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Stock Lab
The best stock to invest in
Toni Case - February 6, 2008
These companies are rare, but when you find them – hold on for the ride – as this could be the stock of a lifetime.
We are talking about companies with wide economic moats, generally regarded as the best companies to invest in. But before we sift through the Australian investing landscape in search of wide-moat stocks, let's take a moment to understand the concept a little better.
Just like a castle in medieval times that was protected from the onslaught of invaders by its surrounding moat, superstar companies also sport a moat of sorts, protecting their wares and market position from competitors; these companies hold particular advantages that keep predators at bay.
So what sort of advantages are characteristic of an economic moat? Well, just as the image of a moat implies, significant barriers to entry are the hallmarks of an economic moat – and this may include a hefty market share generating significant economies of scale (low costs compared to competitors), high switching costs (it’s costly, inconvenient or just darn difficult for customers to ditch this company in favour of its competitor); legal protection via patents, copyright and licenses, a reputable and strong brand name inspiring customer loyalty; and an established network, such as being an important intermediary between buyers and sellers.
An economic moat means that a company has more power to raise prices to boost earnings without losing its share of the market to a cheaper rival.
But beware: the presence of an economic moat doesn’t make a superstar company. Most importantly, does this company throw off above-average returns on capital? If a company doesn’t use its competitive advantage to generate attractive returns to shareholders, then its economic moat is useless. Roll out the drawbridge.
Airlines are a good example of companies with significant barriers to entry – competitors can hardly establish a fleet of planes overnight and land a spot on the runway – but struggle to remain profitable. Constant price pressure (when booking flights, most people just head for the cheapest) and volatile fuel costs make the airline industry a bugbear of an investment. Biotechnology companies are another good example. While a patent for a new-beaut drug might protect a biotech company for a number of years, once that patent lapses, a host of cut-price competitors flood into the market - severing shareholder returns.
The difficulty for companies basking in the fruits of an economic moat is that before long, competitors will be sniffing – seeking every opportunity to get a piece of the action. For this reason, economic moats can be hard to sustain over the long haul; a company with a dominant market share becomes fat and lazy and its market share contracts, competitors put pressure on Governments for changes to regulation, ora brand becomes tarnished and customer loyalty suffers.
Therefore it’s worthwhile investigating the historical returns on capital achieved by a company. If the stock has a track record of generating material returns above the cost of capital for a sustained period of time, then there’s a fair chance that this trend will continue.
Return on capital employed (ROCE) measures how efficiently a company utilises its capital to generate revenue for shareholders. Is it taking out hefty loans to buy equipment that sits in the corner and rusts, or is it using its capital (debt and equity funding) wisely? The best companies are those that use capital sparingly to boost revenue dramatically. For those who like to see ratios in all their glory, here is the formula:
ROCE =
Operating Revenue – Operating Expenses (Pre-Tax operating profit)
Total Assets – Current Liabilities (Capital Employed)
If a company sporting an economic moat exhibits rising returns on capital employed, then this company is worthy of closer scrutiny. It could hold the secret to a superstar stock.
Now legendary investor Warren Buffett, who coined the phrase economic moats, likes to make the distinction between wide and deep moats. It’s widely agreed that wide moats are better than deep moats, or in other words, it’s preferable for a company to hold a range of competitive advantages rather than one advantage in particular. If a company has competitive advantages across a number of its product lines, it’s more likely to withstand competitive threats.
Should it hit a roadblock in one area of its business, other areas can easily pick up the slack – hence, explaining the reason why a popular home loan company will sensibly branch into credit cards, commercial borrowing, financial planning services and so on. The wider the moat, the more likely excess returns on capital can be sustained over the long term.
But lastly, it’s important to acknowledge the effect that structural changes can have on a company’s economic moat. Take the invention of the Internet as an example. The pricing power once enjoyed by many Australian companies – across myriad industries - is quickly eroding due to the onslaught of rival companies setting up on the Internet.
In our Sunday newsletter this week, we’ll continue our investigation into economic moats, by listing a range of stocks in Australia that may fall under this elusive category.
More articles from this edition of CompareShares:
Trader profile: Two market crashes later- Robert Kreft, a story of a full-time trader
Fundamentals: PEG ratio gaining in popularity against the P/E, but beware of its flaws
Stock Lab: The best stock to invest in
Resident Trader: Trading price and volume breakouts on microcap stocks
Stocks: Stocks to rebut US recession- engineering sector
Companies: Moore to succeed Moss at Macquarie Group
Companies: BHP launches improved bid for Rio Tinto
Rates: Major banks review rates after RBA hike
Stocks: US stocks tumble 3 per cent
Whatever your views, you can discuss this article - or any of Toni's articles - on our message board Your 2 Cents.
Toni Case is the editor of CompareShares.com.au and is Australia’s first journalist to specialise on Contracts for Difference (CFDs). She was a staff writer for Shares, Personal Investor and Asset Magazines, and today is a regular columnist with the Australian Financial Review. She is a qualified financial adviser, and has an Economics (Honours) degree from Sydney University.
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