Competitive Advantage That Goes Obsolete?

Stocks with wide moat are companies that have “something” that keeps competitors at bay and allows the business to earn supernormal profits. The term came about from the water-filled moats that surrounded castles of the Middle Ages (like the photo above). The wider the moat, the harder it would be for an adversary to penetrate the castle. Some of the examples of companies with wide moat would include Coca-Cola, Wrigley and Walmart.

Having a wide moat allows companies to have excessive earnings and this eventually causes the share price to rise. However, not all companies with wide moat actually lasts. This may sound shocking but this has become more evident recently. Think of Eastman Kodak, Britannica Encyclopedia, newspaper companies and physical bookstores. Kodak filed for bankruptcy in January 2012. Who would have thought 30 years ago that Kodak would go bust? Kodak was one of the strongest brands in the world and anyone who had used a film camera would have used Kodak’s films (the ones that came in the prominent yellow boxes).

Another company to file for bankruptcy was Borders in February 2011. Even though Borders might not have had the status of being a wide moat company, it also fell into the depths of Chapter 11, just like Kodak. Britannica Encyclopedia is now obsolete too. Who would pay thousands of dollars for an encyclopedia now when information on the internet can be obtained for free (if you do not mind the inaccuracy at times)? Newspaper companies are struggling nowadays as well.

I remember using Kodak’s films and Britannica Encyclopedia when I was in primary school. I also remember  visiting Borders bookstore at Wheelock Place frequently when it was still around. Now, they have all been wiped off due to the advent of something massive – technology. Rarely anyone carries analog cameras nowadays. I don’t think anyone still uses Britannica Encyclopedia as it is no longer in print. Books are now read on a tablet by quite a lot of people (not me, I still prefer physical books). Many go online for their daily dose of news. Technology is changing many aspects of our lives. However, technology cannot change how we chew gum, how we consume chocolates and drinks. Companies with wide moat such as Coca-Cola, Wrigley and Hershey’s will not go obsolete like Kodak.

When analysing companies before purchasing, we have to look if technology can make the company we are about to invest in obsolete. After purchasing the company, we still have to monitor it by looking at the net profit margins and returns on equity (ROE) every year. We have to ensure they are consistent and preferably rising and not dipping year after year. If the margins and ROE are coming down significantly, we know that the competitive advantage is being eroded and we have to look further to determine why this is so.

In conclusion, buying companies with a wide moat without determining if the moat is durable, is disastrous. Technology can rapidly change the economics of a business. We have to always ensure that technology will not destroy the wide moat of the business we are investing in.

Coffee With FFN and “The 21 Year-Old Investor”

This interview involves a 21 year-old investor (he prefers not to reveal himself) who has discovered his undying passion in investing and believes in the value investment philosophy. He likes to buy excellent businesses that are able to compound their earnings over a long period of time. He runs his own investment blog and frequents the Valuebuddies forum. He also has a knack for unearthing information off the internet about his favourite companies, to the astonishment of other forum users.

FFN: At what age did you get started in investing? 

The 21 Year-Old Investor (TTYOI): I started at the age of 20.

FFN:  How did you get interested in investing and who inspired you to get started? 

TTYOI: I seemed to have the impression that the stock market is where one can earn great wealth by buying low and selling high since young from maybe the TV drama serials. I had a chance at it when I was 16 as my school was organising this virtual stock competition. I didn’t really know what the stock market is about as well as all the various terminologies. The competition occurred during 2007 and during the final day, stocks tumbled down in one single day and the winner of the competition was the one who had their positions in cash. The one lesson that I have learnt then is the stock market is very risky and one can suffer huge losses in a single day.

While I was in the army, I tried to read up about investment through books like the dummies as I have the intention to have a go at it once again. I started reading up only in my second year where there’s more personal leisure time. I eventually created a trading account and bought my first stock in September 2011 which was a tumultuous time.

FFN: What was your life like before investing and how is it now?

TTYOI: My life was drastically different ever since I started investing. In the past, I have always been unable to come up with an answer whenever people ask me what I want to do in the future. Now, I am very clear that investing is what I want to do for the rest of my life until my mind starts to fail me. I have found a passion.

It has also slowly shaped my characters and perspective. Patience, focus and long-term view are stuffs which I have learnt during this journey. Regardless whether one is an investor, management or owner, these 3 traits seemed to be a common point for those who have achieved success. I do incorporate them into my everyday decision making process even in non-investment related things.

FFN: How do you choose which stocks to invest in? What are some of your strategies? 

TTYOI: I am a bottom-up investor that is heavily influenced by the style of Warren Buffett. Hence, I try to look for great companies that have the capabilities to generate high return on capital for a long period of time. Great companies are indeed very rare and in most cases they will be overvalued.

ROE is therefore one of my most important criteria and I love to use the Du Pont Ratio to evaluate the component of the company’s ROE. You rarely have a company with a wide moat having a low normalized ROE. Personally, I will also prefer a clean balance sheet as Black Swan will always happen and you do not want your company to face financing problem. I have since started to come to term with having some amount of debt so long as the company should have no problem repaying them even in unfortunate circumstances. High Free Cash Flow Yield is also very important and is often one of the common traits of great companies. If a company has to constantly pump in half its net profit to maintain its business then it means that you are only getting half the cash return as an owner of the company. Decent dividend yield is a good to have but not a must, as I believe it can provide some form of cash flow and return while an investor is waiting for the long haul.

In term of the qualitative, that will be to find a company with a great moat. In most cases, a high return on capital will attract more competitors who are willing to accept a slightly lower return than one does. In such a case, competition will be such that no one is able to earn supernormal profit for a long period of time. The period of time of which a company is able to earn return above their cost of capital is called the competitive advantage period (CAP).

Companies with great moat are then able to fend off competitors who are seeking to erode their returns. Some of the commonly cited moats are high switching cost, network effect, government regulation, monopoly power (not monopoly) and lowest cost structure. However, we have to keep in mind that they will still be constantly attacked upon despite their moat. Some of these moats can also be illusory and temporary which requires the judgment call of the investor.

Thus, I have to admit that this method is riskier than the traditional Graham’s approach of purchasing below book value and cash. Firstly, an investor can make a wrong call on what seemed to be a moat. Secondly, disruptive technology can make the business obsolete as seen from the case of Nokia and Kodak. Thirdly, as they have high ROE, it will almost be certain that you will be purchasing at huge premium over its book value due to the equation of PER X ROE = P/B. A stock with PER of 10 and ROE of 20% is essentially trading at 2x Book Value. In such a case, you are paying for future growth in book value which might not happen unlike buying a company at a huge discount to book value where only losses can slowly erode their book value. The stock will then potentially have a huge downside.

FFN: What are some of the stocks in your portfolio currently? 

TTYOI: Boustead, SIA Engineering, Silverlake Axis, VICOM, The Hour Glass. I am looking to accumulate more of Boustead and THG.

FFN: Where and how do you look for companies to invest in?

TTYOI: As mentioned earlier, I am a bottom up investor so I have to search for companies one by one. I try to screen for stocks with high ROA (min 10%) and ROE before I research on the potential company’s prospect. I also try to look around for the better businesses out there – there’re quite a number of them right in your supermarket. Valuebuddies is also a great platform for people to uncover some of the gems.

FFN: You are well-known for getting information of companies from the internet easily. You dig deep. How do you do it? 

TTYOI: Because of my riskier investment style, I will feel comfortable investing in a company only if I really understand the company as much as possible. Main sources will include IPO Prospectus, Annual Reports and Company’s websites. These are really amazing source of information though many people do not read them. Competitor’s annual report or prospectus can also be very useful.

Beyond that, you have to search through Google pages by pages. In fact, I can go up to 50 pages just to find a single piece of information. Change your search term and start the manual digging again. Often, you will be able to find some information that will lead you to even more information. It can be some important authoritative report or a specific jargon for that particular business.

Sometimes, I also employ some unorthodox techniques like emailing or calling up the company, their competitors or some other organisation in the identity of customers, students and e.t.c. AGM is also a very important avenue for it is the one day each year that the management will be bothered to discuss about the company with you. Being well-prepared for AGM is essential for one to reap its benefits.

It helps if you read a lot so that you have some idea of what to look for in every sector.

FFN: What are some of your favourite investing books?

TTYOI: Intelligent Investor, One Up on Wall Street, Black Swan, The Little Book That Still Beats the Market, Buffettology, Your First Million, Common Stock Uncommon Profit

FFN: What are the mistakes you have done pertaining to investing and what are the lessons learnt?

TTYOI: All sort of mistakes have been made – Buying on rumours, buying without doing FA, selling on fear, buying on greed, failed to cancel order when changing order, speculation. Lesson learnt is probably that mistakes are inevitable and investor should learn from it. I am sure that my list of mistakes will continue to expand in the future.

FFN: What psychology do people need to succeed in investing?

TTYOI: One needs to learn to control the greed and fear within oneself. Losing control of emotion will lead to buying high and selling low instead of buy low sell high. Independence of thoughts is also very important. If one is not willing to stand by his idea and choose to follow the market, he will at best get a mediocre return. Only by going against the general market, can one possibly achieve above market return.

FFN: What advice would you give for beginners who want to start investing?

TTYOI: Start now, make mistakes and learn from there. Investors grow when they learn from their mistakes and not when they make profit.

Always be humble and understand that there’s too much to be learnt out there from everybody.

FFN: What do you thing is the biggest misconception people have about money?

TTYOI: That money is the end. To me, money is merely a mean to an end and in the race for it many people lose focus on what is it that they really want. It is important to know the purpose of making money.

FFN: What is the one thing, in your opinion, do people need to succeed in investing? 

TTYOI: Temperament

FFN: A parting shot for the readers… 

TTYOI: A quote by famous trader Jesse Livermore: “The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the person of inferior emotional balance, or the get-rich-quick adventurer. They will die poor.”

Ironically, he did die poor as he did not follow his own rule at the end. Have fun investing =)

Visit the interviewee’s investment blog at where he shares many great ideas and researches on companies.

Investing in Airline Companies – A “Terrorific” Idea

At the end of last month, Singapore Airlines (SIA) announced that it will buy 20 new Airbus 350s and five new Airbus 380s valued at US$7.5 billion (S$9.2 billion). Deliveries will begin in 2017. The last huge capital outlay was in June 2006 when it bought 29 planes worth the same amount of US$7.5 billion.

US$7.5 billion is a major capital expenditure and it is characteristic of many airline companies. Fleet renewal is essential to remain competitive, especially for SIA. If SIA were not to inject capital to acquire new planes, it would lose its edge as being one of the best airlines in the world. Also, no thanks to increasing competition from no-frills airlines, SIA has to be on its toes.

SIA currently operates 101 aircraft. The average age of the fleet is six years and five months (as of 1st Nov 2012). The fleet is one of the youngest in the world. Thus, every six years, the profits that can be returned to shareholders has to be used to acquire new planes and the capital outlay is humongous too. In the future, the price of new aircraft will increase due to inflation and rising manufacturing costs. With the advent of more budget airlines offering cheaper airfare, you can realise why investing in airline companies is not a terrific idea but more of a “terrorific” idea.

The following data shows the cash flow from operations, capital expenditure and free cash flow of SIA from 2000 – 2012.

The cash flow from operations and free cash flow are erratic. The free cash flow for five out of 13 years was negative. Shareholders have not been getting good returns from the business. Free cash flow mandates how well a business does. The erratic free cash flow shows that SIA is operating in a very competitive industry and airline industry is indeed competitive, as many would agree.

It is not surprising that the share price of SIA has been going nowhere since 2001, just like the free cash flow. In fact, one would have been better off buying the market instead of SIA. In the following chart, the blue line shows SIA’s share price performance and the green line shows the Straits Times Index (STI). It can be seen that the STI gave better returns of +20% compared to returns of SIA of -45%.

You might say using SIA as a sole example is not representative of the whole airline industry. What if Warren Buffett also agrees that airline industry is competitive? In a 2002 interview, Warren said the following: “If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money. But seriously, the airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in. I have an 800 number now that I call if I get the urge to buy an airline stock. I call at 2 in the morning and I say: ‘My name is Warren, and I’m an aeroholic.’ And then they talk me down.”

To illustrate how free cash flow is important for a company to do well, let us compare SIA with another local company, Vicom, which is the vehicle inspection and testing business. The following data shows the cash flow from operations, capital expenditure and free cash flow of Vicom from 2000 – 2011.

The cash flow from operations and free cash flow are increasing more consistently than SIA. Now, let us look at the share price performance of Vicom against STI.

The STI (green line) has been going sideways but Vicom (blue line) has defied gravity (albeit with a few ups and downs)!

Let me sign off with a quote by Warren Buffett – “How do you become a millionaire? Make a billion dollars and then buy an airline!”