People with very high IQs and who are good at math naturally look for a system where they can just look at the math and know what security to buy. It's not that easy. You really have to understand the company in its competitive position and the reason why its competitive position is what it is and that is often not disclosed by the math.
- Charlie Munger at the 2013 Berkshire Hathaway Annual Meeting
In terms of stock picking for the long run, we like the use of a factor-based model to rank business qualities and wait for favorable price entry points to accumulate shares (see "Performance Review: Stocks That Topped My Factor-Based Quality Ranking Model"). A ranking, rather than a filter, would allow us to focus on only a small number of names with truly wonderful businesses.
While our ranking model counts in many important numbers, such as ratios and growth rates, we make sure a few qualitative factors are being weighed, as:
- Numbers alone are usually not telling the whole picture regarding durable business strengths;
- We need to find out whether these numbers (as achieved up to now) would improve or deteriorate in the future.
A Lesson From The Past: NetEase
NetEase (NTES) is a Chinese Internet technology company providing online services centered on content, community, communications, and commerce.
From a purely quantitative perspective, the data below indicates quite strong fundamentals at the end of 2016. The company generated consistently above 15% ROA, above 20% ROE and above 18% ROIC.
Source: Morningstar; data as of 2/5/2019.
The financial strength was also out of question at NetEase, with no debt as well as over 2x current ratio and quick ratio.
Source: Morningstar; data as of 2/5/2019.
The company also earned no less than 30 cents of free cash flow out of 1 dollar of revenue on average any year from 2008 through 2016 - quite a remarkable track record.
Source: Morningstar; data as of 2/5/2019.
So, at the end of 2016 (or early in 2017), you might want to make the call of investing into the company's strong business fundamentals for the future - not so fast, as unfortunately, it turned out that NetEase was not able to sustain its prosperities! As is indicated in the last 2 columns in each of the above three tables, the business at the company deteriorated significantly since 2017 - ROA, ROE, ROIC, current/quick ratios, and FCF/profit margins all trended down (and may continue trending down as we speak). In 2018, the stock plunged nearly 32%.
Source: Yahoo Finance
Here's something that may help explain the myth behind the booms and gloom. NetEase develops and operates online PC and mobile games, advertising services, email services and e-commerce platforms in China. None of its business lines possesses absolute market leadership. Meanwhile, it is widely recognized that the TMT sector in China means quite a lot of competitions, uncertainties, and even self-disruptions. The strategic focus at the company drifted from portals to gaming and to e-commerce - diversification of the businesses delivers little (if any) value to shareholders. Although NetEase is one of the largest Internet and video game companies in the world, none of its businesses has a wide moat, in our view, facing rivalries from competitors such as Tencent (OTCPK:TCEHY, OTCPK:TCTZF), Alibaba (BABA), and JD.com (JD).
Below we list those that are difficult to quantify but matter a lot to long-term investment returns.
Moat width is the single-most important factor in our evaluation of stocks. A wide moat protects the business from competitors trying every possible way to take away its earnings. Therefore, while past numbers may get you to applaud the previous achievements of the company, the qualitative analysis of the moat would tell you its future.
Here are some common characteristics of a wide-moat business (for more details, see "How To Spot Wide-Moat Stocks"):
- Brand power - For example, Hermes (OTCPK:HESAY, OTCPK:HESAF) has strong brand power in many high net worth people's minds; when customers worship the brand, they start to voluntarily lose bargain power and price sensitivity;
- Economies of scale - As the largest pizza seller worldwide, Domino’s Pizza (DPZ) sells more than 2 million pizzas each day through around 14,000 locations globally; such scale provides Domino's with the capability of low-cost production, and hence, the flexibility in terms of pricing when facing tough times and/or competitions from peers, such as Papa John's (PZZA) and Pizza Hut (YUM);
- Network effect - We favor companies with one-sided network effect, such as Facebook (FB) and WeChat (owned by Tencent), over ones with two-sided network effect, like Rightmove (OTCPK:RTMVY, OTCPK:RTMVF) and Tabelog (owned by Kakaku.com (OTC:KKMMY, OTCPK:KKKUF)), as the former enables higher user stickiness;
- Regulation & protection - Drug companies, such as Gilead Science (GILD), Amgen (AMGN), and Novo Nordisk (NVO), benefit from the protection of their patents so as to charge high prices.
We favor management teams with shareholder interests in mind and capital allocation sense. For example, the management at Fuchs Petrolub (OTCPK:FUPBY, OTCPK:FUPEF) has shown great capital allocation skills with the focus on Fuchs Value Added (i.e., EBIT - Cost of Capital), which is the central KPI.
We value companies with leading market shares in their industries (or domains). Microsoft (MSFT), for example, has the monopoly-like market leadership in terms of its Windows operating system and Office applications, which would have been so difficult for rivals to challenge even in the extremely competitive tech sector. These market-leading product lines act as a cash cow, allowing the company to build (and/or acquire) additional ventures one after another in order to stay competitive.
Competition is for losers, as while often delighting the customers, it eats away profits left over to shareholders. Investors with a long-term time horizon would try to avoid highly competitive industries (and even hot sectors sometimes). We mainly analyze the competitive landscape through the following dimensions:
- Concentration - We prefer to invest in stocks in a highly concentrated industry. For example, very few railroad companies in North America hold the majority shares of the market, and even better, within the region, Canadian National Railway Co. (CNI) is the only player that has access to three coasts of the North American land - quite a uniqueness, which we like a lot!
- Regulation & new entrants - Tobacco industry is an interesting example. While companies like Altria (MO) and British American Tobacco (BTI) appear to suffer from tightening regulations, they should, at least in the long term, enjoy the high entry barrier due to those regulations;
- Pressure from substitutes - Competition does not necessarily come from the same industry; for example, traditional retailers were easily disrupted by the tech sector, where more and more online shopping emerged. Meanwhile, we do have confidence in the discount retailing niche domain, including companies like TJX Inc. (TJX) and Ross Stores (ROST), where "treasure hunting" pleasure would be hard for online players like Amazon (AMZN) to replicate.
The best business plans, in our view, are usually those that do not change a lot from time to time. We favor companies with consistent and clear business focuses over a reasonable period. Management shifting their strategies too often or diversifying their business lines either voluntarily or involuntarily often encounter inefficiency in execution and high management costs, both of which damage shareholder value.
As a result, conglomerates like General Electric (GE), Halma (OTCPK:HLMAF, OTCPK:HLMLY) and Mitsubishi (OTCPK:MMTOF) would earn a low score in this regard for our evaluation of stocks. The rare exemption may be Berkshire Hathaway (BRK.A, BRK.B), where extraordinary capital allocators and corporate cultures are in place.
In order to predict future returns as accurately as possible, we prefer to deal with businesses in relatively stable industries. Companies offering products and services that can prevail for the next 10 years or more would not bother facing too much change in terms of customer demand and competitive landscape. Such investments, such as pest control company Rollins Inc. (ROL) and cooking equipment maker Rational AG (OTC:RATIY, OTC:RTLLF), may appear boring but prove to have delivered superior risk-adjusted returns for owners.
Our favorite investments are businesses that survive and thrive no matter where the economy is heading. This is important, as a portfolio of stocks suffering fewer losses during downturns at least (while not necessarily generating larger gains during upturns) would beat the benchmark quite easily for the long run, in our experience. Consumer staples companies, such as Clorox (CLX), and medical device providers, such as Intuitive Surgical (ISRG), would fall into this category.
Leveraging numbers in the financial world, a quantitative model is helpful in ranking business fundamentals, but keep in mind that not all factors are quantifiable. As a matter of fact, we think quite a few important factors are qualitative. This might explain why superior investment returns are difficult for computers to replicate.
Hence, the next time you see a business with a superior ROIC, clean balance sheet, strong cash flow, high margins, reasonable pricing, and with temptation for you to buy, think twice and investigate further!
Disclosure: I am/we are long MOST OF THE STOCKS MENTIONED. 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.