Long-Term Wealth Creation Through Investing in Equities – Chapter 04

Long-term investment in equities is the best way to create long term wealth for most people.

In the previous chapter, we noted that effective long term equity investing requires a rational, consistent framework for identifying outstanding businesses. Such entities are more likely to compound at a higher rate over a long period and at a greatly reduced risk of suffering a permanent loss of capital.

In our view such an investing framework has three steps. These are:

1. Qualitative Analysis
2. Fundamental Analysis and
3. Valuation

In this chapter, we look at the first of these: Qualitative Analysis.

Qualitative Analysis

Our overall aim is to find companies, which over some reasonable long-term period, are likely to maximise free cash flow without significant risk and whose stock is available at a reasonable price.

The first and most important stage in the approach is Qualitative Analysis. Our aim here is to understand how the company makes money and how well it is likely to allocate capital in the future. As a result of this, we are trying to arrive at a high-conviction view of how the company and therefore, its stock price ,is likely to perform over the long-term.

In our view, Qualitative Analysis is the most important stage of the investment process and yet it is one that most investors spend the least time on. As Charlie Munger has noted “People calculate too much and think too little”.

Qualitative Analysis involves two stages:

The first stage is an analysis of the Industry Sector and the company’s competitive position within it.

One is interested in the size of the market, its potential growth rate, the barriers to entry, the degree of competition and the nature and stability of the market structure.

The second stage involves looking at the quality of the senior management particularly the CEO who leads the business and determines its business culture. Investors need to consider the CEO’s character, their stated priorities, and their performance. Investors should look for management that is hard-working, has integrity, a long-term orientation, and acts rationally especially with respect to capital allocation. Long term investors should look for situations where the management’s interests are aligned with those of the shareholders.

Industry Characteristics and Market Structure

The first stage is to look at the Industry in which the company operates.

We prefer sectors which are likely to grow strongly in the future. A company operating in such a sector has a better chance of making money (“a rising tide lifts all boats”) than one in a sector whose overall size is stagnant or declining.

For example, Coal is increasingly seen, in the West at least, as an environmentally hazardous fuel and demand for it is likely to fall as many countries seek to reduce carbon emissions. Therefore, it would be unwise in our view to invest in coal companies. In the next few years, customers and manufacturers increasingly going to migrate to electric vehicles. The longer-term demand for Oil and Petrol for transportation is likely to fall and it is perhaps likely that Oil and Gas Companies are unlikely to be promising for long-term equity investors. A growing sector is a good place to look for attractive investment opportunities.

The competitive structure of the industry is another important factor. Warren Buffet has said he would be keen to invest in the only Toll Bridge in town providing there was no risk of a regulator dictating pricing policy. People have to use the bridge to get in and out of town and so they must pay, at least in the short-term, whatever the bridge operator demands. The latter has pricing power and can raise prices without too much of a decline in demand. In addition, there is no regulator limiting possible price increases.

An unregulated monopoly is an ideal situation for investors, but it is not usually found in the real world. Unfettered pricing power is quite rare, and regulators and competition (often quite intense) are a more normal feature of economic life.

It is more useful to think in terms of degrees of monopoly. The higher the degree of monopoly in an industry, the greater the profitability of companies that operate within it. In some industries there will be a dominant player (monopoly) while others may have two players who have a meaningful market share (duopoly).

Other things being equal, the long-term investor should be more interested in the sector with a high degree of monopoly and the lower the degree of competition.

Some select companies are shown to illustrate the general Concept in the table on the right.

The seminal academic work on the competitive structure of industry was done by Michael Porter in his famous book “Competitive Advantage: Creating and Sustaining Superior Performance (1985)”. He developed his work in various articles and books including “Competitive Strategy (2004)”. Porter argued that the degree of competition in an industry is determined by five forces as shown in the diagram below:

We will briefly consider the key elements of Porter’s Model.

The Threat of New Entrants

A fundamental element in a market economy is how economic prices/ data work as signals. If existing players are making high profits in a particular sector, new entrants will be encouraged to enter the market. The arrival of new entrants trying to win market share will put pressure on existing players. The new entrants may have a strategy of signalling lower prices by loss leading. Aggressive new entrants will put pressure on profitability in the sector and reduce the rate of return likely to be achieved going forward.

Whether new entrants enter depends on the barriers to entry into the industry. If barriers are high, this will reduce the threat of new entrants. If, on the other hand, barriers to entry are low, the risk of new entrants is high. Barriers to entry are an important source of competitive advantage. The long-term investor should look for sectors where the barriers to entry are so high that even a new entrant with significant capital resources would hesitate to compete.

Consider whether a new company could hope to compete with Coca Cola by trying to re-create their brand and reputation and global network that has been built up over a century? Such an effort is likely to lead to a long period of losses before the new entrant would inevitably have to throw in the towel. Similarly, could a new firm come into credit card processing to successfully challenge Visa and Mastercard? They would be un use to do so.

The features which deter new entrants are often called Moats. Moats are the body of water that surrounded Castles. They are designed to deter or slow down attackers. In a similar vein, corporate moats are designed to prevent competitors from invading the company’s markets.

Economic moats protect the high returns on capital enjoyed by the world’s best companies. Pat Dorsey who has written extensively on Moats believes investors who can identify companies with moats and purchase their shares at reasonable prices will greatly improve their odds of success in investing. This is a sentiment with which we heartily agree.

Suppose you have a company that has a dominant position in an industry that has strong barriers to entry. The company is likely to have enjoyed high profitability in the past as shown by numbers for Return on Equity (ROE) and Return on Capital Employed (ROCE). Indeed, high ROE and ROCE numbers are often taken (perhaps in an unsatisfactory tautological way) as evidence of the existence of a moat. However, a historic moat is not a sufficient condition for investing. The Company must also have a reasonable chance of investing retained earnings for many years at a ROCE / ROE which is both high in absolute terms and, significantly higher than the company’s weighted average cost of capital (WACC). Therefore, Moats must be durable and have a reasonable chance of lasting for many years.

“When you are examining the sources of a firm’s economic moat, the key thing 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?”

Pat Dorsey: The Five Rules for Successful Stock Investing (p. 25). Wiley. Kindle Edition.

Most companies do not have durable moats. Capitalism is a dynamic system where technological change and competition are ever-present. Dominant local newspapers were once seen as businesses with great moats due to their monopoly of local news and advertising. However, these moats have been breached thanks to the growth of the internet and the sector is no longer investible. Long-term investors must be aware of changing competitive pressures and need to make conservative assumptions about future returns in their financial models.

Pat Dorsey lists some of the factors which help to create an Economic Moat. Some of these are outlined in the table below:

When looking at a particular sector or a company, evidence of one or more of the above factors plus high persistent ROE and ROCE may be indicative of a durable moat and thus indicate a promising area of further investigation.

We will consider briefly the rest of Porter’s five forces.

Threat of Substitutes

A substitute product uses different technology to try to solve the same economic need. A new player can compete with the incumbent if they can come with a viable substitute. If the existing product has a strong brand or reputation or some other intangible asset, it will be difficult for a new entrant to compete and the threat of a substitute product will be low.

Bargaining Power of Customers

Another key factor is the relative power of customers relative to the supplier. Farmers supplying milk to the large supermarkets have little relative power and are forced to take whatever low price the supermarkets give. They are price takers.

On the other hand, Apple can set a premium price for its phones and the customers have, to some degree, accept them. Apple is a price setter. The key factor is the ability of customers to put the firm under pressure indicated by the customer’s sensitivity to price changes. Firms can take measures to reduce buyer power, such as implementing a loyalty program. Buyers’ power is high if buyers have many alternatives. It is low if they have few choices. Investors should look for companies which have pricing power and can be a price setter to a significant degree.

Bargaining Power of Suppliers

The bargaining power of suppliers is also described as the market of inputs. Suppliers of raw materials, components, labour, and services (such as expertise) to the firm can be a source of power over the firm when there are few substitutes. If you are making biscuits and there is only one person who sells flour, you have no alternative but to buy it from them. Suppliers may refuse to work with a firm or charge excessively high prices for unique resources. Highly skilled elite sportsmen and women are suppliers of services to Sports clubs. They have significant bargaining power, and this explains the high level of economic rewards they are able to extract. Sports clubs are therefore likely to be poor investments as the suppliers (workers) have too much bargaining power.

Competitive Rivalry

The intensity of competitive rivalry is the main determinant of industry rivalry. In one industry there may be many players with products which are substitutes for each other. In this case, the rivalry among competitors will be cutthroat and focused on price and the company and industry profitability will be low. In another industry, there may be only a few players with highly differentiated products and the competition will be based on non-price factors (such as marketing). In this case, company and industry profitability will be high.

The degree of rivalry is not simply a function of the number of companies in the sector. It is possible to have a stable duopoly in a sector with high barriers to entry where the rivals have declared peace and do not engage in price competition. You can contrast this with an unstable duopoly where two rivals are constantly trying to use price competition to win additional market share. The former is a better scenario for investors as it has less intense rivalry and therefore the companies are likely to be more profitable.

Long-term investors should look for sectors where barriers to entry are high, the market power of suppliers and customers relative to the producers is low and where both the industry rivalry and the threat of substitutes is low.

However, nothing is forever, and change is the only constant. Industry characteristics will change over time. Changes in consumer tastes, government regulations and technology can disrupt stable industries and well-established business models.

For example, the trend towards healthy eating has given rise to substitutes and new entrants which might threaten the long-term profitability of companies such as McDonald’s and Coca Cola.

Tougher government regulations on carbon emissions, for example, will disrupt extractive industries such as coal, power generation and the car industry. However, they may give rise to new sectors and significantly boost newer growth companies which respond to the new regulations.

The growth of computing, mobile communications and the internet has disrupted established industry dynamics in almost all sectors especially local newspapers, Travel, hospitality, advertising, retailing and financial services. Legal, Educational and Health Services may be the next sectors that will be disrupted by technology.

Investors must be aware of such trends and make investment decisions accordingly.

We hope the process outlined above will help investors identify companies which have a good chance of performing well in the long run. Ideally, they will be companies with high growth and low competition.

In practice this combination may be difficult to find as high growth sectors are often highly competitive while mature lower growth sectors are often oligopolistic.

Ideally one wants a high growth sector which is a monopoly / duopoly.

However, failing that, a moderate growth sector which has a very low degree of competition is also likely to prove to be a fertile arena for finding attractive stocks.

Once we have selected interesting possible sectors, we need to extend our qualitative analysis to individual companies.

In this stage, the long-term investor is trying to understand as much as possible how the company makes its money.  A word of warning. This requires lots of hard work and lots of reading. It takes a long time and is often tedious. There is no short cut but the work gets easier with time and practice.

The search for information starts with the Investors section of the company website and documents such as the Company Presentation, Annual Report or the 10K form (for US firms).

Just by reading the Annual Report (better still three or four of them), an investor will have done more work than 80% of the participants in the market. If you also read the notes to the accounts, then you are better off than 99% of the market participants.

The Annual Report and other investor communications are the medium by which the management, reports to the shareholders (“the owners”). The management should, at a minimum, be telling you about the following:

Past Performance

• Opportunities and challenges in the future
• The major risks that the company faces.
• The financial position of the company and its track record.
• The performance of the industry and its competitive landscape.

Reading an Annual Report is an art. One must be adept at reading fast and be able to ignore large parts of the report which is bland general PR and often just there to fill up space and focus on the most important issues.

These report scan become formulaic, full of jargon and glossy without much substance. The investor should look beyond this to see if there is some detailed explanation and candour especially if there is bad news. if the annual report is dominated by glossy pictures and jargon, the investor is probably wise to be wary. It is probably an attempt to distract the investor from bad news hiding in the financial statements and footnotes.

In this process, one is trying to both understand the business and the character and priorities of the Management.

Warren Buffet once said something to the effect that he looked for managers who were hard-working, intelligent and have integrity. Of these, the latter is the most important and if the managers do not have integrity, he would prefer them to be lazy and stupid.

The website “Unknown Fund Manager” has the following comment on the importance of management.

“I used to think management didn’t matter much, as long as they weren’t corrupt, and the business model was strong. I have come to realise I was wrong. The people running a business and the culture they establish is crucial. It determines how a business treats its employees, customers, and suppliers; how decisions are made and how it operates; as well as how capital is allocated. Getting all these things right is vital for a business to be enduringly successful. Judging management/culture isn’t always easy. But once I’ve found a management team, I feel genuine enthusiasm for, I’m prepared to relax some of my other investment criteria, because I’ve seen how much value an exceptional management team can create.”

A very capable management can be defeated by a very difficult industry while an average management can do well in an industry and company which has good economics.

Warren Buffet has noted “When a manager with a reputation for brilliance tackles a business with a reputation for bad economics, the reputation of the business remains intact.’’

The long-term investor nevertheless has to consider the management and evaluate them.

How do you decide whether management have these good characteristics that Buffet highlights?

One must look at what they have promised in the past and how they have delivered. The long-term investor must not be seduced by what the management says. It is deeds not words that count.

An investor must look for companies which speak to you in a direct clear language and stick to relevant matters relating specifically and directly to the company. Be wary of management who make vague general philosophical comments about the state of the world especially if the text is accompanied by lots of glossy pictures.

Managers in many large companies today are treated a bit like football club managers. They are brought in from outside at high remuneration levels and put under severe pressure to perform quickly and sometimes unceremoniously fired and replaced if they fail. They are hired guns or mercenaries. Long-term investors must avoid companies which have such a short-term view.

The long-term investor must look for stability in management and this is often found in companies that develop their own deep managerial talent and promote from within.

The long-term investor must look for management that acts in the long-term interest of the company and its investors rather than focus on the short-term priorities of investment analysts and the stock market.

It helps to read an Annual Report from five years ago as well as the most recent one. Has the general management approach stayed consistent over this period or have they chopped and change the strategy?

Have they achieved the things that they promised five years ago or does the management tend to make grand promises but failed to deliver them and failed to give a credible explanation?

In practice – evaluating the management reduces to an evaluation of the Chief Executive Officer CEO – the person in charge.

William Thorndike wrote a book called “The Outsiders” which profiled in some of the most successful CEOs of the day. He summarised the key characteristics they displayed.

Thorndike wrote that each of his outstanding CEOs understood the following:

• Capital allocation is the CEO’s most important job
• Value per share is what counts, not overall size or growth
• Cash flow, not earnings, determines value
• Decentralized organizations release entrepreneurial energies
• Independent thinking is essential to long-term success
• Sometimes the best opportunity is holding your own stock; and
• Patience is a virtue with acquisitions, as is occasional boldness.

We will consider some of these points in detail below. Thorndike first point is “Capital allocation is the CEO’s most important job”.

What is Capital Allocation?

If you have a successful stable company, it is likely to be generating lots of free cash. The CEO and the Senior Management must decide how they allocate that (surplus)capital. They have five basic options.

1. Invest in existing operations
2. Acquire other businesses
3. Pay dividends
4. Pay down debt
5. Buyback stock

The Corporate Finance textbooks will tell us that the company should retain and re-invest money if they have opportunities which generate a Return on Investment (ROI) (conservatively calculated) much greater than the company’s weighted average cost of capital (WACC).

If there are no such opportunities available, the company should return the money back to investors via share buybacks or dividends. Dividend payments are often not ideal because of the income tax that must be paid on them by non-tax exempt investors.

Ideally when considering share buybacks, companies would act like a prudent and intelligent investor. They should buyback shares in large size when the stock price is at a significant discount to its conservatively calculated intrinsic value and decline to buy when the stock price is at a premium to its conservatively calculated intrinsic value.

The long-term investor should look at the company’s words and actions on capital allocation to evaluate if it is being done rationally.

Thorndike second point is that it is “value per share that counts, not overall size or growth.”

CEOs are often obsessed by size and an entrenched belief that bigger is better. Prestige is often associated with large size. Therefore, managements are incentivised to chase growth regardless of its effect on profitability and per share returns. Most academic studies show that acquiring companies usually overpay for acquisitions and destroy value. We are particularly wary of companies which have a history of large acquisitions in unrelated industries which are paid for by issuing equity. We would look a little more favourably at companies which do smaller takeovers in related industries which are paid using internally generated cash flow.

More generally it is easy to show, as a matter of arithmetic, that if the rate of return on the new growth is less the cost of capital then the growth will be profitless and will destroy value.

Thorndike’s third observation is that successful CEOs recognise that it is cash flow and not earnings, that determines value. Analysts and investors are often obsessed with Net Profit and Earnings per share (EPS). Most successful managers are more focused on operating cash flow and free cash flow. It is cash flow which determines the debt service capacity of a company, the capacity to invest in new projects, and the ability to buy back shares or pay dividends. Long term investors should be suspicious of companies which emphasise earnings growth or EPS growth only.

For example, companies whose share are valued highly can take over profit-making (not necessary highly profitable) and lower-rated companies and show strong eps growth. If the market continues to have faith in the acquiring company, it can show EPS growth for a long time even though the overall business portfolio is deteriorating as it takes over more and more marginal businesses.

Decentralized Organizations Release Entrepreneurial Energies

Investors should look for companies where the culture of the business ensures that employees at all levels are empowered to make operational decisions. Companies that do not do this are likely to be less responsive to customers, more bureaucratic and perform less well.

Investors should look for companies where the culture of the business ensures that employees at all levels are empowered to make operational decisions. Companies that do not do this are likely to be less responsive to customers, more bureaucratic and perform less well.

The Principal / Agent Problem and the Alignment of Interest

The relationship between Management and Shareholders is an illustration of the Principal / Agent problem. The shareholders are the owners who provide the Company’s risk capital. They are Principals and appoint the management who are their agents and run the company for them. However, there is often a fundamental information asymmetry to the disadvantage of the Shareholders. The shareholders are on the outside while the management is on the inside and in control. In this case, it would not be surprising if the management pursues their own interests perhaps by hiking their salaries and perks and awarding themselves very lucrative deals on options.

Therefore, we want to look for companies where there is a high degree of alignment of interest between the managers. To take one example consider Warren Buffet who is the Chairman and CEO of Berkshire Hathaway which has total assets of USD 820 bn and is considered one of the best investors and business managers in the world. Buffet’s salary has been capped at USD 100,000 for decades. He owns a substantial share of the company and he has never sold a share. He paid the same amount for his shares as other shareholders at the time (in 1967) and he has never acquired a single share through favourably priced options or other such instruments. There is complete alignment between the management and shareholders of Berkshire Hathaway. The Berkshire Hathaway shareholders know that they will profit in the proportion as their CEO. If they lose money, they know the CEO is also suffering proportionally. This is uncommon, in fact it is almost unique – there are too many cases where shareholders suffer mediocre returns while the failing management enjoy lavish rewards.

Buffet also tries to ensure a similar alignment of interest in the companies that are wholly owned by Berkshire. Management is rewarded for performance by cash (and these amounts can be much higher than Buffet’s salary if the performance justifies it) but no stock options are given.

Buffet also tries to ensure a similar alignment of interest in the companies that are wholly owned by Berkshire. Management is rewarded for performance by cash (and these amounts can be much higher than Buffet’s salary if the performance justifies it) but no stock options are given.

If the management cannot explain their business in plain and simple language and if the company not making any profits and does not look doing so soon, our inclination would be to move on to look at the next company.

For example, if the annual report contains complicated, obscure jargon which cannot be easily understood by an engaged, intelligent non-specialist, this is a warning sign. Either the management do not understand their business, they cannot communicate their understanding or they are trying to hie something. In any case, investors need to be careful.

Conclusions

The only way to win is to work, work, work, work, and hope to have a few insights. – Charlie Munger

The qualitative analysis is the first and most important stage of the investment process. It is at this stage where the long-term investor decides the companies on which he is going to spend his or her time doing fundamental analysis and valuation. If the wrong companies are chosen, a lot of time will subsequently be wasted.

In general, investors spend too much time on quantitative analysis and valuation – that is the stuff involving numbers and calculations. On the other hand, they spend too little time thinking about industries, sectors, companies, business models, degree of competition, management quality, alignment of interest and other factors which are the subject of this chapter.

Time is always short and there is never enough time to look at all the companies one would like to. Therefore, the investor always needs a filter to identify the companies and sectors which are most likely to lead to the most promising long-term investments.

The Qualitative Analysis described in this chapter should, if it works well, should act as an effective filter to identify promising companies.

The next stage is to do Quantitative Analysis and Valuation Work on the chosen companies. This is the subject of the next five to six essays.