In the past article, we looked at a concept called Mr Market. In this article, we will be looking at investing in a business that is predictable and successful.
From 1965-2012, Warren Buffett has delivered a compounded annualised gain of 19.7% to shareholders, compared to an S&P 500 market index return of only 9.4%. How did Buffett do it? Basically, Buffett looks for predictable businesses to invest in as these companies can last for years.
For a business to be predictable, the company must also have a wide moat or competitive advantage that will not be breached that easily, if not, at all.
From Wikipedia, a moat is “a deep, broad ditch, either dry or filled with water that surrounds a castle, building or town, historically to provide it with a preliminary line of defence. In some places moats evolved into more extensive water defences, including natural or artificial lakes, dams and sluices. In later castles the moat or water defences may be largely ornamental”.
Just like that, business should have a wide moat to keep competition at bay. Wide moat can come from a brand name (eg. Coca-Cola, McDonalds), monopolistic or oligopolistic position (eg. Vicom, SGX), pricing advantage and patented technology (eg. Pfizer). What other categories can you think of?
Why is Coca-Cola a formidable business? It will be hard for a competitor to start up a drinks company like Coca-Cola and muscle away the profits that comes because of its huge network and branding. The sugared water is churning lots of cash for Coca-Cola. Warren Buffett once asked a manager if he was given a few million dollars to set up a competition to Coca-Cola, would he do it. The manager immediately said he would return all the money instead as it would be hard to compete against Coca-Cola.
If we look at the earnings per share (total profits divided by number of shares) chart of Coca-Cola, we can get a clearer picture:
The EPS has been increasing almost consistently from 2003 to mid-2013.
Let’s look at a local company, Vicom, which is a vehicular and non-vehicular inspection company listed in Singapore.
The EPS for Vicom is even more consistent as seen from the chart. It had a slight dip from 2003 to 2004 only.
Vicom is able to earn such consistent earnings as it controls a 78% market share in the vehicle testing business.
Predictable business also generate lots of free cash flow. Free cash flow is the cash flow from operations minus capital expenditure. The free cash flow can then be re-invested in the business or paid out as dividends, among others. When the company does not see a need to keep the cash, it will pay out increasing dividends over the years. This can be seen from business like Coca-Cola and Vicom.
Vicom has paid increasing dividends of 8.5 cents per share from 2005 to 18.2 cents per share in 2012. This is an impressive 11.5% compounded annual growth.
What other predictable businesses can you unearth that has growing EPS and growing dividends? One clue would be to look at the S&P 500 Dividend Aristocrats Index. This index measures the performance S&P 500 companies that have increased dividends every year for the last 25 consecutive years. Some of the constituents include Johnson & Johnson, Coca-Cola Co, Procter & Gamble ad McDonald’s Corp.
On the other hand, technology companies are not predictable. Warren Buffett famously shunned all technology companies in 2000, saying he doesn’t understand technology. People said that he was out of touch and didn’t understand the ‘‘new economy’’ when technology stocks were going through the roof prior to the dot-com bubble.
Technology changes almost every year and one cannot say for sure if the technology company will be around 5 years from now. However, companies like Coca-Cola and McDonalds will still be around for many years. Technology would not affect such businesses.
In summary, when investing, we look for businesses that are predictable. Predictable businesses last for a long time and create lots of value for shareholders.
To know more about Value Investing …….
Sudhan, Business Analyst
Mind Kinesis Value Investing Academy