Finding a company with a competitive advantage means finding an investment that will offer solid returns for decades to come. What identifies a company with a strong competitive advantage? Some results may surprise you.
“…managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.”
-Warren Buffett 1982 shareholder letter
There is so much more to finding a good investment than finding a specific ratio on a company’s balance sheet. As Buffett says, evaluating a company’s financial statement should be the beginning of your research, not the end.
Buffett has made his billions by identifying companies with strong competitive advantages, and buying and holding those companies for decades (Or as he says, preferably forever). A strong competitive advantage means that a company will continue to make profits year in and year out, no matter the economic or political environment. It maximizes shareholder wealth by harnessing the power of compounding interest in its accumulated earnings. But a strong competitive advantage is not identified just by looking for a certain Price to Book (P/B) or Price to Earnings (P/E) ratio. Instead, it means understanding how the business operates and how the company’s financial statements identify advantages the company has its in field.
For example, consider Coca-Cola’s current ratio. Historically, it has been under 1. Any basic stock screen that excludes companies with current ratios of less than 1 (which is a quick test to see which companies can afford to pay their bills over the next 12 months, read more on current ratio here), would have excluded Coca-Cola from the results. How can it be possible that one of America’s strongest companies looks like it won’t be able to afford to pay its bills by a simple ratio like the current ratio? It turns out, this may be a sign of a significant competitive advantage, and you have been excluding companies like Coca-Cola all along!
A low current ratio is #4 below, here are the rest:
Some are very simple, some involve some digging into decades of past financial statements. None are sure-fire signs of a future winning investment, but they will give you clues on whether you are looking at a company destined for long term consistency or long term improbability.
1) High Margins
A Company’s margins tells investors how much money the company keeps after it sells a product. Consider Budweiser and assume it sells you a beer for $1. You pay Budweiser $1, but the company does not get to keep that whole dollar. 5 cents may go towards the bottle, 3 cents towards ingredients, 10 cents towards workers’ pay, 15 cents for the cost of the equipment, 20 cents for advertising, etc. After all expenses are accounted for, Budweiser ends up with about 25 cents. This 25 cents left over from $1 in revenue means Budweiser has a 25% margin. By margins here I am speaking specifically to net margins, as this incorporates everything that results in money flowing out of the business. Gross Margins could also be used for similar results.
A company’s net margin can be calculated by looking at its Income Statement. For example, consider Intuitive Surgical Inc’s (Ticker: ISRG). The company manufactures a robot that performs surgery in hospitals, a very unique product.
Look at ISRG’s previous Income Statement:
Calculate ISRG’s net margins by dividing Net Income by Total Revenue:
Which gives us 29.6%. This means for every $1 ISRG takes in revenue, it keeps nearly 30 cents to invest back into the business (or pay dividends, or buy back shares).
Compare this to a company like Amazon (Ticker AMZN) which consistently has net margins below 2%. Amazon is great at what it does, but that doesn’t necessarily translate into higher profits.
Investors looking for viable long term investments should consider a company’s margins. All other things equal, a company with higher margins will generate more profits than a company with lower margins.
Higher margins also tend to signal a proprietary product or way of running the business. Again compare ISRG and AMZN. One has cutting edge medical equipment, the other sells things online. Which one of those is proprietary and offers large margins and which one has to sacrifice margins to gain an edge? If a company is selling a truly unique product, it can charge nearly any price because there is no competition, which is quite a strong competitive advantage!
2) Low Research and Development to Sales Ratio
When a company is forced to spend large sums on research and development, it is a sign that it is in a rapidly evolving, highly competitive industry. In rapidly evolving industries, maintaining a competitive advantage can prove to be very hard as new products and technologies are constantly being introduced.
Consider, a company like Intel that must spend billions every year to keep equipment up to date and able to produce the most cutting edge technology. Then, a year later (or less) that technology is out of date and billions must be spent again.
Now compare that business model to a company like Clorox (Ticker: CLX), maker of laundry detergents, cleaners and other household products. How often do you think Clorox has to change the recipe for its laundry detergent?
With just a quick look at the income statements of Intel and Clorox we can see the difference:
Intel spends about 20% of its revenue on R&D (Research and Development).
Whereas Clorox spends just over 2%.
This is the power of a company like Clorox with a strong competitive advantage. Instead of having to spend the money to just simply keep the company viable, Clorox can invest in acquisitions (like its purchase of Burt’s Bees brand) and/or return money to shareholders (like its 3.3% dividend yield).
Clorox has to spend very little money to be able to keep fueling future sales, where a company like Intel must invest billions into its business just to remain relevant. That is the difference of a great company, and a great company with a competitive advantage.
3) High Amounts of Treasury Stock on the Balance Sheet
Another option for companies with lots of cash available to spend is to buy back its own shares. When shares are purchased but not cancelled out altogether, they are recorded on the balance sheet as Treasury Stock, or Treasury Shares.
Companies can buy back their own shares for a number of reasons; They may have excess cash they want to put to use, they may want to retain shares to fulfill future employee stock options, in order to prevent dilution of the current shares due to any employee stock compensation plans or just because management feels their shares are undervalued.
When a company buys back and retains its stock on the balance sheet as treasury stock it may reissue the shares at a later date. But until the shares are reissued or cancelled altogether, they receive no dividends, have no voting rights and lower the number of shares outstanding, which raises any per share calculations such as EPS (Earnings Per Share).
Consider Proctor and Gamble (Ticker: PG), which has repurchased over 12 million shares (Over $1 billion worth!) in the last year.
From the company’s latest 10-K:
(click to enlarge)
Some of these shares are held on the balance sheet until they are either cancelled entirely or re-issued:
If a company has the money to consistently buy back its own shares over time, it is a sign that the company possesses a strong competitive advantage.
Investors in companies that buy back large amounts of shares should ultimately see increases in the value of their shares as fewer and fewer outstanding shares remain and earnings per share amounts rise.
4) Low current ratio
No, that’s not a typo.
Current ratio is simply a company’s current assets divided by its current liabilities. Generally, it is used as an indicator on whether a company can pay its upcoming bills without having to take on more debt or sell off long term assets. A ratio of less than 1 indicates that the company has more bills due in the next 12 months than it currently has in current assets.
Let’s take a look at Budweiser (Ticker BUD) again. Here, we are looking at Budweiser’s Key Statistics page in Yahoo Finance:
Traditionally, this would cause investors worry. But is the world’s largest brewery really having trouble paying its bills? Of course not. Because of Budweiser’s tremendous earnings power it will have no trouble paying its bills, and in a worst case scenario Budweiser could easily access short term funding because of its financial strength.
Marry Buffett and David Clark talk about this in their excellent book Warren Buffett and the Interpretation of Financial Statements
“The funny thing about a lot of companies with a durable competitive advantage is that quite often their current ratio is below the magical one…which, from and old school perspective means that these companies might have difficulties paying current liabilities. What is really happening is that their earning power is so strong they can easily cover their current liabilities…because of their great earning power, they can also pay out generous dividends and make stock repurchases, both of which diminish cash reserves and help pull their current ratio below one.”
Of course, this is one indicator that should certainly not be used by itself, as a current ratio less than one really can identify troubled companies. However, when you are researching large well established companies and come across a low current ratio, don’t let that be the sole reason to abandon the potential investment.
5) Consistent profits
Does the company dependably produce profits year in and year out? Or is business like a roller coaster, fluctuating between losses and gains?
The answer can be a sign of a true competitive advantage, one that can help carry you through any bear market.
Consider the historical profits for 2 of America’s most famous companies, auto maker General Motors (Ticker: GM) and cereal maker General Mills (Ticker: GIS)
One is tragically exciting, the other was wonderfully boring.
One stock paid solid dividends during the 2008/2009 crash (and actually increased profits Year over Year!) While the other declared bankruptcy, wiping out 100% of shareholder value, despite making over twice as much money as the other just a few years prior.
Typically, it is advised to look back over 10+ years of income statements for evidence of solid and most importantly dependable earnings. Today, looking back 10 years means seeing how the company navigated the post tech-bubble boom, the 2008/2009 housing market crisis and today’s bull market…quite a variety of economic environments. Has the company consistently performed? Would you be willing to bet your retirement on how well they do over the next decade?
If so, it may be a sign of a durable competitive advantage.
6) Steady accumulation of cash
Cash is the lifeblood of every company. Without cash, a business wouldn’t last more than a day. Business has to be generating cash, and a company’s total cash on its balance sheet is a great sign on if it will be able to weather future turmoil.
But just as important as total cash is the consistency of its accumulation on the balance sheet.
Slow, steady accumulations clue investors in that the company’s business is solid and dependable.
However a company (even with a high sum of cash currently) whose balance sheet has unstable cash levels may be a sign of unpredictability in its core business. Sudden large influxes of cash could be a sign of dilutive share offerings, increased debt load or the sale of a previously existing business or asset.
There are several important indicators to look at on a company’s financial statements when identifying this indication of a competitive advantage.
First and foremost, the cash and change in cash levels of the business from year to year. This can be found at the bottom of the company’s Statement of Cash Flows report.
Shown below is Altria’s (Ticker: MO) Statement of Cash Flows from their latest 10-K:
Pay special attention to the last line. This is how much cash the company adds to its coffers each year from its business operations. A positive, stable number like this above indicates a strong competitive advantage, as the company is able to consistently operate business successfully.
If there is large changes in cash, there are a few places to look to identify where the cash is coming from.
Recall the Cash Flow Statement is broken up into 3 main sections:
- Cash From Operating Activities – Cash generated from actual business.
- Cash From Investing Activities – Cash spent on business investments, or selling segments of the business.
- Cash From Financing Activities – Cash from loans or bonds or the issuance of shares.
Cash from operating activities is good, and should be the primary cash generator over the long term. Increases in cash from financing activities is cash the company receives from taking additional debt in the form of loans or bonds or cash received from issuing shares.
Cash from operating activities is a stable source of cash if the company has a solid business, whereas cash from financing and investing operations is a sign that the company’s core business cannot generate the cash it needs to operate.
Once again, it is important to dig into the past decade of financial statements to be sure you are identifying long term trends.
A company that can consistently generate cash is one that can consistently deliver value for its shareholders. Where is a company’s cash coming from? If the company has a 10 year history of getting its cash primarily from operating activities, you may be looking at a company that will keep running strong for decades to come.
7) Inventory and earnings on a corresponding rise
Watching the inventory levels of a business can clue you into the strength of its business. Depending on the industry, inventory levels will vary. In a high tech company, inventory needs to quickly be sold off before it becomes obsolete. Instances where sales are declining and inventory is rising should send a warning to investors. In a company like 3M (Ticker: MMM) inventory levels may not play as much of a significance, because adhesives and sticky pads are unlikely to change in the near future and have long shelf lives.
Look for a long term steady and correlated rise in inventory levels AND earnings as a sign that demand is growing and giving the company a reason to stock additional inventory.
Take a look at a chart showing the Net Earnings and Inventory levels for 3M below. Notice how “in sync” the two values are? That is a sign of a great competitive advantage.
Companies that experience massive ramp ups in inventory for a year or two, followed by slowdowns may have to take large losses on lost inventory, and may not have the money to capitalize on future demand.
8) Low debt
We talked a lot about cash flow earlier. When a company has a strong competitive advantage, its business generates all the cash it needs for operations.
When large amounts of debt start to appear on a company’s balance sheet, investors need to start to question the reason for the debt. Has business slowed to where it can not cover the costs of the business? Is the company borrowing excessively for extravagant upgrades?
The cause of all debts can be hard to track down. Watch the last few years of earnings presentations (which can always be found on a company’s “investor relations” webpage) and see if the topic is discussed or if questions have been asked.
Debt is not always a bad thing, but too much of it nearly always is. How much is too much? Once again we quote Marry Buffett and David Clark in their book Warren Buffett and the Interpretation of Financial Statements:
“Warren’s historic purchases indicate that on any given year the company should have sufficient yearly net earnings to off all its long term debt within a three or four year earnings period.”
How do some of the companies we have evaluated in this article so far compare to this quote?
A company with a strong competitive advantage has no need to take on large amounts of debt, because the successful nature of its business generates more than enough cash by itself.
9) Retained earnings
When a company has money left over (i.e. turns a profit) it has several choices on what to do with the extra money. It can pay its shareholders a dividend, it can buy back its stock, or it can invest the money back into its business. When a company puts the money it earns back into its business it is recorded as retained earnings on the balance sheet.
The retained earnings number is cumulative. Each year the company either adds or subtracts to its previous retained earnings total.
For an example of a company’s retained earnings over time, see Disney’s (Ticker: DIS) Statement of Shareholder Equity from its latest 10-k filing:
Starting from the previous cumulative total in 2010, investors can see how each year of business has added to Disney’s retained earnings total. If Disney would have a loss next year, it would subtract from its retained earnings total.
This same data is also at the bottom of the company’s balance sheet:
What should investors look for in a company with retained earnings?
Retained earnings should be thought of as part of the company’s net worth. If a company is growing its retained earnings, it is expanding its net worth. If the company is not growing its retained earnings, or reducing its retained earnings, it is reducing its net worth.
And the best part about this is that over time, compounding interest starts to take effect. As the company re-invests into itself, earnings begin to grow at a faster and faster rate which means the company’s net worth begins to grow at a faster and faster rate. This is how Warren Buffet has been able to raise the book value of Berkshire Hathaway from $19 in 1965 to more than $172,000 today! (Berkshire Hathaway has never paid a dividend, Warren Buffett has always kept every dollar in profit as retained earnings throughout his career.)
So finding a company which has a long history of rising retained earnings is a sign of a strong competitive advantage, and one that can help make you a lot of money.
How has Disney done since 2006?
Which is an annual rate of 12.34%! Which is a phenomenal growth rate (Buffett has a ~23% Growth rate since 1965) and a great indicator of Disney’s immense competitive advantage.
Most investors today have decades left to save and invest for retirement. What is your best bet for long term capital growth? Instead of flocking to the next high flying internet start-up or electric car maker, use the list above as a basis for selecting companies that have, and will continue to, stand the test of time and offer consistent sustainable growth.
Interested in learning more about finding companies with a competitive advantage? Begin To Invest has gone into in depth detail discussing several chapters of Michael Porter’s excellent book Competitive Strategy. You can find our posts on chapter 1 here, and chapter 2 here.