My first article, How to Think About Stock Ownership, was a big hit, so here’s the next in the series.
The first question I always ask myself is, do I understand the business? And if the answer’s no, that’s fine, just move onto the next company. And if you’re being honest with yourself, then the answer is usually going to be no. Once a year or so, I like to export a list of every company with a market cap of over $5 billion or so, and then I sort them by industry and sector. Then I start chiseling away at the list. I remove airlines. I remove automobiles. I remove fashion. I remove pharmaceuticals. I remove all the stuff I dont understand and then take a look at what’s left. That’s my investment universe, or circle of competence as Buffett would say.
And now keep in mind, I’m not saying ignorance is bliss. You should always trying to be learning, but the important thing is to admit when you don’t know enough about something to invest in it. Investing takes an odd combination of confidence and humility that way.
The next question I always ask myself is, will the company be around in five or ten years? And if the answer isn’t an emphatic Yes! then maybe you should be investing elsewhere. That question forces me to think long term. What are the companies’ long term prospects? Let everyone else try to predict what earnings are going to be this quarter or that. I have really have no interest in that game. And it’s not because you can’t make a lot of money being right about earnings calls, it’s just I don’t think I have any edge there. But I do think I have an edge in thinking about the future of society and how certain businesses may be able to fit into that future.
Which leads me to the last question, does the firm have any competitive advantages? Competitive advantages give me a frame work to analyze the competitive landscape of the business. If a firm is super profitable, then economics tells us that other firms are going to try and come in and take those profits. Competitive advantages are a way for companies to hold off those other firms for as long as possible. I break it down into four buckets.
The first one is Low Cost Provider. This is when the company can provide the product or service for less money than the competitors. So it can either afford to charge less or it can charge the same, but enjoy wider margins. Think of a company like Netflix. It spends a shit load of money on content, but that money is spread out over 220 million subscribers. So their cost to provide you with any given tv show is substantially less than Hulu, for example, on a per customer basis.
The next one is High Switching Costs. That’s when customers are essentially locked into a product or service. Think of Excel. You can download Open Office for free and it works pretty well. But you have to learn new formulas and menus and if you send a spreadsheet in .ODS it may not open for your coworker or client who is using Excel. So even though there isn’t a financial cost to switching, there are still costs.
Then there are Network Effects. Amazon is a great example. Buyers go on Amazon because that’s where the Sellers are and Sellers go on Amazon because that’s where the Buyers are. And each additional seller makes the platform more valuable to each individual buyer, and certainly visa versa.
The final competitive advantage is Intangible Assets, which is admittedly a catch all. This one includes things like patents, regional monopolies, or brand. Brand is often misunderstood. Just because you recognize a brand name doesn’t mean it’s valuable. The brand name has to influence sales, either by providing the business with sales volume or pricing power. A powerful brand is Disney. Every year they can charge more for a ticket to Disneyland and every year more people show up.
Now let me talk about what is not a competitive advantage. Market share. Market share is not a competitive advantage. If it were, there would be no point to do any more analysis. We could just look up the company’s market share, and go “well, that’s never going to change.” But that’s not how it works. The study of competitive advantages is the study of how market shares can change over time. A firm that is lacking in competitive advantages will see its market share erode over time. And a firm that has strong competitive advantages may even see its market share increase. It depends on the specific business.
Another way to define it, is it’s the Kevin O’Leary argument. Have you ever seen Shark Tank on TV? It’s a show about these entrepreneurs that go on television looking for funding. Mark Cuban is on it. Damien, the guy that made FUBU. Anyway, Kevin O’Leary is this guy that always asks the question, “what’s to stop another company from coming in and ripping you off?” And it’s probably the single most important question that ever gets asked on that show. And it’s a question I always ask whenever someone pitches a stock to me. “What is to stop someone else from coming in and doing the same thing?”
The next episode is going to be about quantitive analysis of the business, but there’s one last point I want to raise. In Phillip Fisher’s book, Common Stocks and Uncommon Profits, he delineates 15 points that you could use to appraise a company. He concedes that a company may still be worth investment if it fails on a few points, but there is one point that he lists as an exception. He shares a story about a factory where the workers weren’t being allowed enough time to wash their hands during their lunch break, so they were eating their lunches with hands covered in oil and grease. Fisher said that it didn’t matter how well that company performed on the other 14 points, he wouldn’t invest in a company based on that story alone. And that really has me bothered, because I’m invested in Amazon. I think the point he’s trying to make is, a company’s financial performance may be a mirage if it’s based on exploiting workers. Because eventually those workers will strike.
That’s all I’m going to say on that and on the overall topic of qualitative analysis, but that doesn’t mean those are the only things to consider. Each company is different. That’s why I always say to read through the 10Ks and the 10Qs and really pay attention to the footnotes. Read newspaper articles. Watch YouTube videos. Read books, talk to to customers, talk to employees. Really try to paint a picture. Pretend you’re an investigative journalist or a scientist. Really think about the company’s future before you make an investment.
Alright, thank you for reading, have a great day.
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