How to pick the perfect share – the seven secrets to success

As seen in this month’s Master Investor Magazine

One of the inherent contradictions within capitalism is its tendency to gravitate towards monopolies. From a capitalist’s perspective, a monopoly is the favoured situation, as it removes the competition and enables supernormal profits to be extracted indefinitely. However, in practice, monopolies tend to be bad for the consumer, so most governments take action to break them up wherever possible. At the other end of the spectrum is what economists refer to as “perfect competition”, a situation where myriad sellers operate in a market with no product differentiation or barriers to entry or exit. While such a situation may be advantageous for the consumer – ensuring that prices remain as low as possible – it is clearly not attractive from an investment perspective.

The real investment success stories tend to sit somewhere in between these two extremes: close enough to perfect competition in order to remain off the radar of the authorities, but close enough to a monopoly in order to attain a very high return on capital. These companies tend to have achieved a high level of differentiation in their products or services, either through technology ownership or branding. This enables them to compete highly effectively, but not on the basis of price alone. In the words of Warren Buffett, these companies have built an “economic moat” around their businesses, which is very hard for competitors to scale.

Competitive advantage
However, it is often posited by economists that no competitive advantage is maintainable in the long term. As new technologies arise, old business models are disrupted and previous market leaders often find themselves on the wrong end of Schumpeter’s “creative destruction”. Investors must take a view whether or not they believe a firm’s competitive position is sound or whether it is about to come under threat. In terms of technological advantages, it is often hard to form a view unless one is highly knowledgeable with regard to the specific technology or industry in question. However, competitive advantages formed by branding power are often much easier to assess – for example, it is likely that the Coca-Cola Company will go on making a very respectable profit for decades, if not centuries to come, unless public tastes alter in some drastic, unforeseeable way.

ROCE & profitability
We have addressed the qualitative characteristics of competitive advantage, but what are the quantitative characteristics? Companies with a strong competitive advantage usually exhibit two key features: a high return on capital relative to their cost of capital; and high operating margins (profitability). Return on capital employed (ROCE) is a measure of a company’s bang for every buck it invests in itself. Companies that are capital intensive tend to have a low ROCE, whereas companies that use an asset-light business model (Domino’s Pizza being a very good recent example) tend to exhibit a high ROCE. Meanwhile, operating margins are a measure of profitability and pricing power. Companies that have high operating margins are more likely to be able to increase prices without suffering much by the way of reduced sales – in economic terms we’d say that demand for their products/services is relatively price inelastic.

Cash generation
Profit is a matter of opinion, cash is a matter of fact, as the saying goes. Companies that claim to be highly profitable but do not generate cash will not be around for very long. Cash generation is the ultimate goal all businesses: it enables them to pay dividends to their shareholders, reinvest in the business, and pay wages to their employees and taxes to the government. Cashflow is also much less easily manipulated by an unscrupulous management team, so investors should get used to looking for a history of strong and consistent cash generation. While there are many measures of cashflow, a preferred one among analysts is Free Cash Flow (FCF), which can be calculated relatively easily by taking Operating Cash Flow and subtracting capital expenditures. This provides an overview of the cash available to equity holders after all the necessary investments have been made within the business.

Balance sheet
Needless to say, maintaining a strong balance sheet is of the utmost importance for any successful company. Debt is often the destroyer of companies. However, this is not to say that debt in itself is bad. Investors need to learn to understand the requirements of the particular business sector in which a company operates. For example, a company operating in a highly cyclical sector such as the house building sector should have relatively low levels of borrowing; whereas a company operating in a defensive sector such as utilities can probably afford to take on more debt because it has relatively dependable and stable income streams. Looking at the absolute debt burden in isolation probably doesn’t say much about a company; investors should look for the interest cover, preferably on a cash flow basis, in order to ascertain how close a company is to getting into financial difficulties. The higher the interest cover, the more financially sound the company.

Liquidity
If you had no way of exiting your investment, would you sleep soundly? Warren Buffett has often quipped that he only likes to own companies that he’d still feel comfortable with if the market shut down for ten years. That said, personal circumstances may necessitate a sale of an investment, in which case liquidity would clearly be an issue. While most large stocks are easily traded, many smaller ones are not. However, this is by no means a hard and fast rule; there are plenty of small companies that enjoy a very liquid market for their shares.

Macro backdrop
It always helps to have a tailwind in your sails! Consider the recent experience of the supermarket sector in the UK. Consumers had to endure year upon year of cuts to real incomes, which put pressure on budgets and forced many to ‘trade-down’ to discounters. At the same time, inflation was relatively low throughout, which made it difficult for supermarkets to raise prices. Growing competition has now led to a price war. These are not conditions conducive to a happy investment outcome.

Meanwhile, the pharmaceuticals sector offers a different outlook. The developed world is faced with an ageing population, which guarantees rising demand for decades to come. In addition to this, most pharmaceuticals firms have overcome the so-called ‘patent cliff’, whereby many of their most profitable patented drugs were opened up to ‘generic’ competition. They are now rebuilding their pipelines, and new medical advances are promising to yield a string of new innovative treatments in years to come. That is what I would call a tailwind.

Management
This is often a very difficult factor to assess, especially for a private investor who lacks direct access to management. A good starting point is to do a background check on key members of senior management to find out whether or not they have achieved success in previous roles. Are they properly incentivised? This usually means having a significant equity stake in the business relative to their own net worth, or indeed taking a significant share of their salary in stock. The management factor is usually easier to assess in small companies, where management often constitute the largest group of shareholders. However, In larger companies management shareholdings are usually insignificant in relative terms, so an investor needs to rely on other information. Better still, pick a business that can practically run itself. In the worlds of Warren Buffett, “a really good business doesn’t need good management – and a poor business can’t do well no matter how good management is.”