Nolsen Bedon, Ltd.

In medieval times, a moat protected a castle from attacks. You’re looking for something comparable here. You’re trying to find a business to invest in with a sustainable competitive advantage that means it will be difficult for other companies to compete against it. The wider that figurative moat is, the more difficult it will be for someone else to enter the market. And in turn, the greater the degree of certainty for you as an investor.

As a rule of thumb, you want to invest in companies that will continue to perform well for at least the next twenty years. You want to look for companies that have a sustainable moat. In the modern world, the five usual business moats are:

1. A well established brand name — meaning customers are willing to pay more because they trust what the company offers. (Coca-cola, Disney and McDonald’s are great examples).
2. A proprietary trade secret — the company has some type of intellectual property protection in place. (Notable examples of these types of companies are Intel and Pfizer).
3. Control of a toll gate — the business has exclusive control of a marketplace enabling it to collect a toll from anyone wanting access. (Media companies sometimes have this).
4. High switching costs — so it becomes uneconomic for existing customers to switch suppliers. (H&R Block and Microsoft do this very well).
5. Operational or price efficiencies — a business that has economies of scale nobody else can match. (Wal-Mart and Home Depot are very good examples of this type of moat).

Companies with one or more of these moats will have predictable and durable revenue streams, so it is easier to forecast what they will be worth in the future. These moats also mean the company is less likely to go out of business altogether. Your objewctive as an astute Rule #1 investor is to find businesses that have wide moats, buy them when the market has temporarily priced them too low for whatever reason, and then either continue to hold on to them or resell them again when the market has repriced them at their true market value. The more confident you are in the company’s moat, the greater the degree of certainty you can and should feel when you buy shares in these companies. Wide-moat companies can undergo some appreciable changes in price, just like any other stock. They key is to use these price movements to your advantage.

So how, exactly, do you tell whether or not a company has a sustainable moat? If a business has a moat, there are five numbers that will be 10 percent or greater on average for the previous ten years. These “Big Five” numbers are:

1. Return on Investment Capital (ROIC)
2. Sales (or revenue) growth rate
3. Earnings Per Share (EPS) growth rate
4. Equity or book value growth rate
5. Free Cash Flow (FCF) growth rate

Note that not all of these growth rates are of equal importance. Calculate ROIC first and then look at the other four growth rates. A ranking list of these growth rates from most important to least important would look something like this:

1. Equity growth
2. EPS growth
3. Sales (or revenue) growth
4. FCF growth

That means if you focus on the ROIC, equity and EPS growth rates first, that will be a good screening test. Once a company makes the grade in these areas, you then go ahead and calculate the rates of growth of sales (or revenue) and FCF.

The best places to go to get the Big Five numbers for any company you’re considering investing is at free financial information websites like:

• MSN Money — moneycentral.msn.com
• Yahoo! Finance — finance.yahoo.com

You can also subscribe to some of hte more detailed and fancier subscription services if you want to carry out higher-quality searches for financial information, but you’ll actually be able to do more than 99 percent of the research you need using the free websites and a basic computer spreadsheet like Excel. Once you’re completely up to speed on how to calculate the Big Five using the free websites, maybe then it will make sense to invest in subscription services.

Once you calculate the Big Five and come up with a company that looks good, there ar ealso two other numbers you should carefully look at:

• The amount of debt the company has — which ideally should be zero. As a good rule of thumb, however, as long as a company can pay off all its debt with three years of free cash flow, then its debt load is reasonable and manageable. You’ll usually find most companies that have strong Big Five numbers will also have debt under control but if debt is higher than this, that should be a red flag.
• The amount of dividends the company pays out — which is a management decision more than anything else. Whether a company pays a dividend or not should have no bearing on how you apply Rule #1 in investing. Some businesses with very wide moats don’t ever pay a dividend, others in comparable situations do. Dividends are neither good nor bad on their own, but should simply be noted.

Rule #1

Trackback URI |