash flow from operation declines or doesn’t grow at the same rate as net income grows, it usually means that the company is generating sales without collecting cash which may prove fatal for a company.
- Serial Chargers: One time charges and write downs usually affect different accounts which need to be adjusted to facilitate year to year comparison of financial results. Frequent charges are an open invitation to accounting frauds because companies can bury its bad decision in the name of such one-time charges.Big restructuring charges are incurred to improve company’s future performance by bearing future expenses into the present. All those decisions which are poor may get rolled into a single one-time charge which improves future results.
- Serial Acquisitions: Firms that make numerous acquisitions need to restate their financial more frequently. There’s a huge amount with such firms because acquisite firms spend much lesser time to check out their targets than they should.
- The Chief Financial Officer or Auditors Leave the Company: The people who watch the company’s financial performance are its chief financial officer or the auditors if any of the two leave the company for vague reasons specially for a company which is already under a suspicion for an accounting issues should be an eye opening signal.
- The Bill’s Aren’t Being Paid: One of the ways for a company to increase its growth rate is to loose in customers credit term, which motivates them to buy more goods and services. However loose credit term may invite shakier customers the result of which will be a charge against earnings for the company in the future.
To track this risk the rate of increase of account receivables to the rate of increase of sales can be tracked.
Also the allowance for doubtful account can be tracked to see how much money the company won’t be able to collect from debt beat customers. If this amount doesn’t go up with account receivable, the company may be artificially showing it sales at a much higher amount by not recognizing those customers who aren’t expected to pay their bills.
- Changes in Credit terms and account receivables: Checking the company’s 10-Q filling will help to know any changes in credit terms from customers and any explanation by management as to why AR has increased.
Seven Other Pitfalls to Watch Out For
- Gains from Investments: It is common for big firms to invest in other companies. An honest company reports sale of these investments separate from it sales and reports it below the operating income line on the income statement. However, some companies may use this income to boost their result by including it as a part of revenue or by recording it above the line thereby including it as a part of operating income.
- Pension Pitfalls: The Company invests in stocks, bonds, real estate and other asset classes to fund future pension payments. However if the company has fewer pension asset than pension liability it has an underfunded plan which means it has to divert the profit to meet the gap. In the footnotes of a 10-k filling two keys numbers namely projected benefit obligation and fair value of planned asset at the end of the year can be compared to identify whether a company has an over or underfunded pension plan. In case of an underfunded pension plan the company need to divert hard cash to fund the plan instead of distributing it to the shareholders and increase the firm’s value.
- Pension Padding: When pension assets do well and the return on those assets is greater than the annual pension cost the excess can be counted as profit.However this strange kind of profits can’t be paid out to the shareholders as it belongs to the pension holders. The excess thus benefit the shareholders because the company needs to contribute less in the pension plan in the future. However this income is dependent on the stock market and thus must be subtracted from net income to figure out how profitable a company is really is.
- Vanishing Cash Flow: Employees of a company exercise the stock options the amount of cash taxes that their employer has to pay decline. This means that as long as the firm stock price is going up and it is giving out options the cycle continues. More options are exercised and more deductions are taken. However if the stock price decline fewer option will be exercised resulting in higher taxes for the company. Thus checking that the company’s cash flow growth isn’t coming from option related tax benefit it comes crucial.Thus if inventories are rising faster than sells, the company may be in trouble. (Unless the company is preparing for a new product launch)
- Overstuffed Warehouses: When a company is producing more than its selling, either the demand has decreased or the company has been overly ambitious in forecasting demand. In both the cases the unsold goods will have to be sold at discount or written off. This would result in a big charge to earnings.
- Change is bad: Firms may choose to alter certain assumptions in their financial statements to make themselves look better. Increasing the estimated life of an asset so that annual depreciation reduces can be a way to inflate earnings. Not providing for the irrecoverable amount of debtors in the doubtful account may pose a picture that the firm is stretching the truth which will come back as charge to the earnings at some point in the future. Other things related to how expenses and revenue is recognized can be changed to alter the presentation of financial performance.
- To expense or not to expense: There are certain expenses such as marketing costs and software development which can be treated either as a capital expenditure or as revenue expenditure. However it may so happen that the company treats certain expenses as capital expenditure so that instead of charging the entire expenditure to the current year earnings, it is spread out in a few years to come.
Chapter 9: Valuation – The Basics
Analyzing company’s management and checking its financials can help filter good companies but if they are purchased at too high a price then it is not a worth investment. In bull market of 1990’s and tech bubble people were ready to pay high amount for a stock. Valuation was completely ignored.
Stock market’s return depends on two key components – investment return and speculative return. Investment return is the appreciation in stock price and also includes dividend growth and earnings growth. Speculative return is impact due to changes in P/E ratio.
If P/E doesn’t change and earnings and growth increase over time then investor can earn good returns as compared to a scenario where P/E has decreased.
Starting with valuation, first step can be to analyze traditional ratios such as P/E or Price-to-Sales. Price to Sales (P/S) can be a good option because it measures price of share by sales per share. Sales can be a good option because companies mostly use tricks in earnings (in sales also tricks could be there but it is identifiable). One catch in P/S is what if company is aggressively posting sales but is earning less on these sales. P/S ratio should be used to compare companies with same profitability.
Price-to-Book is another way for valuation. It measures stock’s market value with book value. It is more effective in companies with good tangible assets. Companies using intangible assets have little use of P/B ratio because most intangibles are not directly added to book value. Goodwill can cause an expensive firm to look like a value firm because it inflates book value. ROE also impacts P/B ratio because higher the ROE means company is compounding book equity at a higher rate. P/B can be a good method to value financial firms because many of their assets are revalued every quarter.
Coming to P/E – one of the most popular valuation ratios. P/E can be compared for two firms or for a firm for different periods. P/E can be affected by different things like capital structure, risk levels etc. But comparing a firm’s historic P/E with current P/E can be useful. Drawback of P/E is that relative P/E is neither good nor bad. As P/E depends on future cash flows, capital needs, a single number can’t tell proper valuation. Company which is expected to grow at faster rate will have high future cash flows so it can have high P/E. Also a firm with high debt can have low P/E. There are some questions which can be helpful while analyzing P/E ratio like if any business/asset was sold recently or is the firm cyclical or if the firm has taken any big charge etc.
PEG Ratio is also popular among some investors because it takes in consideration growth rate also. It makes sense because if the company has high growth rate its value will be more in future. Risk should also be taken care of. While analyzing PEG ratio one assumes that risk will be equal which might not be the case.
Apart from multiple based measures, yield based measures can also be considered. Example – we can invert the P/E ratio i.e. divide earnings by market price. By this we get earnings yield which can be helpful in comparing yields of different products. Analyzing cash return is also a good measure. It shows how much free cash flow the company has generated.
Chapter-10 Valuation:- Intrinsic Value
The drawback of using ratio to value stock is that ratio only allows relative comparisons. It means it only helps to compare one company to another.
However knowing the intrinsic value of the stock helps you to know how much you should pay for the stock. Having an intrinsic value helps you to focus on the core business. It forces you to think about present and future cash flows as well as its return on capital. Also it gives you a stronger basis for making investment decision.
Cash Flow, Present Value, and Discount Rate
The value of a stock is equal to present value of future cash flows. Companies create value by investing capital and generating a return. A part of that return is operating expenses, another part is reinvested in the business and the remaining is the free cash flow. These free cash flows are taken to account by estimating the value of a stock.
Cash flows in the future are worth less than those received in the present because there is uncertainty about the future and present cash flow can be invested to get a return on them. The chance that we may not receive the future cash flows needs to be compensated through risk premium. The addition of the government bond rate and the risk premium is just the discount rate. It is the rate of return you would need to make for the indifferent between money receive in present and in the future. Because of this concept the stock with stable and predictable earnings often have high valuation due to lower discount rate.
Calculating Present Value
The present value of a future cash flow in year capital end equals CFn/(1+R)^n.
Fun with Discount Rate
There is no precise way to calculate the exact discount rate. As interest rate increase, so will the discount rate.
The factors which need to be taken into account by estimating discount rate are:
- Size: Smaller firms are riskier than larger firms because they are more vulnerable and are less diversified.
- Financial Leverage: Firms with more debt are generally riskier than others because they have a higher proportion of fixed expenses which will benefit them in good times but make it worse for them in bad times.
- Cyclicality: The cash flows of cyclical firms are tougher to forecast than stable firms.
- Management/Corporate Governance: It refers to the level of trust and the way a management operates. Companies with management which show red flag are definitely riskier.
- Economic Moat: The stronger companies competitive advantage the more likely it will be able to avoid competition and generate a consistent stream of cash flows.
- Complexity: The more complex the business, the more are the changes of something unpleasant happening. A complexity discount can be incorporated to provide for this risk.
Calculating Perpetuity Value
After having the cash flow estimates and the discount rate we need a perpetuity value to put the whole thing together. We need this value because it’s not possible to estimate a company’s future cash flow out to infinity.
To calculate this value take the value of the last cash flow that you estimate (CF), increase it by the rate at which you expect cash flows to grow over the very long term (g) and divide the result by the discount rate(R) minus the expected long term growth rate(g).
Discount this result to arrive at the present value.
Add the discounted perpetuity value to the discounted value of our estimated cash flows and divide by the number of shares outstanding.
Margin of Safety
After valuing a stock, we need to know when to buy it. As an investor, you should seek to buy companies at a discounted estimated value. This discount is called the margin of safety.
Having a margin of safety is like an insurance policy that helps us prevent from overpaying and mitigates the damage caused by overoptimistic estimates.
This margin is different for different stocks. It all depends upon the characteristics of the business like pricing power, market share, stability of demand, etc. The price you pay for a stock should be closely tied to the quality of the company. Having a margin of safety is critical to being a difficult investor because it acknowledges that as humans, we are flawed.
Every approach to equity investing has its own limitation. Sticking to valuation may mean that you will miss out on some great opportunities.
Chapter 11: Putting It All Together
In this chapter, whatever things are taught in the book from starting, are applied on two companies.
Case of AMD (Advanced Micro Devices) –
On reading news or going through company’s website it might look a attractive investment opportunity because it is one of the only two firms in the manufacturing of microprocessors. Also the company is working on a powerful next generation chip which could be better than what Intel could offer.
On analyzing economic moat, it was seen that AMD was making money in times of boom and losing money in normal times. Overall, there was no such sustainable economic moat.
Growth was volatile and profitability was volatile too. It was not efficient in spending. On checking financial health of company, it was found that debt to equity ratio was not high and current ratio was also not poor. But the company lost a substantial amount of money too. On preparing a bear case, management’s compensation was checked and a red flag was raised because even in the year when company was losing money, management team was getting high salaries and bonuses.
Valuation was tough for AMD as it has lost money in past two years and also the share price was higher than what the valuation gave.
Case of Biomet –
Biomet’s business was more promising. Margins are fat in this industry. Also firm is in market from 25 years so it has a trusted customer base.
On analyzing economic moat, it was found that free cash flow, operating margins and net margins were good. On analyzing financial results, it was found that in 1999 company had to pay a charge on legal dispute which was a onetime charge. All else was good. On analyzing factors such as growth and profitability, it was found that growth was a little volatile but sales growth was average. Gross margins are high and have increased over time. SG&A costs have been steady and research and development expenses are declining but this could be taken as a positive sign because company is spreading it over higher sales base. On financial health front, company has no long term debt and current ratio is also high.
On preparing a bear case, it can be concluded that legal disputes can be there in future and also Biomet’s foreign operations are not much profitable. Biomet’s market size is also low compared to industry leaders.
On analyzing management compensation, it was found that management team is taking reasonable amount and options are used responsibly among employees. On doing valuation it was found that share was trading at higher price and by changing scenario it was found that the current market price is near to the valuation outcome.
Chapter 12: The 10-Minute Test
Does the firm pass a Minimum Quality Hurdle?
The first step is to avoid the junk among all the companies. Those companies with very small market capitalization and those that trade on bulletin boards must be avoided. Also those foreign firms that don’t file regular financials must be avoided.
IPOs must be avoided as they there young with short track recorders. However spun off companies aren’t exceptions to this and may prove to be attractive.
Has the company ever made an Operating Profit?
Those companies which are in the money losing stage sound exciting but usually have only a single product or service to offer. Such stocks may blow up your portfolio and thus must be avoided.
Does the company generate Consistent Cash flow from operations?
Those companies which don’t generate enough cash flow or report negative cash flow from operations have to seek additional financing by selling bonds or issuing shares. Both the sources have their own limitations.
Are returns on Equity consistently above 10 percent, with reasonable leverage?
The minimum ROE for a non-financial firm can be taken as 10% and for financial firms, 12%. However the ROE generated must not be a result of the use of leverage.
Is earnings growth Consistent or Erratic?
If the company doesn’t have consistent growth rate it is either in an extremely volatile industry or competitors have an edge over it. The former is not bad if the long term outlook is good, but the latter may prove to be a big problem.
How clean is the balance sheet?
Firms having a lot of debt require extra care because of their complicated capital structure. If a non-bank firm has a high financial leverage ratio or a high debt to equity ratio ask yourself the following questions:
- Is the firm in a stable business
- Has debt being gown down or up as a percentage of total assets
- Do you understand the debt
Does the firm generate free cash flow?
Those firms which create free cash are preferred over others because it is the cash generated after capital expenditure which increases the value of the firm.
However if the cash generated is being invested in good projects than, negative cash flow can also be considered.
How much ‘Other’ is there?
If a company repeatedly shows huge one time charges in its financial statements, it may show that the company is hiding its bad decision.
Has the number of shares outstanding increased markedly over the past years?
If this is the case, the company is either issuing new shares to buy other company or granting numerous options to employees. Most of the acquisition fails and granting option means diluting the stake of the shareholders.
However if the number of shares are decreasing it means firms are returning the excess cash to shareholders. However stock repurchases are good only when the company’s share are trading for a reasonable value.
Beyond the 10-minutes
After a firm passes this test, a summary of its financial statements, its 10-k filing, the management and discussion analysis, its compensation policy and all the other major documents can be gone through to get an idea on its business and everything going on in the company and its sector.
Chapter-14 Health Care
Healthcare is one of the few areas of economy which is directly linked to human survival. Giving the importance for healthcare and a free regulatory environment enables the sector to score above average financial return, Healthcare companies are often highly profitable with a strong free cash and return on capital.
The sector experiences consistent demand as well such as drug companies, biotech, medical device firms and health care service organizations.
Economic Moats in Health Care
Economic moats in the sector include high pack up cost, patent protection, significant product differentiation and economies of scale. These factors create entry barriers as the established big players already excellent in these areas thereby leading to great profitability.
Developing drugs can take several years of research and development and can cost millions over that time frame. This creates a huge entry barrier, which even if surpassed would require a lot of promotion to stand head to head with established players.
The sectors vast side and rapid expansion makes it an attractive investment. However it involves complex relationships, controversy and political pressures.
Role Of the United States Food and Drug Administration
After passing through all the above stages, the toughest stage is yet to come. Once a drug passes the phase 3 testing, a new drug application needs to be filed with the US FDA. It takes about 17 months for FDA to review an application and that too with a 70% chance of approval.
The FDA has advisory committees that meet several times in a year to discuss the application and submit their opinion to the FDA thereby, deciding the fate of the drug.
If the FDA isn’t convinced, a not approvable letter is sent to the company.
Patents, Intellectual Property Rights, and Market Exclusivity
Once a drug is approved by the FDA, the marketing can begin. Drugs generally enjoy patent protection for 20 years from the date the company first completes the patent. However, because a patent application is usually filed as soon as the drug is identified a significant portion of the period is eaten up by trials and approval process. Thus many drugs enjoy only 8-10 years of patent protection after they have been launched in the market.
The information about a drug company’s patent protection can be seen in the 10-k report under the heading “Patents and Intellectual Property Rights”.
Generic Drug Competition
After a drug goes off patent, it is open to competition from generic medications. Generic drug has the same chemical composition with a 40-60% lower price. A firm can lose a significant portion of its sales if it is over dependent on one single drug for its sales.
Hallmarks of Success for Pharmaceutical Companies
Companies that provide stellar performance focus on these traits:
- Blockbuster Drugs: These are drugs with more than $1 billion in sales. Companies with such drug gain manufacturing efficiencies by spreading fixed cost over more products.
- Patent Protection: Every drug eventually loses patent protection, but those companies who manage the losses best will generally provide investors with a more consistent stream of cash flows.
- A full pipeline of drug in clinical trial: It refers to having an abundance of products in development and directing research efforts towards unmet medical needs.
- Strong sales and marketing capability: Pharmaceutical salespeople are the ones who act as a link between the company and the physicians. The relationship of companies with professional medical staff is very valuable for a drug firm.
- The big market potential: Those drugs that treat conditions affecting a large percentage of the population have a better potential than niche products.
Generic Drug Companies
Generic drug makers do not have extraordinary margin but are growing much faster due to their increasing popularity. The return on invested capital varies dramatically depending upon the company’s exposure to branded drug.
Generic drug companies can benefit from competitive barriers. The first company to filed a legitimate patent challenge against a branded drug enjoyed 180 days of market exclusivity.
Biotechnology firms need to discover new drug therapies using biologic cellular and molecular processes rather than the chemical processes used by big pharmaceutical. These firms are also concern with developing therapeutic products.
The greater product risk under this sector because the therapies are often completely new forms of treatment.
Hallmarks of success for Biotech Companies
Three categories into the biotech firms can be divided:
- Established: These include the biggest companies of biotech sector which have annual product revenues of more than $1 billion. These companies have positive earnings and cash flow. Characteristics:
- Large numbers of drug in late stage clinical trials.
- Plenty of cash on hand and cash flow for research and development expenditures.
- Stock having a margin of safety of around 30-40% of its fair value
- Sales sustaining salesforce
- Up and Coming: These firms are on the verge of breaking into the black or those which have already demonstrated small but positive earnings. These firms are a lot riskier and have no economic moat. During this stage companies require a lot of cash for the last phases of clinical trials and for preparing documents for the FDA.
- Speculative: These are companies which make up the majority of all the companies in this industry and are too risky. These firms may have interesting technologies and may become extremely successful one day, real revenues are many years away. The odds of drugs of each company reaching the market are very low and thus a huge margin of safety is required while investing in them.
Medical Device Companies
These are the companies that make hardware for medical procedures. There are two types of device firm – Cardiovascular and Orthopedic. An increase in the aging population and in the life expectancy will drive growth in medical devices. Due to a pressure on medical cost if the demand for medical device company has increased as it reduces the cost of some procedures. Medical device companies have wide economic moat like economies of scale, higher switching cost and long term clinical history. Patent Protection also provides a measure of avoiding competitors.
These companies have a great deal of pricing power as well. Due to absence of substitutes the firms have been able to raise their prices by 3-5% every year.
Device firm are not without risk. Product cycle can be very short and thus expenditure on research and development has to be incurred to keep up with the competitors. There is also legal risk involved.
Hallmarks of success for Medical Device Companies
- Salesforce Penetration
- Product Diversification
- Product Innovation
Health Insurance/Managed Care
Insurance or managed care firms are subject to intense regulatory pressure making them less attractive than other health care industries. They don’t have wide economic moats. Stocks must be chosen carefully and a huge margin of safety is required for investing in this companies.
One of the ways insurer rise to gain pricing control or by creating Managed Care Organization. MCOs make money in two ways. One is by underwriting medical insurance which is known as risk based business. The other way is by simply administrating services known as Fee based business. Companies with a greater proportion of fee based business less risk because of more predictable cash flows.
Hallmarks of success for Health Insurance/Managed care companies
- Effective medical cost management and underwriting: The medical loss ratio calculated by medical cost paid divided by premium revenue. It is the best measure of the firm’s effectiveness in this area. This ratio reflects a company’s overall success and consistency in managing its risk based business.
- Minimal Dual Option Business: Managed Care organization provides individuals the opportunities to choose from two or more types of plan. Companies with a large portion of this dual option must be watched out for due to the risk of mispricing.
- Large mix of Fee based business: Having a large proportion of fee based business as compared to risk based business is always a positive in our book. Minimal exposure to Government accounts: Companies with less exposure to government accounts will outperform those that rely on government revenues.
Chapter 15: Consumer Services
Consumer services firms have a very narrow economic moat generally. Even if a firm has any unique product it does not remain unique for a long time. There are very few firms who have managed an economic moat by offering ready to eat/ quick to prepare food, some stores give 24/7 services or some stores have checkout at the front of the stores. Any firm giving these kinds of services at competitive price can outperform its competitors.
Major industries in consumer services –
This industry can be divided into two segments i.e. quick service restaurants (fast food) and full service restaurants. As both the spouses are working they get less time to cook food and also to buy groceries. So the preference for going out and eating at restaurants has increased.
Now comes investing in these companies. Many restaurant concepts start and after a few time they either fail or they grow. But during this time their earnings may be negative or inconsistent. Those which grow, expand their business by opening new stores. Many times new store are aggressively opened and then again cash flow turn negative. When expansion is not possible it becomes important that profits are generated by existing units. Even when restaurants have reached at the stage of slow growth, it is possible for them to survive by providing what customer wants and by advertising and service. If these things are not done properly then restaurants may decline.
Two major facelift in past decades were – development of category killers and one stop shopping experience. Some firms developed the method of providing goods to customers at a discount every day.
Now comes investing in retail. One of the ways to differentiate good retailers from bad retailers is to check cash conversion cycle. If retailers are selling quickly, is collecting payment quickly and is paying late to suppliers can help them reduce their days in cash conversion cycle. Increasing inventory and increasing days in receivables is a sign of trouble but if there is a increase in payment to suppliers it is a good sign because company is paying late and is using goods earlier. Store traffic and good employee culture needs to be maintained by retail stores.
The only way a firm can build moat in this sector is by providing goods at lower rate because prefer to buy the same good at lower rate (if a sweater is sold for $50 and in next store the sweater is being sold for $40 customer will go for second store providing sweater at cheap rate.
Chapter-16 Business Services
Companies in this sector can prove to be those running wonderful, wide- moat businesses- the ones anyone would like to buy at the correct price and keep as long-term investments.
These companies are varied and thus are divided into three categories- technology-based, people-based, hard-asset based. Not all companies fit perfectly into any one of the three categories. Despite being such a varied business, a few factors affect the majority of companies in this sector.
Outsourcing refers to offloading the non-core tasks to third parties. These are tasks which the firms would find impossible to handle internally. Outsourcing saves time and cost and allows businesses to avoid the hassle of handling non-core activities on their own and allows them to focus on the main business.
Economic moats in business services
In this industry, size matters. Companies may leverage size to boost their top and bottom lines. By handling more volume over a fixed cost network, unit costs can be lowered and profitability can be increased. Many firms acquire others to achieve economies of scale.
Size affects branding as well. Usually, larger and well-known firms are preferred over others.
Many industries in the sector have huge barriers to entry making it difficult for new players to enter. Despite the companies having wide economic moats, they need to differentiate themselves to fight the intense competition in the industry.
Technology Based Business
These companies include data processors; data based providers and other companies that leverage technology to deliver their services. These companies have a sizeable and defensible competitive advantage which helps them to generate better than average long term returns.
These companies offer the strongest cases for outsourcing. These firms require huge initial investments to step up an infrastructure that can be leveraged across many customers. These investment acts as an entry barrier.
In this market price competition tends to be less intense. Rather the companies prefer counting on enough growth to go around for all companies to benefit.
Low ongoing capital investments are very low in this sector because of the huge upfront technology investments that have already taken place.
Companies benefit from both economies of scale and operating leverage. The combination of operating leverage and low capital requirements suggests that these firms have plenty of free cash.
Companies in this sector have predictable sales and profits due to long term contract. This means that 80-90% of a company’s revenue can be booked even before the year begins.
Hallmarks of success for technology based business
- Throw off cash: Big market opportunities, operating leverage and minimal ongoing investment requirement enable these businesses to have free cash flow margin.
- Enjoy economies of scale: The figure players in the industry benefit from cost advantages relative to other small competitors which translates into better financial performance.
- Report stable financial performance: Due to long term contract, the majority of revenues are recurring and predictable for these firms.
- Are exposed to fast growing or under penetrated markets: Due to the operating leverage, exposure to market with lot of growth potential should translate into impressive profit expansion.
- Offer a complete range of services: Those firms who offer a wide range of services benefit because buyers look to consolidate their purchases.
Have strong sales capabilities and excess to distribution channels: To sell business services, most successful companies have strong sale forces.
These companies include those that rely heavily on people to deliver their services such as consultant, professional advisors, advertising agencies and temporary staffing companies.
These businesses make money by leveraging and investment in their employee’s time. Growth for people-based companies comes mainly from finding and hiring more skilled workers. Training is an important component to ensure a standard level of service quality. Salary expense is a big fixed cost which must be covered for profits to be made.
Relationships are an important characteristic in this sector. Products are designed according to clients and purchase decisions may be made because of the relationship.
Brands, relationship and geographic scope can provide a competitive edge in an industry of aggressive competition.
Hallmarks of success for people-based businesses
- Differentiation of offering: Differentiation can help companies generate superior financial results.
- Providing a necessary or low cost service: When customers feel compelled to purchase a service and the cost of service is relatively low, customers need not try to negotiate for a better price.
- Organic Growth: Internally generated growth is preferred over growth generated by acquisitions as it signals healthy demand for the firms service.
These are companies which depend upon big investment in fixed assets to grow their businesses. Airline, waste haulers and expedited delivery companies fall under this sector.
These businesses require large incremental outlays for fixed assets. The incremental fixed investments occurred before asset deployment, and thus, companies in this sector generally finance their growth with external funding. High leverage is not a bad thing unless the cost of debt financing can be covered along with a reasonable return for shareholders.
Airlines are the least attractive investment due to their enormous fixed cost, expensive labour contracts and a non-differentiable commodity service. Thus price competition is intense, profit margins are negligible and operating leverage is too high.
Majority of these businesses fall into the narrow or no moat bucket. Thus investors should look for a steep discount to fair value before buying the shares.
Hallmarks of success for Hard-Asset-Based Businesses
- Cost leadership: Due to the large fixed cost, those companies who are more efficient have a strong competitive advantage.
- Unique Assets: When limited assets are required to fulfill the delivery of a particular service, ownership of those assets is the key. For example, landfill assets.
- Prudent Financing: Having a lot of debt is not a bad thing unless it can be financed by the cash flow of the business.
Chapter 17: Banks
Bank is one of the most important sectors in every economy because they provide the service of lending money to the businesses. In an economy, whichever business needs money can approach bank for financing. Their business model is simple. They borrow money from people at low rate and lend this money on high rate and the difference in this rate is the Net Interest Income for banks. Also they provide other services and earn noninterest income on that. Central bank of countries acts as the lender of last resort. Banks can turn towards central banks in times of liquidity crunch. Banks also get paid for the risk they undertake. Generally the risks are credit risk, liquidity risk, interest rate risk.
Credit risk and managing it –
Credit risk is that the borrower will not repay the loans given to them. Credit risk is always there in the case of banks due to their business model. Banks generally avoid this risk by either diversifying their portfolio, or through collection procedures or by solid underwriting. Banks which specialize in these activities can have an edge over competitors. Investors should keep a check on non-performing loans, charge-off rates (percentage of loans the banks think will never be repaid) and their trends. Investors can also compare this rate for different banks. Lending pattern can also be observed from bank’s financial statements.
Selling Liquidity –
Apart from credit risk, banks also have liquidity risk. Banks offer liquidity management services. Companies sell their receivables to banks for a discount to get immediate liquidity. Customers too pay for liquidity services. When the interest to be paid on deposits is less than interest earned by lending, in this case the bank is earning the spread on depositor’s money and eventually depositors are paying for it. These low cost accounts helps bank earn profits so as an investor we should check whether these accounts are increasing or decreasing. Also we should check whether the banks have given too many loans in a single sector or not because it can lead to a series of defaults. Banks should have diversified loan book.
Managing interest rate risk –
Third and one of the main types of risk faced by banks is interest rate risk. There are four major components to examine i.e. Interest income, Interest expense, noninterest income and provisions for loan losses. If interest rate falls then bank’s interest expense reduces. But generally interest rate falls when economy is facing recession or tough times. In this case defaults also increase so bank’s provisions increases too. But banks have other tools to manage risks. Banks can reposition their risks by focusing on the sector which they are lending. Big banks also have facilities to pass the loan to investors.
Economic moat in banks –
Banks have generally four areas of moat – balance sheet size, economies of scale, regional oligopoly type structure and customer switching costs.
Banking industry is very much capital intensive. According to Morning Star data, out of 20 largest corporations by asset size, 19 were banks in 2003. Economies of scale go hand in hand with capital requirements. The larger the assets of the firm, the more it has the capacity to expand. In terms of regional oligopolies, banks which are operating in major metro cities have good customer base. A handful player dominates the market. Customers tend to stick with the firm they trust. If the customer remains same the revenue remains almost same for banks.
Things to look for while investing in banks or financiers –
Businesses of banks are built up on risk. So the first thing to look for is strong capital base. Equity-to-Asset ratio can be used here. Also banks should have high level of loan loss reserves. These ratios can be compared by industry average. Investors should watch for banks that generate mid to high teen returns on equity. If banks are generating high returns by provisioning too little, this will lead to higher returns in short term but will be risky in longer term. Efficiency ratio can be used to determine how efficient a bank is. Efficiency ratio is measuring noninterest expense as a percentage of revenue. Another good measure could be Net Interest Margin. This is net interest income as a percentage of average earning assets. This ratio is generally around 3-4%. Observation can be done for a longer tenure to see the trend. Banks with strong revenue have capability to grow above average. Three metrics can be useful while analyzing revenue – net interest margin, fee income as a percentage of total revenues, and fee income growth. Banks cross sell new services through which their earnings increases. Do this for a large time frame to understand the trend. Price to book ratio can be a good measure for banks. Assuming that bank’s assets and liabilities approximate reported value, book value can be taken as bank’s base value. Risk should be understood properly.
Overall these metrics can be useful in deciding that a stock is good or not for banks.
Chapter-18 Asset Management
Asset managers enjoy huge margins and constant stream of fee income. Asset Management Companies are so tied to the market that their stock prices reflect the current optimism or pessimism in the economy.
What make asset managers tick?
Asset Management firms run people’s money and demand a small proportion of the asset as a fee in return. It requires a very little capital investment. Compensation is the firms main expense. These firms have operating margin of 30-40% which is a very huge number.
Attaining scale in this industry can act as a solid moat. Reaching a particular level of scale acts as a entry barrier which is impossible for new firms to duplicate.
The most important competitive advantage are:
- Diversification: Asset Managers have started selling a broad array of products, from money market to bonds to equities to hedge funds. This diversification is one way asset managers overcome market fluctuation.
- Asset Stickiness: If customers withdrew money at the first sign of trouble, it would make the firms earning volatile. Most desirable assets like institutions and pension funds tend to be sticky. Wealthy investors are offered a variety of incentives to dump their funds even when the investment haven’t performed well. Generally advisors sold fund are better in retaining their asset because the advisors can convince clients not to sell in a panic.
Asset Management Accounting 101
Asset Under Management is the biggest metric to watch out for any company in this industry. It refers to the sum of all the money that the customers have entrusted to the firm. It is a good indicator of how well the firm is performing.
Key drivers of Asset Management Companies
The level of AUM is the biggest driver of revenue for an asset manager. Money managers charge higher fee to manage stock portfolio than to manage bonds or other money market fund. Thus different percentages of increase in sales of different types of funds would mean different changes in revenue growth.
Changes in AUM can come from market movement or increased sales. The source of this change needs to be observed.
Inside the back office
Custody and asset services are the sidekicks of asset management. They keep track of investments and perform the back office accounting work every day. Mutual Fund companies frequently outsource their back office work to custodians to remain hassle free from the work of record keeping. Custodians charge lower fees and have greater economies of scale.
It requires hefty investment in technology and a penchant for absolute accuracy. It is profitable only if it can collect huge funds in custodian assets, making scale attention to the business.
Key Drivers of Custody Companies
Revenues are primarily driven by the level of assets under custody. As economies of scale are so significant here higher levels of assets are a sign of competitive advantage. These bigger is better the model has led to increasing consolidation leaving only the largest players having the majority of market share.
Custody firms may lend funds which must not be too concentrated in one company, one industry or one sector. Bad loans can be one of the largest risk factors for the firms.
Hallmarks of success for Asset Management Companies
- Diversity of products and investors: Having a diverse pool of assets is very important because swings in the market can adversely affect one trick ponies.
- Sticky Assets: Those asset managers who attract the buy and hold crowd, including institutions investors and retirement savers, can expect a consist stream of cash inflows.
- Niche Markets: Despite the large number of asset management companies, those with unique products and capabilities have more pricing power and less competition.
- Market Leadership: For custodians, economies of scale and for established asset managers, long term performance records and name recognition define market leadership.
Chapter 19: Software
Economies of software industry can’t be matched by everyone. Even though the costs for creating software are huge, production costs are low. Software companies are cash cows too. Low inventory, accounts receivables balance and less capital requirement in creating software can lead to higher cash flows. Also in the time of cost cutting, software can help because it can automate work.
Segments of software industry –
Mostly industry leaders have oligopoly in software industry. Customers also prefer big brands who have very well established themselves in market. Here are some of the biggest segments in this industry –
- Operating system – All the program performed by computer are run by operating system. It also handles direction from hardware such as printers. Microsoft’s Windows have majority of the market share in this segment.
- Database – This helps computer in collecting data and storing it. Switching costs are high i.e. if anyone wants to move data from one database to another it will be costly. Microsoft, IBM, oracle dominates this market.
- Enterprise Resource Planning (ERP) – This program improves firm’s back office work such as accounting, human resource etc. Things can be easily performed using any application, like for example; an accounting application can do the work of budgeting, billing easily.
- Customer Relationship Management (CRM) – It keeps track on client’s data like purchasing history. This can help salespeople know the needs of the customer. Overall it will result in increased customer satisfaction.
- Security – With the increase in online data sharing, the data is available not only to employers and customers but also to hackers. Firms have created products such as firewall, antivirus etc. to protect data. Check Point Software and Symantec are leaders in this segment.
- Video games, graphic design software etc. are also some segments where leaders have monopoly in their respective segments.
Economic moat are tough to build in technology sectors as with every passing day, there are innovation in this sector. Entry barriers are also not there. To assess economic moat, following points can be observed –
- High switching costs – If firm’s place switching costs high, then customers will not turn towards competitor’s product because they will be not be able to do this hassle free.
- Network effect – Adobe can be a good example here. Majority of people view file in Adobe Reader. So people try to create documents in acrobat reader only. Majority of the computers have acrobat reader installed in it.
- Brand names – Strong brand names can help company increase their sales because people prefer to buy those software’s which are popular.
Generally tech firm’s balance sheet is clean and easy to understand. But as an investor few things should be checked i.e. License revenue tells that how much new software was sold. Trend can be observed i.e. if license revenue is increasing that means company’s software have demand in market and vice versa. Deferred revenue is also one noticeable point. It shows the amount the firm has received upfront i.e. before providing service. It can help investors to know about future’s revenue. Analyzing Days Sales Outstanding (DSO) can also be useful for investors. It shows how many days the firm is taking to collect receivables.
While analyzing software firms, some issues should be watched out like Revenue recognition changes. If management is changing the rules for recognizing revenue, there can be changes in the amount of revenues. So it should be watched carefully. There may be some questionable transactions which should be also carefully watched. Firm may engage in some wrong practice to boost sales.
Apart from economic moat, there are five hallmarks; we should look for in software companies. First is increasing sales. If a firm’s sales are increasing it means that there’s a growing demand for its software. Steady growth indicates that company has loyal customers, or has the ability to raise prices without losing out on business. Company which has given good performance in different business cycles can be good. Even though there are no entry barriers but it is very difficult to create a brand that is still there after many years. As the cost for creating a copy of software is almost nil, every sale after the first one is going to bottom line. If company is able to achieve economies of scale its profit margins will widen. Customers are loyal towards the successful software firms. If the company has good customer base, it can be assumed that the customers will buy from the same company. The saying “buy the jockey, not the horse” fits perfectly for software firms because its biggest assets are its people.
Things which might not seem to be in favour of software industry is that in the times of boom, software industry performs well but in crisis times, it is the biggest hot because people defer it. Also software companies are not cheap.
Factors like product cycles, price competition and technological advances are very intense in the hardware sector. It is very difficult, thus to build sustainable competitive advantage.
What drives the hardware industry?
The hardware sectors central driver is its ability to innovate. According to the Moose Law, all the technology innovations happens at a rapid pace, the benefits of that innovations are passed on to the n users. Earlier IT processing power was only affordable for military, communications and financial applications. Today, an average person can afford a very powerful computer and IT has countless applications in everyday life.
The second driver is the shift of advance economies from manufacturing towards services. Services require a much larger investment in IT and manufacturing.
The third driver is the relationship between technology hardware and software.
Hardware Industry Dynamics
The industry is cyclical in nature. Corporate spending on technology makes up the bulk of the total hardware sales. Demand from these firms exit only in time of financial prosperity.
Consumer spending on technology is even more prone to dramatic swings. Customers spend on technology only when they have a stable job and a regular income.
The demand is volatile even over short period of time.
Economic Moats of Hardware
Large companies such as Intel and IBM have built moats by focusing on distribution channels, dominant scale and broad product lines.
- High customer switching cost: Telecom Equipment manufacturers such as Nortel, Alcatel and Lucent benefit from high switching cost. This is because their customers run complicated networks and thus need equipments which fit within their networks. Such conservative buying habits benefit the equipment manufacturers.
- Low cost producer: Dell is one of the largest PC vendors. It purchases chips and disk drives in large volumes from its suppliers and therefore can negotiate lower component cost than its rival. Dell’s suppliers are willing to wait longer for payment and make the component available to it exactly when it wants to them allowing the inventory levels to be low.
- Intangible Asset: Companies often use intangible asset such as patents and brand names to maintain the excess return on investment for a long period of time.
- The Network Effect: Network Effect can arise because hardware often needs to operate with other hardware and to be maintained by people.
Hallmarks of success for Hardware Companies
- Durable market share and consistent Profitability: Those firms which have strong profitability and a stable market share are evidence that a wide economic moat is allowing the firm to defend the competition.
- Keen operational and marketing focus: These companies don’t spend much time where they don’t have a particular advantage or those that don’t pick their strategic focus.
- Flexible Economics: The best hardware businesses have revenues and cost with well matched timing and levels that can be change fairly easily. Those firms which can change their cost depending upon different situations have less risk.
Chapter 21: Media
Companies in media sector benefit from competitive advantage and monopolies. Media sector gave returns above S&P 500’s return between 1993 and 2002. Two most important factors for strong showing in media are economics and competitive advantage. Media can be divided into three sectors i.e. publishing, broadcast and cable television, and entertainment production.
How media companies make money
Media companies make money be delivering a message to public. This message can be a numerous ways like television, movies, magazines, newspapers etc. First source of income for media could be the user fees. For watching movie or to read novel customers pay the onetime charge. If the movie is hit then media company can earn higher amounts. Cash flows can be volatile depending on how the content is. If content is hit then cash flow will be good. Another source is subscription. Many businesses provide subscription based services in which customer pays upfront fees (before getting actual service). This could be a good source because through this company receives cash on advance and it lessens their dependency on other sources of capital. Advertisement revenue is another source of capital for media companies. This revenue can be volatile according to the market because when businesses are suffering, the first thing which company cuts are the expenses on advertisements.
Economic Moats in media sector –
There can be a number of competitive advantages in media sector. But most common are economies of scale, monopolies and intangible assets. Companies which have monopoly have the ability to increase pricing and have potential to earn big amount of money. Companies having licenses can also be good because licenses are not provided to everyone and it acts as a barrier to entry. Due to deregulation, companies were able to spread the fixed costs over more number of customers and become more profitable. Publishing profits can be a good sign because if the company is improving its economies of scale, its profit margin will rise. Companies can do acquisitions to increase the market share and increase profitability. Companies in the radio, broadcast, cable television can have profitability due to licenses and deregulation (as discussed above). They also make money from advertisements. Cable industry has faced hard times because of satellite television providers. Also, it is highly capital intensive.
Entertainment Industry –
Companies in this industry can see volatility in cash flows due to one-time user fees. Also, there is a barrier for new entrants i.e. it takes significant amount of capital to produce new movie or television series. But as the distribution is getting simpler through internet, profitability has taken a hit.
Two simple hallmarks are there to identify good companies – free cash flow and sensible acquisitions. Higher free cash flow indicates that customers are ready to pay a premium for company’s service or company doesn’t need much capital investment or the company is very efficient. If a media company has low cash flows then check that whether the core business of the company is in a good shape or not. Sensible acquisitions can be done to acquire larger market share. Companies which are running behind large companies for acquisition should be given proper time to analyze because these kind of acquisitions doesn’t succeed.
This sector includes companies which have mediocre return on capital, economic moats are non-existent, future depends on regulators and lots of money needs to be spend just to stay in place.
Building and maintaining a telecom network requires a lot of capital. These acts as an entry barrier and protects the established players. The emergence of the internet, the opening of local networks to competition and rapid wireless growth allowed new players to grab a piece of the action. Due to these even a mature telecom firm will need to invest significant capital to maintain its network, meet the changing consumer demand and respond to competitive pressures.
These companies have very low asset turnover ratios due to the enormous cost to build a network. A mature company should expect to earn operating margin between 20-30%, sort of which would make it difficult to earn an attractive return on invested capital.
Economic Moats in Telecom
Long distance carrier, in most cases, have no economic moat. Companies with strong reputation are preferred over others providing them with a small competitive advantage. Long distance firms face the threat of competition which makes it difficult for them to raise prices and thereby earn lower returns making them unfavorable investments.
Local phone companies enjoy stronger competitive advantages. They earn very healthy margins and generate enormous cash flows.
Without economic moats, there are a few investment opportunities.
Hallmarks of success in Telecom
Strong financial health is required for firms to be attractive. A strong balance sheet and solid free cash flows are even more important. Healthy and consistent margins are also required because they mean free cash flow can remain strong.
The future of the telecom sector will see greater competition and will be shaped by regulatory and technological changes.
Chapter 23: Consumer Goods
Consumer goods industry can be a good investment because even if economy is facing crisis, people still use toothpaste or shampoo etc. Consumer goods industry has a simple business model. They produce goods and sells to customers, usually supermarkets, convenience stores etc. Beverages companies sell their products to their distribution channels.
Factors for Growth –
In consumer goods industry, mostly huge companies have a monopoly as they have major sales in the industry. Companies rely on same growth opportunities i.e. stealing market share from competitors by introducing new products. But many new products are launched and very few are able to succeed. Another way is by acquiring other consumer goods companies. Companies acquire other companies to enter in those product categories. It is generally hit or miss strategy. If it works then it is good but it can also result in losses if the strategy doesn’t work. Reducing operating cost can also help to grow. Businesses reduce cost to increase their margins and can be successful but this could be dangerous because firms focus on earnings growth and not revenue growth. Many businesses also opt to expand in international market for growth. But it is not risk-free. There’s a currency risk involved in doing international business.
Things not to like in consumer products –
There are few risks investor must consider before investing in consumer goods companies. Retailers such as Wal-Mart dominate market. Producers too want that their goods should be there in Wal-Mart. So overall Wal-Mart can dictate different terms and conditions like which product it will sell and pricing also. There are also foreign currency risks, litigation risk. As the financial performance is good, their stocks can be expensive.
Economic moats –
Despite having risks, there may be moat in consumer goods industry. First moat is having economies of scale. As few firms are dominating a market, it is obvious that they have good customer base. Good consumer companies have become a brand and people are ready to pay a premium for their products. Distribution channel that manufacturers use can be a competitive advantage for their firms. It is hard for smaller firms to build a good distribution channel.
Few things which investors can look for before investing can be market share, free cash flow, brand building, innovation etc. Firm having a dominant position in market can retain the same position for several years in most cases. Many businesses in this sector are old and have already set up themselves in the market. Due to this, they don’t have to put much cash again in business and they can distribute free cash flow among shareholders in the form of dividend. Companies that are regularly investing in their brands can be foundation for the birth of new brands. However investors should look for those businesses who are selling their brands. If companies are innovating and introducing new products, investors can check whether the product is just a new flavor or an all different new product.
Chapter-24 Industrial Materials
This sector involves those companies which are concerned with buying raw materials and facilitating the production of inputs and machinery used by other companies to meet their customer’s demand.
Industry materials can be divided into two groups: 1) Basic materials such as commodity steel, aluminum, and chemicals and 2) Value added goods such as electrical equipment, heavy machinery and specialty chemicals.
Since the companies provide inputs to the industries, their demand is subject to the economic cycles
The problem with cyclicality
When the economy is booming, profits and revenues intensify, so does the demand for raw materials and labor increasing their costs. Interest rates rise due to increasing demand for capital. High interest cost and operating costs leads to lower margins and thereby, a reduction in capacities leading to layoffs and reducing inventories and prices.
Economic cycles drive the demand for products in various industries thereby, driving the demand for the industrial products used in the manufacturing of those products.
Dealing with demand swings is difficult for industrial companies who generally tend to have slim profit margins. High fixed costs can prove to be profitable as well as deadly.
These companies also use product diversification in sectors like finance, media etc. to save themselves from cyclicality.
Economic Moats in Basic Materials
Economic Moat in the basic material industry tend to be very few because many of these companies produce commodities and thus would create a sustainable competitive advantage only by becoming the low cost producer. Some of these companies achieve low cost by increasing their size and attaining economies of scale.
Although basic materials industry do have significant barrier to entry due to the cost of constructing a plant is stiff, stiff price competition results in low profits. The cost of equipment is high and profit margins are low meaning that they have poor return on capital making them unattractive to investors.
Economic Moats in Industrial Materials
Only a few of industrial material firms countaract the problems like cyclicality, fierce competition, low profit margins, etc because they have a stable consumer base, predictable sales and profits and the ability to reinvest their capital more efficiently.
Technology and Competitive Advantage
Due to fierce competition in the industrial material sector, there is often price competition and little room for top line growth. The only way to improve the bottom line is by developing a differentiated product or by reducing costs. In this sector product differentiation is not possible and thus efficiency is the only way to improve the bottom line.
Investment in technology can lead to lower cost production methods.
Some companies have found ways to take a raw commodity and alter it, so it adds value for the customers. Such value added products command premium to a basic commodity.
Chapter 25: Energy
Energy can be generated from different sources but the mostly used resources are oil and gas. Majority of the world’s energy resources are under the ground. Also a large percentage of world’s resources are under members of OPEC countries. OPEC keeps price artificially high by coordinating and limiting supply. Some companies also focus on exploration and production. After extracting oil from ground, it needs to be transported to refineries and then again to end consumers. Pipeline plays an important role in transportation of oil. Many companies own pipelines they use but there are also pipeline companies. Refineries then break down the oil into various components like gasoline, jet fuel etc. Refining profits can be cyclical. After refining, oil is supplied to end consumers through oil stations, marketing fuel for industrial use.
There are also some companies which give services to oil companies such as seismic studies or services related to drilling etc. But these companies have high volatility because if oil prices are high then oil companies wants to drill more and when prices are low drilling budgets are the first to see a cut. However, if countries have good oil fields which can produce more oil, then service companies can see sales growth in long term.
Impact of commodity prices –
This industry has a lot of impact of commodity prices. Amount of oil pumped on a single day is almost fixed. Large percentage of operating costs is also fixed. So if oil price rises it can result in higher profits because costs are almost fixed. This reliance on commodity prices makes profit highly variable.
Economic moats in oil industry –
It is difficult to create an economic moat in an industry which has high impact of commodity prices. OPEC is a significant helpful factor behind oil producing companies. Even though OPEC control’s a little amount of world’s oil output, it can manipulate commodity prices. OPEC keep price of oil from $20 to $28 per barrel because below this range profitability suffers and above this range, consumers become conservative. Another moat is that companies have economies of scale. Economies of scale play a major role in the profitability of energy companies. Larger companies can spread costs on more number of customers.
Hallmarks of success –
If companies are generating profit even when oil’s per barrel price are low then it is a good sign. The higher the profitability and the longer the track record, the better. If company is having less debt then it is a good sign because industry can take a hit if oil prices suffer. Reserve replacement ratio which shows the amount of new oil the company has found divide by amount of oil it has produced during that same period. Also companies which have matured don’t have much cash flow requirement so they can give dividends to shareholders.
Risks in energy sector –
Major risks are that OPEC will lose its influence, or Russia can be a threat to OPEC because it has the most reserves after OPEC and it can also produce high number of barrels. Development of technology can also lead to alter how the world gets energy.
Utilities was a sector which comprised of companies which were regulated monopolies with guaranteed returns. In contrast, today highly competitive and volatile market with high fixed cost due to deregulation.
The electric utility business can be divided into three parts: Generation, Transmission and Distribution. Earlier, all the three parts were integrated into one entity but deregulation forced companies to operate in focused components.
These are operations that run the power plant themselves. It is the area that has the greatest competition because entry barrier are comparatively low and falling. With increasing competition and decreasing profitability it is becoming increasingly difficult to make a profit.
Transmission is the business transporting electricity over long distances. Rates in these sector are regulated and there is open access for generators which is a result of deregulation creating more competition. These firms have fairly wide economic moats because of entry barriers due to large upfront cost.
These companies own and service the final mile of cable that brings power to individual homes and businesses. Distribution has the widest economic moats because they tend to own monopolist with no alternatives even in deregulated states. The natural monopolies have the most government control. These means that the rates charged are regulated and return on investment are capped making it difficult for utilities to convert their economic moat into excess returns without which creating shareholder value is difficult.
Regulation, Regulation and Regulation
Regulation is the single most important factor shaping the utility sector. Companies in these sector face heavy regulation on multiple factors. From the investment perspective, the most important regulation is done at the state level because states decide how utilities are structured, degree of competition allowed and the rates to be charged.
The next most important level of regulation comes at the federal level. These regulations make it difficult to analyze the sector.
Hallmarks of success for Utilities Companies
- Stable, Favorable regulatory structure: Utilities that operate in states with minimum competition are positioned much better than those in states where deregulation have their open markets.
- Strong Balance sheet: Large amount of cash and low debt levels is always attractive but it is important in an uncertain sector like utility sector. The average utility has a debt capital ratio of 60%, and companies with less debt are preferred.
- Sticking to the basics: Those companies which had stayed focus in their core businesses have performed better than those companies which haven’t.
Risk in the Utility Sector
- Changing regulation
- Environmental risk i.e. the risk of tightening environmental regulation
- Liquidity Risk i.e. inability of the firms to roll over the debt