Economic Moats – Consumers Worst Enemy, Investors Best Friend?

“In business, I look for economic castles protected by unbreachable ‘moats’.” – Warren Buffett

The best kinds of businesses that I love are the ones with strong economic moats. They are often characterized by supernormal profits and high returns on capital. In this post, I characterize the different economic moats that exist.

Companies with profitable margins are often eroded over time. The bubble tea craze a few year back is a textbook case. Initial start-ups were immensely profitable and its novelty soon became a craze. Competitors soon entered the market and before long, the once profitable industry became over-saturated and profits plummeted.The bubble tea industry is one in which firms possess virtually no economic moat at all. Coupled with the fact that entering the industry was relatively low, pioneers of bubble tea were soon unable to maintain past profit margins.

Industry Without an Economic Moat

You will often find firms with economic moats to be extremely profitable in the long run – provided that their competitive advantage is maintained.

Type of Moat Examples
Intangible Assets Tiffanys & Company, Nike, Coke
Customer Switching Costs Adobe. Microsoft
Network Effect Microsoft, Visa, eBay
Cost Advantages Dell

 

Intangible Assets – Brands, patent and regulatory licences. Patents of drugs drives profits from pharmaceutical companies – one reason why they are so highly guarded. Strong brand names such as Nike or Tiffanys & Co. allow companies to charge much higher premiums as compared to their competitors. If consumers are willing to pay a premium for a brand name – you have evidence of a moat.

Customer Switching Costs – Adobe has come to become the gold standard for image editing software.  Most designing firms run using its propriety software not because it’ cheap but because were trained using Adobe Photoshop. Switching to cheaper software doesn’t make sense as any savings made will most likely be offset by the loss of productivity (not to mention the risk involved).

Network Effect- Credit card companies are a prime example of this economic moat. You’ll find that shops readily accept cards like AMEX or VISA. Competitors who try to enter the market will be hard pressed to competing against well established networks.

Cost Advantages – Dell, famous for their optimizing and reducing cost in the process flow has done exceedingly well compared to its competitors. By cutting out the middle-man and selling directly to consumers, they have a comparative advantage against well established players like HP.

This list is by no means exhaustive but merely acts as a good reference point.

I recommend reading “The Five Rules for Successful Stock Investing” as a great primer for learning more about economic moats in different industries.  I also recommend “The Little Book That Builds Wealth” as a secondary reading.

I will be covering economic moats of locally listed companies in my next post. Look out for it!

Starhub – Irrational Debt Levels; Irrational Management?

There has been much speculation & confusion regarding the significant amounts of debt that Starhub now carries on its balance sheets. As of September 2010, Starhub possessed an astounding financial leverage ratio of 33.8. This means that for every dollar in equity, the firm had $33.8 in assets (anything above 4 or 5 is a potential red flag.)

So what’s going on here?

Bank loans made up 0.9 billion dollars in 2009! Let us take a closer look at the footnotes.

Even in a world awash with cheap money, I found the interest rate that Starhub was borrowing at to be extremely low. In 2009, their floating rate loans bore i/r of only 1.24% to 2.13%. This already low interest rate was reduced further in 2009 to only 0.92% to 1.39%. In opinion, it makes perfect sense for Management to leverage on the historically low rates to fund their capital expenditures.

Healthy Cash Flow Levels in Starhub:

Starhub is one of the few companies that use Free Cash Flow figures in their annual reports (a plus point for me) and for good reason. Even in the wake of the financial recession, they have posted impressive results.  I do not foresee a problem with loan repayments at this current point of time.

The Bear Case:

Starhub paid $20 Million in interest from bank loans last year (taken from the Cash Flow Statement of 2009’s Annual Report). Assuming that interest rates suddenly quadruple (highly unlikely in the near future but let’s take the worst case scenario here) to 5.6%, Starhub would have to fork out $80 Million in interest payments. A sizeable increase of $60 Million – but still within tolerable limits. I envision that as long as interest rates remain at their current levels, Starhub will have no qualms about maintaining the status quo.

 

Cash Flow Statement from Starhub Third Quarter 2010.

I want to bring your attention to another point – Refinancing. Judging from their cash flow statements, I suspect that Starhub is refinancing significant portions of their debt as the maturity date loans. This is akin to what REITs do when their debt is about to expire. In other words, they will be able to extend their loan maturity dates as long as they remain credit worthy.

I came across a post in another blog stating that Starhub was not making enough in FCF to cover their monthly 5.0cents dividend payment. The more risk adverse among you (it could be just me though..) might be wondering why Starhub doesn’t reduce its dividend payment in order to give itself a greater buffer or margin of safety. The argument is that once a company has started paying a regular dividend (in this case Starhub has committed itself to 5.0cents a quarter), the market will expect it continue the cycle at regular intervals forever. Any disruption to this cycle will be perceived as a potential sign of financial difficulties and a loss of confidence.

Conclusion:

In my opinion, debt levels while significant, should not pose much problem for Starhub. Close monitoring of their financial performance in their years to come is in order however. I feel that management has delivered solid returns up till this point of time and I see no reason why they wont in the years to come.

Tell-Tale Signs That Investors Should Look Out For in Reconsidering Their Investment in Starhub:

  1. Significant drops in Free Cash Flow over a sustained period (i.e. 1 – 3 years)
  2. Starhub being forced to raise additional amounts of money (i.e. through bond issues) AND refusing to cut its dividend yield
  3. Starhub taking on even more debt despite a significant rise in interest rates.

When faced with special situations such as these, its always good to dig deeper into the financial statements. Always make sure you understand the debt structure of the company. If its too complex, skip it. There are plenty of other companies that are much easier to understand.

Disclaimer: The author is vested in Starhub.

Free Cash Flow Part 1: Why it’s better than Net Profit!

Why Free Cash Flow?

In this post, I will discuss the benefits of using Free Cash Flow (FCF) instead of Net Profits to evaluate the worthiness of our potential investments.  FCF is simply Net Cash Provided by Operating Activities – Capital Expenditures. Companies with healthy FCF are able to pay dividends, acquire other companies and pay off their debts. Cash is the lifeblood of all companies, and without it, you can be sure that weren’t be around for very long.

I have included figures from the now defunct behemoth, Enron to illustrate my points.

Enron Financial Results Summary (1996-2000)

By all means, Enron appeared to be a fantastic company. Revenue had jumped seven-fold and net income had jumped two fold in a short span of five years! Pundits loved the company and the stock priced soared.

The Rise & Fall of Enron - Taken from "BBC Enron: Timeline"

Free Cash Flow on the other hand, tells us a vastly different tale:

Enron Financial Results Summary (1996 – 2000)

In four out of five years, the company was facing a massive outflow of cash. A tell-tale sign that something is amiss. Enron had burned through all its cash and still required a substantial amount of money to keep running.  Eventually, it was revealed that fraud was being perpetuated. Enron eventually closed its doors as it crumbled beneath its own weight.

If it doubt, always remember the old axiom: Cash, not profit is king!

Value Investing Philosophy

As part of a series of introductory posts, I decided that making clear my investment philosophy would best serve my readers (or lack of).  Drawing inspiration of Benjamin Graham and David Dodd, I follow a value based approach to investing. I have summarized the key tenets of my philosophy as:

Safety of Capital

“Rule No.1: Never Lose Money

Rule No.2: Never Forget Rule No. 1”

- Warren Buffett

Preservation of capital is of paramount importance to me. I am extremely rise adverse, and choose to invest only after making a substantial time and effort to run through my investment thoroughly.

Margin of Safety

Suppose you were an engineer building a bridge. You estimated that 150 tons of vehicles passed through its roads at any given time. How much weight would you design the bridge to withstand? 150 tons? I doubt it. 200 tons? Now we are getting somewhere. How about 400 tons just to be safe.  That’s more like it.

The additional weight is the margin of safety (MOS) that engineers give themselves in case their calculations turn out to be wrong. Similarly, the same applies to investments. Suppose you calculated that the intrinsic value of a company was $0.30 a share. How much would you pay for it? The buffer that exists between the Intrinsic Value and the actual price paid is the Margin of Safety. I will provide a more in-depth discussion on this in subsequent posts.

Take Time To Mark Out Your Circle of Competence

Circle of Competence

Understanding what you know and what you don’t is essential in getting your investments right.  Never buy into anything that you can’t understand, no matter how appealing or attractive it looks.  Despite my extensive effort, I have yet to figure out how to analyze financial companies like UOB or DBS; hence I have never considered investing in them. We all have our specific areas of expertise. Getting our circle of competence right will play great dividends in future investments.

Mr. Market

Mr. Market suffers from wild mood swings; he might be on a manic high one day and depressed the next. The most important thing to realize is that you are free to ignore him if you chose to do so. Treat him as your friend if need be, but always realize that he’s serving you and not the other way round.

In short, exploit the tendencies of the market to swing from extreme high to record low. The market is just like a pendulum swing from one side to the other. Accepting it as part of the business cycle will give you conviction when others forecast only doom and gloom.

PE Ratio of the S & P 500. Don't be a slave to the market - Exploit it to your advantage.

Do note that this list is not exhaustive. I do hope that it’s a useful guide to get you started.