- Stay away from perfectly competitive businesses.
- Obsolescence has a further reach than you think.
- Think like a business owner.
I love stock market investing. It provides an individual the best possible chance of wealth expansion. I have been a student of the stock market for 23 years, since my sophomore year of high school. My boss, who was also my uncle, first turned me on to stock market investing when I worked my first job as a bagger at Winn-Dixie Stores, Inc.
I remember reading every book I could about the stock market, including Common Stocks and Uncommon Profits by Philip Fisher and The Intelligent Investor by Ben Graham. Eventually, about 10 years ago, I developed a 6 Point Inspection criteria list that I use in evaluating publicly traded businesses, as seen in some of my writings here on Seeking Alpha. However, experience taught me a few important and costly lessons down through the years that I wish I knew when starting out. Here's some advice to my younger self, and to other high school stock market enthusiasts and investors at large who are just getting started.
Stay away from perfectly competitive businesses
Essentially, companies that operate in a perfectly competitive environment face a huge number of competitors with similar products. Also, the barriers to entry reside in the low range. As a prime example, I purchased shares in my first employer Winn-Dixie Stores, Inc. with the reasoning that everyone needs to eat. I also noted the huge number of competitors that the company faced. I bought into the rhetoric that competition can keep a company on its toes.
However, I didn't fully grasp the full downside risk of operating in a highly competitive environment. I discovered what generally happens is that all players drag each other down, unless one of them differentiates in a serious way or buys up the competitors.
I hit it lucky with Winn-Dixie. Observing the increase in management turnover around the turn of the century, I sensed trouble and sold my shares for roughly the same price I purchased them. In 2005, Winn-Dixie announced its bankruptcy, wiping out the common stockholders in the process. Winn-Dixie cited struggles in competing with retailing giant Wal-Mart (NYSE: WMT).
The concept still didn't really sink in with me. In November 2007, I purchased my first shares of the apparel retailing company American Eagle Outfitters (NYSE: AEO), after a major correction, for roughly $22.90 per share. My thinking involved purchasing a company with a strong brand on the cheap. I didn't realize at the time that this company would morph into one big lousy value trap.
In the best of circumstances, apparel consumers gravitate to the coolest item available, and what's cool can change quickly. Also, with the onset of a recession, consumers tend to gravitate to cheaper options. In tough times, consumers say, "who cares about the brand?" Apparel simply morphs into another commodity sold by many players in the marketplace. I watched American Eagle Outfitters struggle over the next three years. The company cited a challenging consumer environment. Three years and one month after I bought my first shares in American Eagle Outfitter, I sold all of my holdings for $15.42 per share, representing a 33% capital loss.
American Eagle Outfitters saw its revenue advance a mere 9% in the past seven and a half years, since I first bought shares in the company. Its net income and free cash flow declined 74% and 47%, respectively, during that time (chart below).
AEO Revenue (TTM) data by YCharts
I would have broken even had I kept my shares until now thanks to American Eagle Outfitters' dividends. American Eagle Outfitters' total return amounts to a negative 0.11% in the past seven and a half years vs. a total return of 65% for the S&P 500 as a whole (see chart below).
AEO Total Return Price data by YCharts
Obsolescence has a further reach than you think
In recent years, I used the idea that carbonated sodas and beverages in general will never become obsolete, unlike a computer or a mobile phone, to justify my holdings in beverage giant Coca-Cola (NYSE: KO) and snack and beverage conglomerate PepsiCo (NYSE: PEP). After all, everyone needs to drink something to stay alive. However, recent trends demonstrate the opposite. Consumers, wary of the health effects of sugary drinks and aware of the increased health care costs that go along with it, seek healthier options. According to Beverage-Digest, carbonated soda case volume shrank each year since 2004, meaning that the carbonated soda portions of these beverage giants face significant headwinds. Coca-Cola's and PepsiCo's revenue expansion have leveled off in recent years as a result (see charts below).
KO Revenue (TTM) data by YCharts
PEP Revenue (TTM) data by YCharts
PepsiCo copes better with its challenges by possessing a more diverse product portfolio. It sells snacks to go along with its beverages. Moreover, its sells healthy foods under the Quaker Oats label that caters to consumers' desire for healthier foods.
Coca-Cola and PepsiCo's friction on the top line contributed to sub-par returns of 79% and 76% respectively vs. 114% for the S&P 500 as a whole over the past five years (chart below).
KO Total Return Price data by YCharts
Think more like a business owner
My lessons in retail investing and the observance of trends in carbonated soda, solidify my business oriented approach to stock market investing. If I was a business owner I would want a company that sits behind wide barriers to entry with few competitors, sets itself apart, and has staying power. I like to cite entertainment conglomerate Walt Disney (NYSE: DIS) as an example of one of these companies.
What sets Walt Disney apart also represents its barrier to entry. It would prove impossible for someone else to produce the overall combination and range of productions from Mickey Mouse to Spider-Man to Star Wars. Many competitors would envy the ubiquity and exposure provided by its television networks, such as ESPN. Walt Disney also provides many ways for consumers to enjoy content, such as motion pictures, theme parks, branded merchandise and cruise lines. Of course these products aren't impervious to falling out of fashion. A handful of competitors stand in the same league with Walt Disney, but they don't have Goofy. Moreover, Walt Disney has proven itself on the adaptability front.
Walt Disney's rock solid qualities served as a catalyst for a 33%, 100% and 67% expansion in revenue, net income, and free cash flow respectively over the past five years. This translated into a total return of 265% for its investors vs. 114% for the S&P 500 as a whole during that time (charts below).
DIS Revenue (TTM) data by YCharts
DIS Total Return Price data by YCharts
Other things to look for
Avoid businesses that need to compete for every dollar they make and that sell a product that competitors find easy to duplicate. It also pays to look for "picks and shovels businesses" -- businesses that sell products that other business can't do without. In addition, look for businesses that focus on one or two core competencies. Like people, it's easier for a company to gain an edge and become really good at one or two things vs. many things. Finally, these lessons represent only a small part of the evaluation process for publicly traded businesses and are by no means fool proof.
This article was written by
Analyst’s Disclosure: I am/we are long DIS, KO, PEP, WMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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