Newsletter September 9, 2012

InvestorsFriend Newsletter September 9, 2012

To Invest Better, Watch the Market Less?

Most people seem to believe that do-it-yourself investors in stocks need to watch their stocks closely during the day.

In fact, watching stock prices move during the day is probably counter productive in most cases. It probably leads to panic selling more often than astute trading.

And what about watching analysts talk about stocks on television? Most of them are closer to day-traders than long term investors.

Fear and panic may keep ratings high but they are not useful emotions for long-term investors.

A better use of time would likely come from reading investment books rather than watching what amounts to minute by minute “noise” on television.

Also reading annual reports would be a better use of the time. These days companies don’t automatically send out annual reports sine they are available on line. Investors would be wise to obtain copies of annual reports of the companies they own and to read them carefully.

The average standard of living in North America has never been higher. And yet pessimism abounds. Too much television focus on bad news is part of the reason.

A Rational Approach to Investing

A rational approach to investing is to invest in (i.e. own) entities that can rationally be expected to earn attractive returns on their money and which are available at attractive prices.

Let’s review how to find investments like that.

Ideally, the companies that you invest in will earn good returns on their money. This is measured by return on equity or ROE. All else being equal, a company that can be expected to earn a higher ROE will be a better investment.

But what kind of businesses can be expected to earn above average ROEs?

In a highly competitive market high profits (high ROEs) attract competition and prices get driven down so that profits are no longer abnormally attractive.

In order for a company to sustain a particularly attractive ROE over the longer term, it must be at least partly protected from aggressive competition. It must also be largely free to set its own prices (not regulated by government as to prices).

There are a number of ways that this can happen:

Collusion is one way, industry participants can collude and agree to keep prices higher for the good of all producers. This occurred in the 1970’s with the Organization of Petroleum Exporting Countries (OPEC). But usually it is illegal. Also collusion often tends to fall apart as individual members of the group jockey to do better than others.

Patents and other proprietary knowledge can lead to very high returns on investment. Certainly this is the case for Apple. It was definitely the case for Microsoft as well over the years although less so in recent years.

The Network Effect can lead to very high returns. The Network Effect refers to cases where the more people that use a product the more useful it becomes to each user. As Microsoft Word became the dominant word processor it became easier to share documents across companies. At some point when the great majority of offices were using Microsoft Word it became almost impossible for a competitor to make inroads into that market. It’s no good to have a better word processor if few others can read or use that file format. And consider eBay. Once it became the go to site for sellers, because all the buyers were there and for buyers, because all the sellers were there, it became virtually impossible to compete against except perhaps in small niches. And consider credit cards.  Merchants and consumers are willing to carry two or three main brands (Visa, MasterCard and maybe American Express) but beyond that it became extremely difficult to try to get traction with another main brand.

Brand Power. Coke, Pepsi, Rolex, Nike and many other brands can make very high ROEs because of the power of their brand names. Often consumers know that they are simply paying more for the name and not even getting a better product in many cases. But for a variety of complex reasons we pay up.

Scale. Sometimes being the biggest player in an industry offers cost advantages that competitors can’t match. Possibly, this applies to Wal-mart. Overall however, it may be over-rated as a potential advantage.

Cost Advantages. With a true commodity product like most minerals, agricultural products and natural resources a sustainable high return (absent chronic shortages) will require cost advantages. The cost advantages may come from a variety of sources but in this situation it is only a low cost producer that will sustain a high return on equity.

Access to Scarce Resources – This could occur in the case of rare minerals. Often however, the high ROEs have a way of attracting competition and new resources are found which alleviate the scarcity and eliminate the high ROEs.

Sticky Customers. In some businesses, like airlines and most restaurants you essentially have to win your customer’s business anew with each purchase. But for other businesses including insurance, money management, cell phone service, and basic banking services customers are very sticky indeed. These industries often invest heavily to acquire new customers. But once they build up a large number of customers the returns are often very attractive.

Managerial excellence and execution – There are cases where superior management effort including motivation of employees and superior cost controls have led to sustained high profitability. A number of companies have grown large and made high ROEs by a steady process of making small acquisitions. Their competitors could have done it but simply did not and do not.

Companies do not get into the position of having any of the competitive advantages listed above without a certain amount of managerial excellence at least at the outset. In the ideal case the initial managerial excellence has led to certain competitive advantages that are now so strong that they can now be sustained even by average or mediocre managerial effort.

Warren Buffett refers to companies that possess characteristics that allow them to make high ROEs as being companies with “wonderful economics”. Examples he gave were owning the dominant newspapers in large cities in the days before the internet. Also owning television stations affiliated with one of the three main networks in the days when those networks were extremely dominant. Companies that Buffett invested in because of their wonderful economics include See’s Candies, Coke, and American Express. In most cases Buffett places heavy emphasis on management ability and attitude in addition to the wonderful economics.

In contrast, what kind of businesses can be expected to earn poor profits?

Any business that faces intense price competition will have a difficult time making a high ROE.

The most notorious cases are industries in which the product has a high fixed and a low marginal cost and where there is excess capacity in the industry.

Commercial passenger Airlines seem to be a poster child for an industry that reliably loses money. Due to the low marginal cost of carrying one extra passenger, combined with the availability of empty seats, airlines are often willing to sell seats at prices that fall far short of covering fixed costs. Passengers see travel as basically a commodity product. Despite all the marketing efforts customers usually have almost no loyalty to any particular airline. At the end of the day customers choose the lowest airfare that gets them to their destination.

Any business where customers tend to shop around on each purchase is unlikely to offer high returns on equity.

How do we find specific companies with high ROEs?

We are looking for companies that will continue to have high ROEs in the future. A good place to start is to look at companies that have a consistent  history of making high ROEs in the past and where we can also identify some competitive advantage (such as the type of things listed above) that is likely to continue.

Buying at Attractive Prices

Finding a company with a high expected return on equity is not sufficient. We have to be able to purchase it at a reasonable price.

This requires analysis to compare the ROE to the price being paid.

A company that is expected to continue earning a 15% ROE would be quite attractive if it could be purchased at book value. However if it is trading at three times book value then it may not or may not be attractive.

The reciprocal of the P/E ratio tells you the initial earnings on your investment. A P/E of 10 represents an initial earnings on market value of 10%, while an initial P/E of 20 represents an initial earnings on market value of just 5%.

But it is not the case that the company with a P/E of 10 is automatically a better investment than one with a P/E of 20. What really matters is what will the company do with the earnings and to the extent they are retained, what ROE they will they earn. A company that has a P/E of 20 and trades at four times book value has an ROE of  20% (since Return on year end equity = P/B divided by P/E).

If this company dividends out its entire earnings and, perhaps as a result, never grows then the return to the investor will be stuck at the reciprocal of the P/E of 20 that was paid by the investor or 5%.

If however, this company retains all the earnings and reinvests it and earns the same 20% ROE then the investors return will eventually approach the ROE of 20%.

Warren Buffett suggests that we make very few investments and that instead we bide our time until we find a company that is expected to continue making a high ROE and that is available at an attractive price. These may be rare but we only need a handful of them to be very successful as investors.

Our Stock Research subscription service attempts to identify and track these type of companies. Click the link to try out our service at a very reasonable price.

Avoid Long-Term Bonds at This Time

Our new article explains why long-term bonds, purchased or held today are almost certain to be a terrible investment over their lives.

Is the Overall Market a Good Investment at This time?

Based on the S&P 500, our updated analysissuggests that the overall U.S. stock market appears to be about fairly valued and priced to return an average of about 7% annually over the next decade. This 7% is certainly not guaranteed and in any given year there could certainly be negative returns. The 7% seems attractive compared to long-term bonds at about 2.4%.


Shawn Allen, President
InvestorsFriend Inc.

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