A few years ago, a good friend of mine was "between opportunities"; in other words, he was unemployed. He called me and told me that he was tired of working for other people, helping them grow their businesses and then being let go as they found someone who would accept a lower salary to carry out what he implemented. "I've had it," he said and then informed me that he wanted to go into business for himself. It wouldn't be a problem raising the funds to make the purchase; he was just having a difficult time deciding what type of business to buy.
I quickly responded that he should buy a business that he knows something about. I shared with him my personal experience of 25 years ago. My father, who was an excellent warehouse and logistical manager, purchased a ladies sportswear manufacturer. Not only did he buy into a business in a highly competitive industry, which he knew nothing about, but he also had no experience in the garment business. This was an accident waiting to happen, and three years later he shut the doors on his garment business.
"Could I treat you to lunch?" my friend inquired. Although I'm not one to pass up a free lunch, I learned early in life that "free lunches" are hardly free at all; but as long as someone wanted my ideas and not money, I readily agreed. We met on a cool autumn day at a diner near my office. My friend went to a business broker and put down a $5,000 deposit in order to get a listing of businesses for sale. As he started to rattle off the "numbers" of some of the businesses he had highlighted (earnings, expenses, net profit, sale price), I asked him to slow down, put down the listings and lets talk about business in general.
Before jumping into the numbers side of the business, I asked him what he thought was the most important aspect to look for when purchasing a business. His reply was, "How much money it's making"-in other words, the earnings. My friend's response was not so different from the way most analysts on Wall Street would answer the question. Although earnings are a very important factor when looking into a business, there is something even more important to consider before turning the first page of the financial report.
Many companies have great earnings per share. I am sure that the top five buggy whip manufacturers in 1900 all had fantastic earnings. In fact, I would bet that the top three had consistent earnings going back decades. If you had invested in one of those companies based "just on the numbers," you would have lost most of your investment as you saw the first automobile chug down Main Street.
Other analysts focus on profit margins and cash flows. They want to see how much a company is making on every widget they sell or service they provide. They get very excited when they see large profit margins and huge cash flow falling to a company's bottom line. Once again, those numbers alone can paint a very one-sided picture. Software companies in the early 1980s may have had large profit margins and healthy cash flows but were blindsided by the dominance of Microsoft and eventually were gobbled up or went bust.
At this point, you are probably scratching your head wondering where I am leading you. If earnings, profit margins and cash flows are important but not number one in my book, what is the most important aspect when looking to purchase a business?
Days of yore
We live in the greatest capitalistic society the world has ever known. The U.S. share of total world output is 21% and has remained relatively constant for over 30 years! The total U.S. output in 2002 (the latest year for which world data is available) was $10.3 trillion, more than the two next-largest economies, China ($5.9 trillion) and Japan ($3.4 trillion), combined. Yet the U.S. population makes up less than 5% of all the people on this planet. Another way of looking at it: a small portion of the world's population living in the United States produces about one-fifth of the total world's output-a staggering statistic.
In a capitalistic society such as ours, the competition is fierce and the rewards are great. Companies that are able to have a competitive advantage and can dominate an industry reap huge rewards, with competitors continually nipping at their heels. Warren Buffett, the second-richest man in the world, likes to call this competitive advantage an "economic moat." In days of old, a castle was protected by the moat that circled it. The wider the moat, the more easily a castle could be defended, as a wide moat made it very difficult for enemies to approach. A narrow moat did not offer much protection and allowed enemies easy access to the castle. To Buffett, the castle is the business and the moat is the competitive advantage the company has. He wants his managers to continually increase the size of the moats around their castles.
When looking to purchase a business, Buffett pays careful attention to a business he understands not just in terms of what the business does but also of "what the economics of the industry will be 10 years down the road, and who will be making the money at that point." He is "also looking for enduring competitive advantages." This, in a nutshell, is what makes a company great: the width of the moat around the company's core business. Companies with wide moats are able to weather wars, recessions, depressions and change. They are the ones that survive, thrive and continue to grow stronger over time.
In almost every industry there are companies that have wide moats, or large competitive advantages. The types of competitive advantages companies have differ from industry to industry. Large competitive advantages can usually be found in health care, consumer products and data processing industries. When looking for consumer products with wide moats, the examples Coca-Cola, Wrigley and Hershey jump right to the front. These are companies with long and successful histories, huge profit margins, consistent growth and dominance in their industries.
It is very hard for competitors to take market share away from such companies. If you and I, for example, formed a partnership and decided to manufacture chewing gum, we would have a pretty tough time going head-to-head with Wrigley. Wrigley is a 114-year-old company with a share of the chewing gum market that is greater than 50% in the United States and is close to 80% in some parts of Europe. Wrigley introduced a new brand of chewing gum, Orbit , less than four years ago. Due to the company's tremendous resources, brand name, efficiencies in productions, marketing-in other words, their competitive advantage-Orbit is the number two brand in chewing gum in the United States. Not bad for an upstart brand. What chance would that leave our partnership in challenging Wrigley's market share?
Buy 'em while you can
Now that I have shared with you the benefits of companies with large competitive advantages, why doesn't everyone just buy those companies and hold them forever? The main problem is that there are not a whole lot of these types of companies around. Morningstar StockInvestor has its own way of figuring out economic moats, and it admits right up front that it is more art than science. Out of the universe of 8,000 publicly traded firms in its database, it identified only a handful that can be described as having wide moats. When you find such companies, you are usually not the first to discover them. The price and P/E of such companies more often than not reflect the company's unique position in the world, and they carry a lofty price.In my database that I use for Hidden Values Alert, I have identified about 75 companies that have enduring competitive advantages. I keep up-to-date on their industries and corporate developments and then wait for their prices to fall to an area that includes a good margin of safety. I have learned that the biggest influence on your return is the price you pay. You can buy a great company at a bad price and have terrible returns over the long haul. Wal-Mart, the most dominant retailer in the world, is selling at a five-year low. Buying Wal-Mart in 1999/2000 at a price that was very high produced a negative return for shareholders. The key is buying great companies that have enduring competitive advantages, when Wall Street offers them at discounted prices.
When adding companies to the Prime-Time portfolio, I first identify companies that have large and enduring competitive advantages. Over time, these companies will be able to weather economic storms better than their competitors while at the same time increasing shareholders' value. Daktronics Inc. (DAKT), a company we added to the Prime-Time portfolio in February 2005 (2/22/05-$21.50/share), is a world leader in scoreboards, electronic displays and large-screen video systems. It is among a handful of competitors and dominates the industry. FactSet Research Systems (FDS), added to our portfolio in April 2005 (4/8/05-$31.50/share), is a data supplier to the financial industry. FDS's competitive advantage is that it combines more than 200 databases from industry-leading suppliers and a client's own proprietary data into a single powerful information system. Its service is a must-have if you work in the financial industry.
The enduring competitive advantage a company has is one of the most important aspects to investment success. Fortunately for us, Wall Street doesn't spend too much time looking at the competitive landscape or discussing the economic outlook for a company in a certain industry. Instead, it seems to focus on quarterly numbers, which to me represent nothing more than noise. Every business will have speed bumps and fall off into a ditch every now and then. Knowing that the companies you purchase have the edge, over time, will make all the difference in the world to your investment returns. This month I highlight Thor Industries, Inc. (THO) that holds a 28% market share of the RV market and 35% of the small and midsize bus market (buy at or below $31/share). I also feature Mile Marker Intl. (MMRK) that has a competitive advantage due to its patented hydraulic winch (buy at or below $4.40/share). As for my friend who was looking for a business, he is still looking for a company with an enduring competitive edge.
Charles Mizrahi is editor and publisher of Hidden Values Alert newsletter, which focuses on finding stocks trading significantly lower than their underlying business value. He has over 23 years experience in the financial world as a money manager and investor. Email: [email protected], Webpage: www.HiddenValuesAlert.com