Competitive Advantage Equals Great Expectations

Greetings it is time to think about capitalism again. And like always I bring glad tidings. This month we will look at one of the key factors in identifying stocks that can give you the investor great expectations. To reiterate the mantra as long term share investors we need to restrict our share investments to those companies that are high quality businesses, have favourable longer term prospects and can be bought at a rational (not over valued) price. At any given time this eliminates the majority of stocks in the market. Although the number of stocks that meet these criteria does tend to increase in down markets as some businesses that are high quality and have favourable prospects but were potentially overvalued become available for a while at a rational price. But not to worry it means that we only invest when the longer term probabilities of achieving returns (combination of dividend and capital growth) sufficient to justify the risks are comfortably in our favour. Being disciplined like this reduces the longer term risks with share investing big time. And as we have previously discussed it doesn’t really matter whether the bulls are charging and the bears are in hibernation or whether like at the moment the bears are out and about and causing some mischief. It’s a question of being able to identify those stocks that have the potential to increase profits and dividends and increase in value over time not picking whether the market is going to move and groove or swan dive. Over time you are going to experience both bull and bear markets. If we are only in these types of stocks, even though not every single company will live up to its potential, we can indeed feel that we have great expectations.

So let’s run the gimlet eye over this question of favourable prospects. Generally this means that a business has both a high level of profitability (Return on Equity or ROE in the jargon) and has realistic expectations of profit, dividend and value growth. Slow growth high quality businesses can also be considered if the share price is well below what is a reasonable value and has a high dividend yield that is likely to be sustainable with the key words being likely to be sustainable.

Historically most businesses that have delivered sustained (over a number of years) strong profit, dividend, value growth and consequently capital growth have had a strong competitive advantage. With any of your stocks you should always ask whether it is a business that has a competitive advantage. To be able to consistently have a high level of profitability (high Return on Equity or ROE) a business must have a competitive advantage i.e. it does something in some way which its competitors cannot easily replicate. If what a business is doing can easily be replicated then even if the industry is fast growing the main area of competition may become the price of the particular product or service. And prices will more likely than not over time fall towards the cost to provide that product or service as any excess returns are competed away. Nothing like a good old price war to destroy profit margins. Remember computers and profitless prosperity where price deflation is almost a constant. Which means all things being equal (which they rarely are) lower profits, dividends and value. Not what we want to experience and hardly favourable investment expectations what ho. And the competitive advantage must be sustainable. An initial screen is to look for companies that have a high ROE. If this has been sustained over a number of years then more likely than not the company will have some kind of competitive advantage. The big question of course is whether the high ROE is more likely than not going to continue into the future.

So what are some examples of businesses listed on the ASX that appear to have competitive advantage? There are some of the obvious ones like the big four banks, Telstra and some of Wesfarmers’ businesses like Bunnings and Coles. And Woolworths of course. Aldi seems to be making some headway in eroding the competitive advantage of Coles and Woolworths although it’s a very gradual process. Metcash (IGA) has been the big loser. Nothing is static in the world of investing and business (or life for that matter if one wants to wax philosophical). With companies on the stockmarket ugly ducklings become swans and roosters become feather dusters. Stocks require regular review. In some ways they are like little children they can bring us great joy but boy do they take some watching at times. Then there are some large names that do not have strong competitive advantage. Think BHP and RIO here. The profitability and profit and dividend growth potential of these companies is mainly a result of what is happening with commodity prices and exchange rates which are volatile and totally outside the control of management. If commodity prices fall like is currently happening there is only so much BHP and RIO can do to protect profits and dividends. BHP aims for a progressive dividend i.e. it tries to at least maintain its dividend each year and increase it when it considers that it can do so on a sustainable basis. The forecast dividend (grossed for franking credits) for BHP this year at a price of $22.93 is 11.5%. Fantastic I hear you say. And most unusual BHP have not traditionally been regarded as a yield stock. However with the severity of the slump in commodity prices (iron ore and oil are the main culprits with BHP) profits are forecast to fall about 66% this year. If that forecast is correct (and mind you forecasting for miners is very difficult at the best of times) then the current dividend represents 185% of forecast current year profits. Unless commodity prices recover even BHP can’t indefinitely pay out in dividends more than what it is making in profits. There is a time when cyclical businesses like the resource stocks do have favourable prospects and can be bought. Read the February 2015 blog “Oil, Oil Shares, Cyclical Investing and the Cobra Effect” at www.lifestylefstas.com.au for, for want of a better expression, the good oil. Anyway I digress so back to the subject which is competitive advantage.

Another example dear to my heart is Lifestyle Financial Services the publisher of this blog. While perhaps not as well known as the banks, Telstra, Wesfarmers, Woolies, BHP et al Lifestyle Financial does have competitive advantage. Apart from the expertise and experience (far out does this boy have tickets on himself or what haha) and the genuine focus on the client, costs of providing financial services to clients are lower than most of the major financial advice firms. After all there are no fat executive salaries to pay, no shareholders who want dividends and no big signs to stick on top of buildings in downtown Hobart. Clients share the benefits of the lower cost structure by having in many cases lower (and far more reasonable) fees. A classic example of sustainable competitive advantage which results in a win win situation for everyone.

Future blogs will discuss other stocks that do and do not have competitive advantage. Care is however required. Just because a business has a sustainable competitive advantage does not mean that it is potentially a good investment. It could have heaps of debt meaning that it may not be a high quality business. It’s no good having favourable longer term prospects if you go broke in the shorter term. I still remember Henry Walker Eltin (a mining contractor) going broke in the middle of a mining boom. Or it could be that every man and his dog recognizes the stock as having favourable prospects with the result that the shares are significantly overvalued. Stocks should be high quality businesses and have favourable prospects and be able to be bought at a rational price. You need all three.

Do the stocks in your portfolio have competitive advantage? Do you have great expectations? Have you had enough today of reading investment blogs? Ok that’s enough of capitalism for today.

If you would like further information send me an email or give me a call or go to www.lifestylefstas.com.au