The most important factor for long term stock picking is selecting a business with a strong competitive advantage. A strong lasting moat and a reasonable purchasing price increase the chances of long term investing success. Selecting good stocks for long term comes down to finding a business with a lasting competitive advantage.
If you want to invest long term, then you need to ensure that the business still exists in the future! This will also decrease the chance of losing money significantly. After all, not losing money is the most important rule of Warren Buffett. Warren Buffett has the long term in his mind when thinking about this rule. Not short term market volatility that might send down the stock price temporarily.
I’d like to share that much of my knowledge comes from reading. I discovered some great books that can help you to become a better investor and to improve your mindset. Please check my overview page where I have summarized these for you: https://www.financeandinvestingfacts.com/best-investing-books/
What is a moat or competitive advantage?
Moats (also known as a competitive advantage) are of enormous importance if you want to increase the chances of investment success over the long-run. The competitive advantage is the advantage that a company enjoys compared to the competition. For example by having lower costs or a stronger brand that provides more value to consumers.
Select a stock with a strong moat
The best long term stock pick is a business that you understand with a lasting competitive advantage that can achieve consistent high rates of return on investments. Then you can just wait for years, while the business is earning more money each year. The stock price will follow the earnings in the long-run. This is just what Warren Buffett and Charlie Munger are basically doing. They make a few big bets on strong companies and then wait for years.
If you are unsure of selecting a business with a moat then it might be best to simply buy an index fund. If you are capable of understanding business economics then general diversification advice makes no sense to you. It is far better to select a couple of businesses (say around 5 to 10) over the years. It is important that you understand this company very well and are able to say with high certainty that the earnings will increase over time due to the moat.
Understand the position of the company in its industry
The competitive position of a business in its industry is essential to understand. A long lasting moat makes a business a fortress that is very well protected against the competition. A business also need a very good manger who is investor orientated and able to allocate capital wisely. The castle (business) needs a big moat (competitive advantage) and a good king is what Warren Buffett says about investing.
What are the types of moats of a company?
The most important moats are a cost advantage (higher margins and the ability to transfer value to consumers) and a brand (value to the consumer). The strength of the moat differs per company. Coca-Cola and Nike both have a strong moat, but some might argue that the brand of Coca-Cola is stronger. Note that these companies are in very different industries.
Competitive advantage categories and company examples:
- Intangible assets like a brand, customer position, reputation, patent, intellectual property and a trade mark (Coca-Cola, Disney, Apple)
- Network effect (MasterCard, Facebook)
- Cost advantage and economies of scale (Costco, GEICO)
- Switching costs (SAP, Oracle, Microsoft)
- Toll bridge moat which is a monopoly/only place to get product or service (only newspaper or tv station with significant advertisement revenue; Duke Energy)
It is fair to argue that companies can have multiple moats, but most of the time one moat is clearly stronger than the other. Google has a strong network but you could also argue that the name itself is a moat. Their search engine is very powerful and useful to people. Machine learning and new data ensure a dominant position. This allows Google to use very effective marketing which helps their customers to build brands and generate sales.
Costco is famous for having low margins and allowing consumers to buy goods cheaply. The high turn-over rates still lead to excellent returns on capital. A brand like Coca-Cola can be seen as a customer franchise that allows the business to ask higher prices. What memories do you have when thinking about Coke?
A look at MasterCard’s annual report
The moats of businesses are often mentioned in the 10-K (annual report). Let’s look at an example of MasterCard first. Later on I will describe Facebook and Amazon. In the latest 2019 annual report we can read the following about MasterCard:
Mastercard is a technology company in the global payments industry that connects consumers, financial institutions, merchants, governments, digital partners, businesses and other organizations worldwide, enabling them to use electronic forms of payment instead of cash and checks.
MasterCard Annual Report 2019
We authorize, clear and settle transactions through our core network for our issuer customers in more than 150 currencies and in more than 210 countries and territories.
MasterCard Annual Report 2019
MasterCard’s competitive advantage is seen in the 10-K
Page 16 of the annual report shows that MasterCard’s competitive advantages include (I mention only the first 3):
- Globally recognized brands
- Highly adaptable global acceptance network built over 50 years which can reach a variety of parties enabling payments
- Global payments network with world-class operating performance
I’m using MasterCard products myself for many years via my bank. MasterCard has the network and trusted brand that allows the company to process payments worldwide (just like Visa). They basically collect fees and don’t worry about providing the cards or credit. That is done by other companies (e.g. your bank). This allows MasterCard and Visa to earn very high returns on invested capital. Please look up the stock price to see what the growing free cash flow did to the share price over the last 10 years.
Essentially, we do need to be careful because a business can lose its moat. This is up to the investor to determine and can only be done with the right amount of knowledge. Examples of businesses with a moat can also be found in my previous blog.
Warren Buffett and his description of moats
The moat is crucial to ensure that the business can earn sustainable high returns on invested capital over the years. Warren Buffett (and his partner Charlie Munger) are mentioning this in many interviews. Below are some quotations from his letters to shareholders:
Moreover, both Coke and Gillette have actually increased their worldwide shares of market in recent years. The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles. The average company, in contrast, does battle daily without any such means of protection. As Peter Lynch says, stocks of companies selling commodity-like products should come with a warning label: “Competition may prove hazardous to human wealth.”
Warren Buffett, 1993
Buffett gave more moat examples in 2007:
A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express, Disney) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed. Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
Warren Buffett, 2007
You’d like to see a lasting competitive advantage in a stable industry. Ideally, cash flows steadily increase which makes it way easier to make a reasonable estimation of the value of a stock (see DCF Analysis).
Selecting a long term stock
The qualitative part of the analysis is understanding the moat and the ability to explain the business model. That is, how does the company earn money and how will the company earn money? Why is the company better than the peers in its industry? Is the management honest and capable? Will the company enjoy an advantage over the competition in the future?
Furthermore, ensure yourself that capable and integrate management is running the business. Reading the quarterly earning discussions will help to check if management was honest about their business. Also Google the persons and read the letters of the CEO and the management discussion in the annual report.
The next thing to research are the financials of the company. I would recommend looking at the last 10 years to ensure that for example the margins are stable and that the income was positive in each year. Some variability in earnings is allowed if there is a good explanation (e.g. a crisis or fixable problem).
Financial superiority of stocks with a moat
Crucial are the margins, free cash flow, return on investment, and adding value over time by making sure that each dollar that is retained increases the market price with at least a dollar. Companies with a proven competitive advantage have higher margins and turnover ratios. That means higher returns on invested capital than the competition. This in turn means more free cash flow and less need for debt (see e.g. the Facebook example below). Such a business is very safe!
Basic economic sense should enforce the understanding that a business can never sustain high margins if it does not have a moat. The competition will copy a successful business concept and take away a part of the profits. E.g. if a restaurant does well in a town then this could lead to more restaurants.
Typical steps for picking a long term stock:
- Have a good understanding of the industry standards (e.g. debt levels, margins, growth, CAPEX needs, general trends) and the company (why will it outperform the industry)
- Understand the business model and moat (how the company makes money) and the key variables that drive the income of the company and sector now and in the future
- Read and analyze at least: the annual reports, quarterly report, presentations, earnings calls, insider buying/selling and Google the company and management (repeat for the biggest competitors)
- Ensure that the financial statements are providing an honest view (read the notes to the statements in the annual report)
- Analyze the financial strength and profitability of the business first before looking at per share data
Next, figure out what the business is worth
- Look at the 10 year data for (the pattern should be stable or improving ideally): margins, turnover, return on invested capital, growth, stability of earnings and free cash flow, interest coverage and debt repayment strength (debt/FCF < 3 years as a rule of thumb), and dividend record (optional; a strong stable company with low debt can pay dividends with a higher certainty)
- Analyze the per share data like earnings and cash flow per share growth at the end (high growth rates are not always sustainable)
- Figure out at what rate the company can compound its earnings (the returns on the incremental future investments)
- Value the stock with a DCF analysis (if the business is stable and understandable. Remember that paying a little more for an outstanding company is better than buying a mediocre business cheap in general due to the compounding certainty)
- Have the ability to explain the quantitative and qualitative steps in layman’s terms in a 2 minute investing pitch
Good stock selection requires effort
Note that most of the information can be found on the investor page of the company. It should be noticed that this will take a lot of time. But it is the only way to ensure yourself of a sound investing decision for the long term. It is dangerous to your financial well-being to buy stocks without doing proper research. Index investing can limit the amount of research significantly.
Looking at the stock picks of investors like Warren Buffett can help to generate ideas. Luckily, knowledge compounds so research time will decrease over time as you learn more. But a fair warning should be given that simply buying a stock without doing the research might not enable you to have the mental strength to believe in your stock pick. Furthermore, investors like Warren Buffett have sometimes different deals then ordinary investors can make and their buying price might differ significantly.
The big advantage of long term investing
A long term stock picker does not have to worry about monthly or even yearly movements in the stock price. Recessions or market down terms should also be largely ignored. You just have to make sure that the business can reinvest its earnings against good returns. For example in new medicine or a new data center to increase future profits.
The individual investor does not have to worry about quarterly reporting and answering portfolio return questions like professional money mangers have to do. This is a huge advantage! Because it is very likely that your stock picks will not perform well during each given year. But a good business will be able to do very well over 5 year period if the company can reinvest its money against high returns.
Dividends compound over the long term
Established companies like Coca-Cola and Johnson & Johnson pay dividends as they are likely not able to invest all the earnings in high growth opportunities. Increasing earnings over the years will allow these companies to pay more dividends. A dividend is just a part of the earnings that is paid to the shareholder.
The yield on cost is the dividend divided by the share price. If you hold on to Coca-Cola for 10 years and the dividends doubled in 10 years then your yield on cost will also double. Quick example of Coca-Cola from the figure below. In 2010 the stock price was approximately $20 and the dividend per share $0.64. The yield (return) is then 0.64/20 = 3.2%. The dividend in 2020 is $1.61.
Yield on cost in 10 years for Coca-Cola
My yield on cost (because I bought the shares at $20) is then 1.61/20 = 8%. As a bonus, the stock price also more than doubled in the 10 year period. 20 dollar to 50 dollar in 10 years is a roughly 9.6% compounded annual growth rate. Obviously, this superb result can only be achieved by selecting a great business without overpaying and then holding on to the stock for years!
The competitive advantage of Amazon
Amazon’s competitive advantage is a good example of a network and cost moat. The growing network of Amazon over the years leads to further efficiency and cost advantages. Please find a summary of the moat of Amazon below that I’ve made based upon interviews of Bezos and investor relation material.
Amazon strategy consists of the following main points:
- Increase efficiency
- Increase customer satisfaction (obsessive customer focus)
- Invent the future (AWS cloud for example)
- Operational excellence (selection, price, fast and convenient delivery)
Bezos understands that the stock price is largely determined by the free cash flow and the return on invested capital. So he will improve those factors to increase the stock price in the long-run. Bezos said that he is willing to make some big riskier investments in order to have large rewards in the future.
Free Cash Flow can be increased by less costs and this can be achieved by making less fulfillment mistakes in the warehouses of Amazon. This will also lead to more happy consumers and hence higher profits. This relates to the network effect of Amazon where a better customer experience leads to more sellers and traffic. So more sellers and buyers will use the platform and this will reinforce itself.
Summary of Amazon’s competitive advantage
I’d say that the growth of Amazon can largely be explained by: happy consumers, more sellers, more choice, more visitors, lower prices, economies of scale and then coming back to a great customer experience and an improving reputation. This is a great example of a picking a stock with a moat to increase the long term chances of success. Unfortunately, the price of Amazon stock is also often very high due to these qualities.
Remember, the stock price will follow the earnings in the long-run. Higher earnings, higher stock price (given an equal multiplier). Even better, if earnings go up during longer times, then the market is willing to pay a higher multiple. The stock price is simply the earnings per share multiplied by the multiple. The latter is higher if the prospects of a company are seen as good by Wall Street.
You can watch the interview of Bezos where he describes the moat of Amazon here: https://www.youtube.com/watch?v=psPf-tx9OwY.
I would also advice to check out the Investor Relations page of Amazon.
Research for selecting a long term stock
Moats lead to high margins and the ability to earn plenty of free cash flow. A good brand or products requires relatively little additional capital expenditures which means more money is available to the shareholders. For example for debt repayment, dividends and share buybacks.
Good long-term stocks show a stable pattern over long periods. Always check this of at least the last 10 years. Let’s look at Facebook here as I’ve used examples of Apple, Google and Amazon already in previous articles.
Note that I’m often using these companies because of the moat and safety for investors. The most money will be made if you discovered Amazon 20 years ago. Luckily, good and safe profits are still possible with these companies in my opinion.
Facebook enjoys strong network effects
Facebook is able to capture the time of people and developed a business model that lets its user build the content. Facebook’s mission is to give people the power to build community and bring the world closer together. It is basically a media company that has more than 2 billion readers. The network effect is very strong and attracts people and businesses. Facebook also owns WhatsApp, Instagram and Oculus (a virtual reality company) which means there are plenty of growth opportunities. Understanding the moat and any long term risks is crucial.
The gross margins are huge as there is basically no inventory (costs of goods sold is low). Facebook can offer very efficient advertising possibilities to its customers which is the main driver of the revenue. This information can be seen in the annual reports and presentation on the Facebook investors page (always check this for each company).
Digital advertisement industry
A quick industry analysis which is relevant for Google and Facebook. The digital advertisement market is going to grow significantly from roughly 300 to 500 billion USD in 3 years (67% up; source Statista). The question is: how much share can Facebook and Google take? And what additional opportunities do they have? Is there risk of losing market share due to competitors or regulation? The latter question is also answered in the annual report of the company. See page 9 for the risk factors of Alphabet (Google) as an example.
Key ratios of Facebook
Morningstar provides the investor with easy tables that summarizes the data of the last 10 years and the trailing twelve months (TTM) financials. Try to go over each line and see if you understand the meaning behind the numbers and check if things are improving.
Note that we can see in the table below that Facebook enjoys excellent profitability numbers without long-term debt. That is why the interest coverage is zero as of 2016 (there is no interest on the debt to be paid). The crucial part for the long-term investor is to figure out if Facebook can continue this trend over the years. Will people still be on the platforms in 10 years? If the answer is yes, then you need to figure out what a reasonable price would be to still make a decent profit.
What do the Facebook financials tell us?
The figure below shows the increasing free cash flow per share over the last years. The price is increasing over time with a few bumps now and then. Facebook had (has) privacy issues and was required to pay large amounts of fines which lowered the share price. Note that Facebook pays a substantial amount of money to its employees in the form of stocks. I believe this is a fair treatment of rewarding your employees and this can improve the long term relationship between the company and its employees.
Accounting standards treat stock payments as non-cash expenses. These are added back to the operational cash flows and treated as a non-expense. Many investors like Warren Buffett will see this as an expense. Additionally, the CAPEX also includes growth investments and hence the maintenance CAPEX is lower. These adjustments to the Free Cash Flow are examples of what you need to do to come to a reasonable estimate of the financial power. Facebook free cash flow per share shows a stable increasing pattern (see figure below).
What Warren Buffett looks for when long term stock investing
Warren Buffett is arguably the best long term investor with the best mind set that I know. It is often a smart thing to try to learn as much as possible from people that are successful and honest.
Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago… a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.
Warren Buffett, 1987
Buffets says that it helps to find a business that will likely be doing the same thing in 5-10 years that it’s doing now. This makes it understandable, stable and will mean that the business does not have to spend much money to keep on reinvesting. Also, this allows the business to further build the consumer relations.
Questions that Warren Buffett asks before buying a stock
Buffett said in interviews that he always asks questions like: can the business be replicated with 50 billion dollars? Can you build a second Coca-Cola for $100 billion or 500 billion dollar? You want to figure out what is in the mind of the people in the world about a brand now and in 10 or 20 years. What are the associations with the brand? Does the brand make you happy and gives you good memories like Disney or Coca-Cola do?
See this video where Warren Buffett talks about the consumer mind. It is about a share of the mind of the consumer. You need to figure out if this brand can grow along with the growth of the people and their income. Like we did for Facebook and Google by looking at the digital advertisement market.
Summary of how to pick stocks for the long term
- Find an understandable business with a future proof moat, good management and high returns on capital (you’re probably using their products and services)
- Do enough research to really know the numbers and the industry
- Make sure your behavior and attitude is adequate for long term investing
- Have a long term vision about your business
- Calculate your buying range and do not overpay for a stock
- Keep the stock as long as the business can increase its intrinsic value
Think up-front if you think you will get nervous from decreasing prices of your long term stock pick. If yes, then you might want to reconsider your choice. Obviously, you need to ensure you have enough money (an emergency fund) and don’t invest it all at one point in time. Cover your costs for months and enable yourself to take advantage of declines.
Your goal as an investor is to pick a few stocks of which you can say with high certainty that they will grow their earnings over time. Don’t get distracted by the daily news but focus on the quality of the business as Buffett mentions about selecting a stock portfolio.