Stock market investing – Using Competitive Advantages to Find High Quality Businesses



Stock market investing

My name is Brian Bollinger, and I am the founder of Simply Safe Dividends, a website that helps individual investors responsibly build and manage their dividend portfolios.

Prior to starting Simply Safe Dividends, I worked as an equity research analyst at a multibillion-dollar investment firm that actively managed several equity funds. I am also a Certified Public Accountant.

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My favorite part of my job is helping individual investors learn more about the art and science of investing, and it’s obvious that Andrew shares my passion.

While my focus is on investing in dividend-paying stocks, my investment philosophy and research process share many traits with other types of investing.


My Investment Philosophy
I do my best to adhere to a simple and conservative investment philosophy, which begins with sticking to investment opportunities that I can fully understand.

Warren Buffett refers to this as one’s “circle of competence,” and I have learned over the years that my circle is not very large!

There are over 10,000 publicly-traded stocks out there, but a reasonably diversified portfolio doesn’t need more than 20 to 40 holdings in most cases.

Since we can afford to be picky, the first line of discipline I follow with my philosophy is avoiding confusing businesses and industries.

If I can’t quickly figure out how a company makes money and why it might have some staying power, I move on. Many businesses are too complex for me, creating unnecessary risk.

After finding a company that I feel I can understand well, the real work begins. Like many other investors, I try to buy high quality companies when they trade at reasonable prices.

But what exactly does “high quality” look like?

In my opinion, high quality businesses possess the following characteristics:

• Time-tested operations
• Reasonably diversified by products / customers / end markets
• Large end markets with at least moderate long-term growth potential
• Consistent free cash flow generation
• Above-average and stable returns on invested capital
• Healthy balance sheet metrics
• At least several enduring competitive advantages that I can fully understand and believe in for the long term

Identifying advantaged businesses is very difficult and often involves a number of judgment calls.

How to Identify Competitive Advantages
According to Professor Richard Foster from Yale University, the average lifespan of a company in the S&P 500 has decreased from 67 years in the 1920s to just 15 years today.

He also estimated that 75% of S&P 500 companies will be replaced by new businesses by 2027!

Increased globalization and the widespread use of increasingly-affordable technology have accelerated the pace of change faced by businesses in virtually every industry.

Competitive advantages are proving more difficult to maintain as the world moves faster and faster, and our job as investors certainly isn’t any easy because of it. 

To begin assessing whether or not a company could possess sustainable competitive advantages, I review a company’s past annual reports, read conference call transcripts, research competitors, watch YouTube videos, and do whatever else I can to gain or lose conviction in a company’s business quality.

During my research, I am trying to pin down a few of the most important drivers for a business and understand what factors help the company survive and keep growing.

Are there network effects? Economies of scale? Unique intellectual property?

I prefer to invest in companies that have been in business for a very long time – at least a couple of decades or even more than a century in some cases.

Some of my favorite holdings have been doing the same thing for decades. Industries with a slow pace of change are increasingly harder to find in today’s world but often provide advantages to the market leader.

A group of stocks that is popular with dividend investors is Dividend Aristocrats. These businesses are S&P 500 companies that have managed to increase their dividends each year for at least 25 years.

Roughly 10% of S&P 500 companies are dividend aristocrats, making this a rather exclusive club. Surviving for 25 years is one thing, but raising dividends over that time period is even more impressive as it usually requires steadily growing cash flow.

If my qualitative research checks out and gives me conviction in a company’s staying power, it is time to dive into the financials.

Analyzing Financial Statements
Some of the financial jargon I referenced while talking about my investment philosophy might sound confusing to beginning investors.

I remember how overwhelming all of the financial data out there felt when I was first getting started investing.

Fortunately, in my opinion, the 80/20 rule applies to financial statements. In other words, no more than 20% of the financial information out there drives 80% of the insights an investor needs to make reasonably informed decisions.

Here are some of the most important financial metrics I pay attention to when I review a business:

Return on Invested Capital: return on invested capital, or ROIC, measures how efficient a company is with its investments. Companies are funded with debt and equity and earn a return on those investments through their operations. ROIC divides the profit a company generates by its total debt and equity.

Businesses that earn higher returns create value for shareholders and can compound their capital at a faster rate. I prefer to invest in companies that generate a high (e.g. at least 10%) and stable ROIC. This can be a sign of a firm with real competitive advantages.

Free Cash Flow: free cash flow measures how much cash is left over after a company makes the necessary investments to sustain its operations. If free cash flow is negative, a business burns through cash on hand and eventually needs to raise funds via debt, new shares, or asset sales. In other words, companies can’t survive over the long term without generating free cash flow.

I like to invest in businesses that generate free cash flow throughout all phases of an economic cycle.

Debt Ratios: a company’s balance sheet can make or break its business. Too much debt can cause a business to declare bankruptcy if it falls on hard times, cash flow dries up, and no one is willing to lend it additional money.

Debt-to-capital is one ratio I pay attention to because it tells us what proportion of a company’s financing is from debt (versus equity). As a general rule of thumb, I prefer to stick with companies with a debt-to-capital ratio no higher than 50%.

Another debt-related metric I use is net debt / EBIT, which measures a firm’s debt relative to its operating profits. Net debt is calculated by subtracting a company’s cash from its total book debt.

EBIT stands for “earnings before interest and taxes” and is most commonly measured over the course of one year. It represents operating profits.

I like businesses with a net debt / EBIT ratio no higher than 2.0, which indicates that their debt loads could be eliminated using cash on hand and no more than two years’ worth of operating profits.

Sales Growth: sales growth is a pretty simple indicator that measures the change in revenue from one period to the next. While earnings can be distorted by a number of factors, revenue growth can be a clear indicator of whether or not a firm is actually growing and how cyclical its operations are.

I prefer to invest in companies that have not had sharp swings in sales (e.g. no declines greater than 20% over the last decade) and have shown a knack for continued growth over time.

To summarize, I like to invest in businesses that earn a high and stable ROIC, generate predictable free cash flow, have manageable balance sheets, enjoy numerous opportunities for long-term growth, and have operations that have withstood the test of time.

Remember, “It’s Not Supposed to Be Easy”
One of my favorite quotes about investing is from Charlie Munger, who is vice chairman of Berkshire Hathaway.

Talking about investing, Munger once said, “It’s not supposed to be easy. Anyone who finds it easy is stupid.”

Even the “best” investors are wrong at least 40% of the time. There is simply too much competition and randomness to expect success from every investment.

Rather than setting out to try and “beat the market,” I recommend staying focused on your own goals, developing an easy-to-understand process you can stick with (through the good and bad times), and staying focused on the long term.

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