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Geoff Gannon
Geoff Gannon

How to Find Great Businesses – Without Resorting to Actual Math

Read the 'Competition' section of the 10-K. Look for businesses that say they don't face significant competition. Favor stocks with 4+ predictability stars. Pick stocks that don't need capital

In yesterday’s article, I said that the two best lists to come up with as far as stocks to research next are a list of great businesses and a list of stocks likely to be mispriced. I should point out that we can’t know whether a business is great or not before we research it. So what we’re talking about here is the ability to quickly identify businesses you don’t yet know much about but which you should spend time getting to know better.

An example I recently wrote about on my member site (Focused Compounding) was NIC Inc. (NASDAQ:EGOV). I wouldn’t say NIC is an especially cheap stock. But it did stick out right away as a fairly normally priced – relative to other stocks you can buy today – stock that is a much better than average business.

Why do I think it’s a much better than average business?

There are three things that hold a lot of businesses back from making tons of money over time:

  1. The business requires capital to grow.
  2. The business faces competition.
  3. The people running the business make serious mistakes every so often.

So a potentially “great” business is one that is the opposite of these three things, meaning it:

  1. Takes almost no capital to grow.
  2. Faces almost no competition.
  3. And has almost no discernible “cycle.”

I don’t want to get overly philosophical here. But note that I’ve equated a “cycle” with a business that makes mistakes. This conflation of the two concepts is not obvious to many investors. But it’s an important one. Cycles aren’t magical. They come about because of human error. If all buyers, sellers and suppliers really knew their future actions and the future actions of their customers and suppliers, they’d be able to avoid creating a cycle. They don’t though. And so they make misjudgments. And these misjudgments cause cycles. As a stock investor, you are familiar with human misjudgments causing cycles in prices. The value of public companies changes very little over a given decade or two – but the price of these public companies fluctuates tremendously. Often, a stock that was valued at eight times earnings in early 2009 will now be valued at 24 times earnings (three times more per dollar of earnings) just nine years later. And within nine years from today, we may see a collapse in prices again that goes too far. So we’re used to cycles extending over periods as long as 18 years. The kinds of mistakes we make as a group of investors are also made by groups of competitors in many industries.

An example of a cyclical industry would be something like oilfield services. A rising price of oil encourages producers to look for and extract more oil while it also sows the seeds of an eventual decline in prices (both by increasing the incentive to increasing production and the incentive to reduce consumption). What I’m saying here is that there’s a difference between a market where oil is sometimes $30 a barrel and sometimes $100 a barrel versus a market where oil is always $65 a barrel. As a business owner – you will likely do worse in something that fluctuates from $30 to $100 and back again than you would in something that always stays $65. But, this is due to a lower “hold” return – not a lower “buy” and “sell” return. There are two parts to being a value investor. The “value” part, which means buying something for less than it’s worth and selling it for more than it’s worth. That part of what you do benefits from volatility and cyclicality. It’s easier to get a bargain in a cyclical industry. But, it’s harder to make money as a long-term holder of a cyclical business.

One way to think of this is that the safest business to hold long term would be one with the highest harmonic mean in terms of return on equity. You don’t just want a high arithmetic mean. You especially want the “bad” years to still be pretty good. I wrote an article called “How to Find Mispriced Stocks.” In that one, I say you should look for cyclical stocks. But here, where I’m talking about finding good businesses – you should avoid cyclical stocks. Non-cyclical industries tend to have better long-term returns than cyclical industries. The exception to this would be if you have a good capital allocator running the business. Smart capital allocators can’t take advantage of cycles by being contrarians.

Let’s move away from the theoretical – look for non-cyclical businesses – and into the practical. How?

One, you look for any stocks that GuruFocus gives a 4-, 4.5-, or 5-star predictability rank. Those are the companies to focus on. And the industries those companies are in are the industries to focus on. I mentioned NIC. It has a 4.5 predictability rank. But you’ll even find high predictability companies in tough industries like retailing. Tandy Leather (TLF) has a 5-star predictability rank. It’s a retailer. But it’s a giant among ants in the leathercrafting retail business. It has a dominant market share in the U.S. and especially a dominant relative market share – with no close competitor. Even AutoZone (AZO), which has a couple strong competitors – often located quite close to its stores – has a predictability rank of 4. Just knowing a company has a predictability rank of 4, 4.5, or 5 is enough to put it on your list of stocks to research next.

Don’t just focus on the well-known predictable stocks though. Look for the less-known and unknown ones too. Tandy isn’t that well-known. Transcat (TRNS) – which GuruFocus gives a 5-star predictability rank – is probably even less well-known.

To come up with a list of “non-cyclical” companies, I’d use GuruFocus’ star predictability ranks (4 to 5 sounds good to me). What about a list of non-cyclical industries?

The least cyclical industries tend to be a low-cost consumer product that is purchased frequently. Anything related to food is non-cyclical. Fast food restaurants, restaurants in general and supermarkets are all less cyclical than most other industries. Habit-based businesses are very non-cyclical. Two of the most predictable products you can think of are coffee and pizza. So businesses like Dunkin Donuts (NASDAQ:DNKN) and Starbucks (NASDAQ:SBUX) and Domino’s (NYSE:DPZ) and Papa John’s (NASDAQ:PZZA) are good stocks to research now if you haven’t already. Value investors often neglect looking at these kinds of stocks – just like they’d neglect NIC – because the stocks are usually too expensive. However, if you research the business regardless of the stock’s current price – you can then pounce on the stock when it finally does fall in price. An example I’ve given before is AutoZone. It’s an $800 stock today. It was about an $800 stock before. But – within just the past 12 months – it plunged to $500 and rose back to today’s price. If you’d researched the stock ahead of time – you could’ve pounced on that brief moment of unusually opportune pricing.

So that’s how you find non-cyclical businesses. You start with something like GuruFocus’ predictability star ratings. And you think in terms of products like pizza and coffee. Stuff millions of people buy every day.

What about businesses that don’t require capital?

Well, supermarkets are out. And restaurants – if they aren’t a franchisor of the concept – are also likely out. Domino’s and Dunkin are both franchisors. So those two are still businesses I’d suggest reading about. But take a stock like Ingles Market (NASDAQ:IMKTA). It’s in a predictable line of business (selling food). But it uses a ton of capital. The unleveraged return on equity in that business isn’t high. Even with debt, it often hits just an ROE of 10-12%. One of the highest return supermarket stocks around – in terms of return on capital (not leveraged up) – is Village Supermarket (NASDAQ:VLGEA). It hasn’t been a predictable business lately. And even in good times, the return on capital was 20-30%. The business might be able to produce an after-tax ROE of 15-20% in good times. That’s enough to own the business (it won’t drag you down over time). But, it hardly qualifies as a “great business.”

And I cheated.

I used Village as my test case for the supermarket industry knowing full well that Village’s business model produces some of the best returns on invested capital of any generalist supermarket company in the U.S. In other words, supermarkets qualify as non-cyclical enough and perhaps predictable enough to be great businesses. But they require too much capital to run. You are often investing in a 60,000-square-foot building (though some supermarkets lease instead of buy) and you are always investing in inventory that doesn’t turn fast enough to give you a negative working capital cycle.

For the most part, manufacturing and retailing businesses can’t be called “great.” What’s a “great” business?

It’s usually a service business. Domino’s and Dunkin Donuts are really more service businesses than manufacturing or retail businesses. Here, I mean the company that owns the trademark. So, you can invest in them and know you own a “great” business.

But, what about Carrols (NASDAQ:TAST)? That’s the biggest Burger King franchisee in the U.S. It owns something like 10% of all Burger Kings in America.

It’s a non-cyclical business. But it’s too capital heavy to be called a great business.

A “great” business usually has something like triple-digit returns on capital using the Greenblatt method. Often, free cash flow is higher than reported income. It’s almost always a service business.

Examples include NIV, Omnicom (NYSE:OMC), FICO (FICO), Dun & Bradstreet (DNB), and also the franchisors we talked about like Dunkin and Domino’s. Websites often qualify. Google is a great business. So is Facebook (FB). So is Cars.com (CARS). And, of course, so is Priceline.com (PCLN).

Priceline.com – really Booking.com – is the modern exemplar of a great business. It is predictable (GuruFocus gives it 5 stars in terms of predictability). It doesn’t require capital to grow (the “Greenblatt” ROC is usually 1,000% to 2,000% in other words, pointless to calculate).

But what about competition?

This is where businesses like Cars.com and Priceline.com fall short of businesses like Facebook, FICO, Dun & Bradstreet and NIC.

There’s a lot more competition in car search and hotel room search websites than there is in credit scores our outsourced state government portals (which is what NIC does).

So, if you do choose to research Priceline.com or Cars.com – you’d focus on this competition angle. You’ll see a lot of TV ads from competitors. That’s a bad sign. Often, a terrible sign. Advertising is a form of investing by rivals. It’s a form of competition.

Strong rivalry in an industry is a huge red flag. It’s probably the biggest red flag there can be. Generally, I want to have a research “pipeline” full of stocks from low- to no-competition industries.

My advice is to always favor stocks you know face little competition over stocks you know face a lot of competition. The danger of misjudging a business in a competitive industry is huge versus the danger of misjudging a company in a non-competitive industry.

If the one thing you take away from this article is to focus on the least competitive industries in the world – that’ll be enough. That’ll improve your results as an investor. Most investors waste way too much time analyzing highly competitive industries. These industries are hard to figure out. And if you guess wrong about the future – there’s a chance you’ll lose everything betting on the wrong company in the right industry if that industry is highly competitive.

Imagine you knew computers were going to be big in the 1990s and so you bet on Apple at the end of the 1980s. Imagine you knew smartphones were going to be huge in the 2010s and so you bet on Nokia in the 2000s.

It’s easier to just focus on businesses with little competition, high retention rates, etc. What’s the most practical way to do this?

Just skim one little portion of the 10-K. Don’t read the 10-K yet. But, as soon as you hear about a new public company, look at the “competition” section of the 10-K.

For example, I said NIC doesn’t face much competition. Here, I quote from the 10-K:

“We do not currently have significant competition from companies vying to provide enterprise-wide outsourced portal services to governments.”

That’s the first line of the “competition” section of the 10-K. Using EDGAR (the SEC filing search tool) it takes less than 60 seconds to find that first line of that section. It tells you NIC doesn’t have much competition in its main line of business.

Meanwhile, Priceline.com’s 10-K says this:

The markets for the services we offer are intensely competitive, a trend we expect to continue, and current and new competitors can launch new services at a relatively low cost. Some of our current and potential competitors, such as Google, Apple, Alibaba, Tencent, Amazon and Facebook, have access to significantly greater and more diversified resources than we do, and they may be able to leverage other aspects of their businesses (e.g., search or mobile device businesses) to enable them to compete more effectively with us. For example, Google has entered various aspects of the online travel market, including by establishing a flight meta-search product (“Google Flights”) and a hotel meta-search business ("Hotel Ads") that are growing rapidly, as well as its "Book on Google" reservation functionality.”

Other things equal, always take the company with the 10-K that says it doesn’t face much competition and put it at the top of your research pile and take the company with the 10-K that says it faces intense competition and put it at the bottom.

Priceline may end up being a much better stock than NIC. But, I’m telling you now that NIC will be a better use of your research time. This is because a business that doesn’t face significant competition is much easier (and quicker) to conclusively analyze than a business that faces “intense” competition.

So, here’s our three-point checklist for quickly identifying a potentially great business.

  1. Is the GuruFocus predictability rank at least 4, 4.5 or 5 stars?
  2. Is the “Greenblatt” ROC often in the triple digits?
  3. Does the “competition” section of the 10-K start with a line saying competition is “not significant?"

Look for stocks with predictability ranks of 4 or higher, triple-digit Greenblatt ROCs, and which don’t have the word “intense” in the “competition” section of their 10-K.

Something like Ingles Market is a bad choice of a business to research next. Something like Priceline.com is a good choice. But something like NIC is the best choice. It ticks all the boxes. So, research something like NIC first, something like Priceline second, and then something like a supermarket stock last.

I’m not saying don’t analyze supermarket stocks. I’m saying approach analyzing supermarket stocks from the other side of value investing. Research something like NIC even when it’s an expensive stock. And then remember what you learned about the business for later. Only research something like Ingles Market when you suspect it’s trading at a discount to its asset value and a super low P/E ratio.

Two things can attract you to a stock: high quality or low price.

Supermarkets are not high-quality businesses. A service business that doesn’t face “significant” competition is. So, when looking for potentially great businesses, start with stocks like NIC.

Disclosure: Geoff owns NC, CFR and BWXT

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Geoff Gannon

Rating: 4.6/5 (14 votes)



Praveen Chawla
Praveen Chawla premium member - 11 months ago

EGOV crashed by 20% soon after you wrote the article. I get it, just bad timing, nothing more. The problem with EGOV is 1) You are dealing with a powerful and sophisticated customers - state governments who can always take over the portals themselves 2) the prospect of non-renewal of contract as exemplified by the recent non-renewal of the texas contract which caused the draw down.

Gstewart622 - 11 months ago    Report SPAM

Previous commenter made a good point. EGOV look attractive in many ways, but one HUGE weakness is that they basically only have one customer: the American government. When any business has one client (or handful of clients) that provides most of the income, that is a seriously, seriously risky business. What if the government decides they don't need the service anymore? The government changes its policies all the time...

If anyone wants to see what can happen when a tech company like EGOV loses a big client, look no further than AAOI. That company had several large clients, but then one, Amazon, pulled out. The stock lost 70% of its value within months, and there are serious doubts that AAOI can even survive as a business. Now imagine what would happen to EGOV if it lost a big client like, say, Texas. Oh, wait... that just happened. 20% gap down.

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