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Five Keys to Long-Term Profits

March 30, 2010 | About:
It's no secret that share price appreciation goes hand-in-hand with earnings growth.

If only it were that simple.

Screening for companies with the strongest outlooks will only get you so far.

You might know that Chinese search engine Baidu (BIDU) is expected to deliver +40% compounded annual earnings growth during the next five years. But so do about 10 million other people that are watching the stock. That optimism is already priced into the shares, which trade for about 50 times forward earnings at this point.

That doesn't necessarily mean Baidu's meteoric ascent is over, but any future gains are hardly a slam dunk. The surest path is for the market to rethink (and revise upward) its growth assumptions, which in this case won't be easy.

The real winners spotted the company's potential back in 2006. They understood what surging Internet traffic, skyrocketing paid search revenues and a highly scaleable business model could do long before it actually played out. Then they held on tight as the shares went from $50 to $450.

My point here is that it's far more important to focus on the means than the end.

If the crash of 2008 taught us anything, it's that all those numbers on a firm's balance sheet and income statement can change with the financial weather. So I prefer to spend less time monitoring sales and profits and more time evaluating the underlying factors that influence them.

If for no other reason, they can give you a critical "heads-up" that changes (either positive or negative) are right around the corner.

A flash-in-the-pan stock rally can come from anywhere. But virtually all long-term wealth creation stems from durable competitive advantages. Companies like Baidu have something that their rivals just can't emulate -- and that's why they've been so successful.

These advantages form economic moats that help businesses defend their territory from marauding competitors. The wider the moat, the longer a company can hold rivals at bay and continue generating outsized returns for shareholders. Warren Buffett won't even sniff at a company without a moat to protect its returns on capital.

One of the most basic rules of stock analysis is that it can be misleading to compare the profit margins of companies in different sectors. After all, a grocer pocketing 5% of every dollar in sales might be best-in-class, while a biotech firm with margins of 25% could be the group's laggard.

Most experts will tell you that it's best to compare grocers to other grocers and biotechs to other biotechs. And that may be true. But they're missing the bigger picture. Instead, ask yourself this: Why can some industries maintain profit margins five times greater than others?

The answer lies in the "Five Forces" diagram below, which was developed by Harvard Business Professor Michael Porter.

03-30-10-five-keys.jpg

Let's briefly examine each of these forces:

  • Competitive Rivalry: This refers to the competitive intensity of the industry itself. Obviously, concentrated industries with only a handful of players tend to be less competitive and more profitable than fragmented industries (like fast-food) where hundreds of players try to undercut each other.
  • Barriers to Entry: Success always invites competition. But some industries are harder to crack into than others. It's usually best to look for industries with high barriers to entry that shut out would-be competitors. These barriers can take the form of anything from government regulation to capital requirements. Anyone can start an online retail business, but coming up with the billions needed to buy a fleet of cruise liners is a different story. This is why barriers to entry can be so valuable -- and why, as I tell my readers in monopoly, there are many buyers, but just one dominant seller. The flip-side is a "monopsony," where there are many sellers, but just one buyer (like specialized defense equipment sold to the government). In this case, it's the buyer that calls all the shots.
We've barely scratched the surface here -- but you get the idea: a company's profitability and stock are both governed by the competitive framework of its industry.

All of these forces interact to determine whether a specific industry is highly attractive to investors, or screams, "stay away!"

We see these forces at work all the time. Sometimes suppliers must cave to the demands of a powerful buyer like Wal-Mart (WMT). Other times it's the buyers that must yield to the demands of the seller -- like when BHP Billiton (BHP) dictates iron-ore prices to steelmakers.

There is a symbiosis to any business relationship. The buyer needs the seller's wares, and the seller needs the buyer's money. But, the balance of power always favors one party over the other. If you can determine who has the upper-hand in these relationships, you'll be a step ahead of the crowd.

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Nathan Slaughter

Editor: Market Advisor, The ETF Authority

About the author:

Street Authority
StreetAuthority, LLC is a research-intensive financial publishing firm that aims to level the playing field for small investors by giving them access to the ideas and insights of some of the country's top investment researchers, analysts and writers. Although we specialize in income and international investment research, we publish a wide variety of newsletters that are geared towards helping EVERY kind of investor profit from today's volatile marketplace. Visit StreetAuthority.

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