How to choose great stocks – part 1

Financial Journalist
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How do you trade a great blue-chip stock? Answer: don’t try. Focusing on unpredictable share prices and meaningless market-driven financial metrics is a mug’s game. Instead, think like a business owner: concentrate on finding great companies and buying them below fair value.

Granted, the idea of buying “great companies” sounds like simplistic investment preaching. Of course we want to buy great companies. The problem is, the market knows these companies are outstanding and has already (over) priced them for perfection.

But here’s the thing: look at the market’s great stocks over the past few years: Commonwealth Bank, REA Group, Seek, Domino’s Pizza Enterprises, and Slater & Gordon, to name a few. They had obvious traits of exceptional businesses, but many investors resisted them on valuation grounds, confusing price and value. Or they were suckered by market noise and short-term price moves when they should have focused on industry and company fundamentals.

Every stock, of course, has its price. And there’s no magical formula for identifying great companies and buying them below fair value. The market is pretty efficient in blue-chip land, much more so than in small caps. If the majority of large-cap Australian equity fund managers struggle to outperform their index over time, what chance do retail investors have? Plenty, if they follow a simple framework for choosing great companies.

Having written on share investing for more than two decades, I’m still surprised at how much over-promotion of low-quality companies occurs. And how too many retail investors scour the market for “hidden gems” and become obsessed with short-term share price moves, when they would do better by narrowing their search to 100 of the highest-quality companies.

I use a seven-part framework to identify great companies. It will not suit all investors: for example, I prefer growth over income stocks, believing companies with a high return on equity (ROE) are better off reinvesting those dollars to magnify growth, than returning them to shareholders as dividends.

My approach is grounded in long-term industry analysis and sustainable competitive advantage – identifying companies that have a so-called “economic moat”, and being prepared to pay more for them. Here are the seven steps.

1. Start with the industry

Bad industries can kill good companies. And good industries can make bad companies look better than they are. Start your blue-chip research with analysis of the company’s industry. Does it have good long-term growth prospects? Will it grow faster than the economy? Does the industry have favourable characteristics: for example, low or fragmented competition, or other factors, such as regulatory barriers, that make it attractive?

Simple industry analysis can be the difference between huge gains and losses. Those who knew print media would struggle, while online media would boom, would have sold Fairfax Media and bought Seek or REA Group. They might also have sold David Jones and Myer Holdings because traditional retailing has unfavourable long-term industry characteristics. Or they might have bought Japara Healthcare or several other stocks exposed to the favourable trend of an ageing population.

2. Sustainable competitive advantage

Only one thing is better than a great industry: a sustainable competitive advantage in an industry growing faster than the economy. It means companies can enjoy higher profits for longer, and better capitalise on their “window of opportunity” before rivals erode their advantage. For established companies, sustainable competitive advantage gives a precious commodity: the ability to lift prices. REA is a good example: its price rises weren’t popular, but what else could property advertisers and real estate agents do?

Sustainable competitive advantage comes in many forms. For BHP Billiton, it is arguably the strength of its balance sheet. For the Commonwealth Bank, it is its technology head start over rivals. For Seek, REA and Carsales.com, it is a powerful “network effect”: more buyers attract more sellers, and vice versa, making their platforms impossible to overtake – or even get close to. For Domino’s, it is scale, brand and technology.

What gives the companies in your portfolio a sustainable head start over competitors? If the advantage is hard to identify, you might have a lower-quality company.

3. The business model

A strong business model is the key to exploiting a sustainable competitive advantage and favourable industry conditions. I seek three core characteristics: recurring, annuity-style income with high certainty; a capital-light business model; and high customer switching costs. Put another way, companies that don’t need a lot of capital to grow, get paid when they are sleeping, and make it hard for customers to leave for a rival.

Carsales.com.au is a good example. Like many Internet stocks, it has a capital-light business model because it is essentially a website. Unlike mining-service stocks, it does not have vast sums of money tied up in machinery that depreciates as it sits idle. Or big factories to build, or inventory that is less valuable the longer it is unsold. And it does not have to raise huge slabs of capital to expand offshore.

TPG Telecom, iiNet, and fund managers such as Platinum Asset Management and Magellan Financial Group, benefit from recurring, annuity-like income. Customers sign up for one product, and pay fees on it, month after month, year after year. It makes for beautiful business.

Commonwealth Bank benefits from high switching costs. You open an account, get a credit card and take a mortgage. And because it takes ages to move to a rival bank and open new accounts, you stay put. With customers locked in, these companies have greater scope to lift prices, cross-sell other products, and spend more time attracting new customers than keeping existing ones.

Do your stocks have recurring income, capital-light business models, and high switching costs? They don’t need to tick all three boxes. But if your company only makes money every time it sells something, is a price taker, requires huge capital to grow, and can be dumped easily for a rival, it is probably of lower quality.

– Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at September 24, 2014.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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