The Five Rules for Successful Stock Investing

by Pat Dorsey

ECONOMIC MOATS

Pat Dorsey's Investor Checklist for Successful Stock Investing:

• Successful investing depends on personal discipline, not on whether the crowd agrees or disagrees with you. That's why it's crucial to have a solid, well-grounded investment philosophy.


• Don't buy a stock unless you understand the business inside and out. Taking the time to investigate a company before you buy the shares will help you avoid the biggest mistakes.


• Focus on companies with wide economic moats that can help them fend off competitors. If you can identify why a company keeps competitors at bay and consistently generates above-average profits, you've identified the source of its moat.


• Don't buy a stock without a margin of safety. Sticking to a strict valuation discipline will help you avoid blowups and improve your investment performance.


• The costs of frequent trading can be a huge drag on performance over time. Treat your stock buys like major purchases, and hold on to them for the long term.


• Know when to sell. Don't sell just because the price has gone up or down, but give it some serious thought if one of the following things has happened: You made a mistake buying it in the first place, the fundamentals have deteriorated, the stock has risen well above its intrinsic value, you can find better opportunities, or it takes up too much space in your portfolio.

Pat Dorsey is the Director of Stock Analysis for Chicago-based Morningstar, Inc. In his recent book, The Five Rules for Successful Stock Investing, Doresy outlines a solid Graham/Buffett investing philosophy and methodology - a good read for all fundamental investors. Chapter three of Dorsey's book discusses the concept of sustainable competitive advantage as a key indicator ingredient of a successful investment business - what he calls '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 as surely as night follows day. And the bigger the profits, the stronger the competition. That's the basic nature of any (reasonably) free market - capital always seeks the areas of highest expected return. Therefore, most highly profitable firms tend to become less profitable over time as competitors chip away at their franchises.

We can learn much about the subject of economic moats by studying investment greats like Warren Buffett or academics that focus on competitive strategy like Harvard professor Michael Porter. To analyze a company's economic moat, Dorsey recommends following these 4 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.


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?


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 of competition for just a few years, and some firms may be able to do it for decades.


4. Analyze the industry's competitive structure. 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?

Evaluating Profitability

We are looking for companies that can earn profits in excess of their cost of capital - companies that can generate substantial cash relative to the amount of investments they make. These high profit businesses are identified by asking the following questions:

Does the firm generate free cash flow? First, look at free cash flow - which is simply cash flow from operations minus capital expenditure. Firms that generate free cash flow essentially have money left over after reinvesting whatever they need to keep their businesses humming along. In a sense, free cash flow is money that could be extracted from the firm every year without damaging the core business.

Next, divide the free cash flow by sales (or revenues), which tells what proportion of each dollar in revenue the firm is able to convert into excess profits. If a firm's free cash flow as a percentage of sales is around 5% or better, you've found a cash machine - as of mid-2003, only one-half of the S&P 500 passed this test. Strong free cash flow is an excellent sign that a firm has an economic moat.

What are the firm's net margins? Just as free cash flow measures excess profitability from one perspective, net margins look at profitability from another angle. Net margin is simply net income as a percentage of sales, and it tells you how much profit the firm generates per dollar of sales. In general, firms that can post net margins > 15% are doing something right.

What are Returns on Equity? Return on Equity (ROE) is net income as a percentage of shareholders' equity, and it measures profits per dollar of the capital shareholders have invested in a company. Although ROE does have some flaws, it still works well as one tool for assessing overall profitability. As a rule of thumb, firms that are able to consistently post ROEs above 15% are generating solid returns on shareholders' money, which means they're likely to have economic moats.

What are Returns on Assets? Return on assets (ROA) is net income as a percentage of a firm's assets, and it measures how efficient a firm is at translating its assets into profits. Use 6% to 7% as a rough benchmark - if a firm is able to consistently post ROAs above this benchmark, it may have some competitive advantage.

What you are looking for in all 4 of these metrics is consistency over more than just a single year. A firm that has consistently cranked out solid ROEs, good free cash flow, and decent margins over a number of years is much more likely to truly have an economic moat than a firm with more erratic results. Consistency is important when evaluating companies, because it's the ability to keep competitors at bay for an extended period of time - not just for a year or two - that really makes a firm valuable. Five years is the absolute minimum time period for evaluation, and 10 years is much better.

Building an Economic Moat

Next, Dorsey recommends that we try to figure out why a firm has done such a great jog of holding on to its profits and keeping competition frustrated. Although being in an attractive industry can certainly help, the strategy pursued at the company level is even more important. The mere fact that there are excellent companies in fundamentally unattractive industries (e.g. Southwest Airlines) tells us intuitively that this must be the case. Academic research suggests that a firm's strategy is roughly twice as important as a firm's industry for building moats.

When you're examining the sources of a firm's economic moat, the key is to never stop asking, 'Why?' Why aren't competitors stealing the firm's customers? Why can't a competitor charge a lower price for a similar product or service? Why do customers accept annual price increases?

When possible, look at the situation from the customer's perspective. What value does the product or service bring to the customer? How does it help them run their own business better? Why do they use one firm's product or service instead of a competitor's? If you can answer these questions, odds are good that you'll have found the source of the company's economic moat. In general, there are five ways that an individual firm can build and sustain 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 and offering a similar product or service at a lower price.


4. Locking in customers by creating high switching costs.


5. Locking out competitors by creating high barriers to entry or high barriers to success.

How Long will a Moat Last?

Think about an economic moat in two dimensions. There's depth -- how much money the firm can make -- and there's width -- how long the firm can sustain above-average profits. Technology firms often have very deep but very narrow moats, so they're incredibly profitable for a relatively short period of time until a competitor builds a better product. A niche firm such as WD-40 is just the opposite. It's never going to make an enormous amount of money in any one year by selling cans of household lubricant, but it has such a solid franchise that its excess returns are likely to persist for quite a long time.

Estimating how long a moat will last is tough stuff, but you need to at least give it some thought, even if you can't come up with a precise answer. Just being able to separate firms into three categories -- a few years, several years, and many years -- is very useful.

In general, any competitive advantage based on technological superiority -- real product differentiation -- is likely to be fairly short. Successful software firms, for example, can generate huge excess returns because they have high profit margins and they don't need to spend much money on fixed costs such as machinery. However, the duration of those returns is typically very short because of the rapid pace of technological change. In other words, today's leader can quickly become tomorrow's loser because the barriers to entry are so low and the potential rewards so high.

Cost leadership, brands (perceived product differentiation), customer lock-ins, and competitor lockouts can each confer competitive advantage periods of verying lengths -- there's no good rule of thumb, unfortunately. To give some guidance in what separates a wide moat from a narrow moat and what kinds of companies have no moat al all, Dorsey lists the following well-known companies and briefly discusses their competitive situation...

• Dell... Classic low-cost producer: lean operating structure and direct Internet-based sales allow the company to run circles around its rivals.


• eBay... Network effect: The more buyers and sellers the network has, the more attractive it becomes to prospective users and the tougher it becomes for competitors to contend with.


• PepsiCo... By far the market share leader in salty snacks and sports drinks, the diversified food company boasts a stable full of strong brands, innovative new products, and an impressive distribution network.


• Comcast... Controls roughly one-third of cable households in the U.S. This gives it unparalleled leverage with content providers and equipment suppliers.


• Intel... Chipmaker's dominant position gives it significant economies of scale. Brand name and patents are also significant intangible assets.


• H&R Block... Dominates the U.S. tax preparation market. One in every seven tax returns filed is prepared by Block.


• Wal-Mart... Largest retail company in the world is also the preeminent low-cost provider. The firm flexes its muscles with suppliers in negotiating prices and passes the savings down to consumers.


• Federal Express... Sure, it practically invented overnight delivery, but behind the scenes, FedEx is a cargo airline, and airline margins are thin.


• Nokia... Although the Nokia brand is strong, cell phones are becoming commodities.


• ExxonMobile... Enjoys enormous economies of scale, but still operates in a commodity industry.


• General Motors... Operates in deeply cyclical industry. Legacy costs and reputation for mediocre quality puts it at a competitive disadvantage relative to most peers.


• Delta... Not the low-cost provider and doesn't offer a differentiated product. In a commodity industry where competition revolves largely around price, its business model is unsustainable.

THE TEN MINUTE TEST

With literally thousands of companies available to invest in, one of the toughest challenges for any investor, say's Pat Dorsey, is figuring out which ones are worth detailed examination and shich ones aren't. Assuming that you know the various tools of in-depth fundamental analysis, you further need some tips on narrowing down the field of stocks to apply these tools. Apply the following tests to any stock that you think might be a worthwhile investment, and you should be able to decide in 10 minutes whether it warrants more time and in-depth tools.

In fact, asking the right questions will allow you to eliminate at lease half, if not more of the stocks you run across from consideration. Throwing out less-promising stocks early in the process will leave you more time to investigate the value of the ones that really might be great investments.

Two caveats before we start: First, these rules of thumb are starting points, no more and no less. There are exceptions to every guideline listed. These shortcuts aren't designed to cover every possible situation, but if you apply them, they will eliminate poor investments more often than not. Second, although the following list of questions might seem daunting at first, you can answer all of them if you gather the proper data.

Does the Firm Pass a Minimum Quality Hurdle?

Avoiding the junk that litters the investment landscape is the first step in Dorsey's 10-minute test. Companies with miniscule market capitalizations are first ruled out. He also avoids recent IPOs, believing that companies sell shares to the public only when they think they're getting a high price. Moreover, most IPOs are young, unseasoned firms with short track records. The big exception to this rule is firms that are spun off from larger parent companies. Spinoffs are often solid companies with long operating histories that the larger firm no longer wants to manage, and the stocks can often be attractively valued as well.

Has the Company Ever Made an Operating Profit?

This test sounds simple, but it'll keep you out of a lot of trouble. Very often, companies that are still in the money-losing stage sound the most exciting -- they're investigating a novel treatment for some rare disease, or they're about to offer some exciting new product or service, the likes of which the world has never seen.

Unfortunately, stocks like this will also blow up your portfolio more often than not. They usually have only a single product or service in the pipeline, and the eventual viability of the product or service will make or break the company. (Going by the statistics of how many start-ups fail, break is a more likely occurrence than make.) Unless you're looking for an alternative to lottery tickets, take a pass on any firm that hasn't yet proven it can earn a buck.

Does the Company Generate Consistent Cash Flow from Operations?

Fast-growing firms can sometimes report profits before they generate cash -- but every company has to generate cash eventually. Companies with negative cash flow from operations will eventually have to seek additional financing by selling bonds or issuing more shares. The former will likely increase the riskiness of the firm, whereas the latter will dilute your ownership stake as a shareholder.

Are Returns on Equity Consistently above 10%, with Reasonable Leverage?

Use 10% as a minimum hurdle. If a nonfinancial firm can't post ROEs over 10% for 4 years out of every 5, for example, the odds are good that it's not worth your time. For financial firms, raise your ROE bar to 12%. Don't forget to check leverage to make sure that it's in line with industry norms. A 15% ROE generated with minimal leverage is a much higher quality result than one generated using lots of bank borrowings.

One exception is that cyclical firms -- companies whose results vary strongly with the general economy -- may have wildly varying results from year to year. However, the best will make money and post decent ROEs even when times are tough.

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 shellacked by competitors. The former is not necessarily bad as long as the long-term industry outlook is good and the shares are cheap, but the latter is potentially a big problem.

How Clean is the Balance Sheet?

Firms with a lot of debt require extra care because their capital structures are often very complicated. If a nonbank firm has a financial leverage ratio above 4% (or a debt-to-equity ratio over 1.0) ask yourself the following questions:

• Is the firm in a stable business? Firms in industries such as consumer products and food can withstand more leverage than economically sensitive firms with volatile earnings.


• Has debt been going down or up as a percentage of total assets? One thing you don't want to see in a highly leveraged firm is even more debt.


• Do you understand the debt? If a quick glance at the regulatory filings reveals questionable debt and quasi-debt instruments that you can't wrap your head around, move on. There are many fine companies out there with simpler capital structures.

Does the Firm Generate Free Cash Flow?

As we know, free cash flow is the holy grail -- cash generated after capital expenditures that truly increases the value of the firm. Generally, you should prefer firms that create free cash to ones that don't and firms that create more free cash to ones that create less. Divide free cash flow by sales and seek out companies above a 5% benchmark.

The one exception -- and a big one -- is that it's fine for a firm to be generating negative free cash flow if it's investing that cash wisely in projects that are likely to pay off well in the future. For example, neither Starbucks nor Home Depot generated meaningful free cash flow until 2001 -- yet there's no question that they had been creating economic value (and shareholder wealth) for many years before 2001. That's because they were plowing every cent they earned right back into their business because their management teams believed that they still had many high-return investment opportunities for the cash they were generating.

So don't automatically write off firms with negative cash flow if they have solid ROEs and pass the other tests discussed. Just be sure you believe that the firm is really reinvesting the cash wisely.

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. Not only are charge-happy firms more difficult to analyze because of their complicated financials, but numerous charges hint at a management team that may be trying to burnish poor results.

Has the Number of Shares Outstanding Increased Markedly over the Past Several Year?

If so, the firm is either issuing new shares to buy other companies or granting numerous options to employees and executives. The former is a red flag because most acquisitions fail, and the latter is not something you want to see because it means that your ownership stake in the firm is slowly shrinking as employees exercise their options. If shares outstanding are consistently increasing by more than around 2% per year -- assuming no big acquisitions -- think long and hard before investing in the firm.

However, if the number of shares is actually shrinking, the company potentially gets a big gold star. Firms that buy back many shares are returning excess cash to shareholders, which is generally a responsible thing to do. Just be careful that the company isn't going hog-wild with share repurchases even as their shares keep zooming ever upward because stock repurchases are a good use of capital only when the company's shares are trading for a reasonable valuation. You don't want to see a company buying its own overvalued stock any more than you want to invest in overvalued shares yourself.

Credits: This article is extracted from Pat Dorsey's book, The Five Rules for Successful Stock Investing, Wiley 2004,