Of moats, compounders and business models (Part 2)
Hello everyone,
Thank you for the incredibly positive response to my last post and part 1 of my stock selection. I didn't want to keep you in suspense for too long and finally found a few hours of time for Part 2, in which I'd like to give you more insights into my company picks. Enjoy!
I recommend everyone who has not yet seen the last post to read this one first (https://getqu.in/aX61yv/), because the posts build on each other!
Disclaimer: This is my personal investment strategy to my own investment horizon. This strategy is not set in stone and can be adapted at any time. I hope you can take something useful from this for your own strategy, but I do not recommend anyone copy any content without doing their own research. ⚠️
I really appreciate your feedback, sit back, the post has become a bit longer again. 😜
First of all, the overview again:
Phase #1 (Part 1 - last post: "All key figures of my stock valuation") ✅
Today I will show you Phase #2 and Phase #3 where, in contrast to the overview in Part 1, there have been a few minor changes (🆕) that I will explain to you afterwards - as mentioned in the disclaimer, nothing is set in stone 😉
Phase #2 (Part 2 - this post)
- Moat + ESG
- Morningstar MOAT Rating
- Morningstar ESG Risk
- Compounder? (removed Profitability Rank, Mohanram G-Score)
- Financial Strength Rating 🆕
- FCF / Share 10Y CAGR 🆕
- Gross Margin 5Y CAGR 🆕
- Predictability Rank 🆕
Phase #3 (Part 2 - this post)
- Business Model Understand
- Comparison with the competition
--> What remains after this: Inclusion in my "Investable Universe"
Phase #4 - My valuation model (part 3 - contribution desired?)
- FCF Yield
- Valuation Framework
- Comparison 5Y FCF CAGR with required future 5Y FCF CAGR to achieve market P/E.
- GF Fair Value
- Morningstar Fair Value
Result of part #1:
At the end of phase #1 I received a first score, which is the sum of the achieved points and can reach a maximum of 35. The points from "Margin" and "Profitability / Efficiency" are still added up to a "Quality" score.
Phase #2 is reached by all those stocks whose Phase 1 Score is >= 18, whose Quality Score is at least 13 and whose Growth Score is at least 2 (no negative growth).
This has already sorted out some companies in Phase 1, only every fourth company I have looked at so far in Phase 1 made it to Phase 2. One or the other might notice that whole sectors will most likely not make it to Part 2. And that is intentional. There are sectors that historically outperform the market (Software, Consumer, Healthcare) and sectors that consistently underperform and should not be in my portfolio (Banks, Energy, Insurance, Mining, Airlines, Utilities...).
So let's start with Phase #2.
Here, my first focus is on the MOAT rating, which is essential for me. For this I use the Morningstar MOAT Rating.
An "Economic Moat" or Competitive Advantage indicates how likely it is that a company will keep the competition at bay over a longer period of time. Companies with a competitive advantage are always one step ahead of their competitors. Morningstar distinguishes between a wide moat and a narrow moat. There are five factors that give companies an economic advantage. 🏰
A network effect exists when the value of a service to new and existing users increases as more people use the service. Example: Visa/Mastercard - the more consumers use it, the more attractive the payment network becomes for merchants, which in turn makes it more attractive for consumers (cycle). 🕸
The next competitive advantage lies in Intangible assets.. These include patents or regulatory licenses, which often provide a competitive advantage, especially for pharmaceutical companies. In addition, brands are another important aspect that enables a company to charge higher prices and makes it more difficult for competitors to enter the market (example LVMH). ™
The third possible competitive advantage lies in a simple Cost advantage.. Companies with a structural cost advantage can either undercut their competitors on price while achieving similar margins, or they can charge market prices while achieving relatively high margins. 💸
Switching Costs (Switching Costs) are the next obvious competitive advantage If it is too expensive or cumbersome to switch to a competitor's product, this indicates pricing power. An example of this is Nemetschek's software or, in the current trend, the battle of the cloud giants. 💱
The last possible competitive advantage lies in Efficient scale.. If a niche market is effectively served by one or a few companies (example Railroads) building the same line by a competitor is too expensive and not profitable. 🤏🏻
These competitive advantages are easy to identify on your own, a paid subscription to Morningstar Investor to obtain their assessment is absolutely not necessary, just simplifies things a bit. A good indicator for a competitive advantage is also the ROIC, which has already been discussed. ⚠️
So why are competitive advantages so important? Everyone should know that the Oracle of Omaha, Warren Buffet, has been building on competitive advantages for decades. ""What we're trying to do," he said, answering a question from the audience, "is we're trying to find a business with a wide and long-lasting moat around it, surround -- protecting a terrific economic castle with an honest lord in charge of the castle.""
And even in the sheer numbers, the advantage of a MOAT can be seen -- and it's huge. The median annualized 10-year total return of wide-moat companies (11% p.a.) and narrow-moat companies (9% p.a.) beats no-moat companies (2.9% p.a.) by FAR.
For some companies Morningstar still gives a trend and distinguishes here between Positive, Stable and Negative.
Accordingly, I award points. A Wide&Positive MOAT gives 5 points, Wide&Stable 4.5 points, Narrow&Positive 3.5 points, Narrow&Stable 3 points. A Negative Trend gives one point deduction for a Wide-Moat, 2 points deduction for a Narrow Moat, the same for no competitive advantage.
The influence of the MOAT is thus very large in my model - and as a small spoiler: In my Investable Universe there is no company with a negative trend and with Clinuvel Pharmaceuticals only one company which has no competitive advantage according to Morningstar, which I see differently.
The next point I look at is the ESG riskto include a little bit of the environmental aspect, which I think will become more and more important in the future. With this, I just want to weed out companies that are too high risk. Morningstar assigns 1 to 5 "Globes" (points) for this. Where 5 is the lowest risk (negligible), and 1 Globe is a severe risk. Here I distribute the points as follows: 5 Globes (negligible) = 3 points, 4 Globes (low) = 2 points, 3 Globes (medium) = 0.5 points, 2 Globes (high) = -3 points, 1 Globe (severe) = -5 points. (Source Morningstar Investor). 🌳
Part 1 of Phase #2 we have thus ticked off. Now let's move on to the second part, which is about the last key figures of my model and the "Compounding".
Compounding is a term used by Joseph Carlson and other super investors I follow and is simply a way of summarizing the overall strategy. Compounding describes reinvesting earnings to generate additional profits over time - so it's nothing more than the compound interest effect we all follow reduced to one company. Compounders are companies with high returns on capital, permanently growing earnings and competitive advantages that guarantee long-term value growth - these are exactly the companies I filter out in my model.
In this second part of Phase #2 I picked out some more summary indicators that take into account several factors and result in a kind of "compounder check" - which is only fulfilled if all indicators fit (no scores - only yes/no). For this post I took a closer look at the available scores and ranks from gurufocus and decided to adjust them a bit. The Profitability Rank was removed, because it summarizes exactly the aspects I have already covered and would therefore be duplicated, only the Predictability Rank would have been new, so I took it out as a single indicator. The Mohanram G-Score makes more sense for mainly growth companies and was therefore removed.
The first indicator used here is the Financial Strength value, which is based on three factors: Interest Coverage is a ratio that determines how easily a company can pay interest expenses on outstanding debt. It is calculated by dividing a company's operating income by its interest expense. The higher, the better.
The second factor Debt to revenue ratio. The lower, the better.
And the Altman Z-score - an accurate prediction of default up to two years before the emergency.
Based on this, Gurufocus calculates a score of 1-10, a company with a rank of 7 or higher is very unlikely to experience distress. Companies with a rank of 3 or less are likely to be in financial distress. The Financial Strength Rank was integrated as Phase #1 only the Debt-to-EBITDA ratio looked at debt, to provide a little more certainty here. For the Compounder Score, companies with a score >= 5 are accepted. (Link to the Financial Strength Rank: https://www.gurufocus.com/term/rank_balancesheet/ADBE/Financial-Strength/Adobe) 💪🏻
The FCF/Share 10Y CAGR is in my opinion the ultimate and most important growth metric as it also takes into account Stock Based Compensation in contrast to the simple FCF growth. Here I would like to have at least 5% for the compounder check. If the FCF/Share 10Y CAGR is >10%, there is an extra point in the total score.
Because of the score scheme in Part 1 also companies with a Gross Margin <50% can reach Part 2, the CAGR of the Gross Margin has been integrated on a 5 year basis to filter out those stocks that have a margin decline at Gross Margin <50% haben. Heißt der Compounder Check ist erfüllt, wenn entweder die Gross Margin >50% or if it is lower, the margin is moving in a positive direction. In addition, if a company has a ROCE <15% and the growth of the other growth ratios from part 1 must also be positive everywhere.
If this is the case, the compounder check is fulfilled.
The Predictability Rank is a final "metric" that gurufocus has developed itself. In this, they evaluate the predictability of companies based on the consistency of their revenue per share and their EBITDA per share over the last ten fiscal years and examine the correlation between stock performance and predictability the business. The ulterior motive here is to make Warren Buffet's statement that he wants to buy companies with "predictable and proven earnings" more tangible. For this, stars from 1-5 are assigned, which are added to the total score in my model. For a Predictability >3 stars an extra point. (Link to the Predictability Rank: https://www.gurufocus.com/term/predictability_rank/ADBE/Predictability-Rank/Adobe)
THAT's it with key figures and Co. phase #2 is checked off.✅
As a result of phase 1 and 2, we now have a total score and a compounder check (true/false). All companies with a total score >= 30 and a positive Compounder Check will now be selected for my Investable Universe and reach phase #3.
Phase #3 deals with the part that is extremely neglected by many in my eyes. I can't write too much about this, because there are no numbers or concrete procedures, so I would simply like to give you a few tips. The most important question that everyone should ask themselves is:
Understand I the company and its business model?
No matter how good a company's numbers are, if I don't understand how a company makes its money, I can't invest my own money in it. Look at the company website, read company reports and not Instagram posts, look at investor relations, company management....
Listen to your gut - read that right - gut, at least in one direction. You've already filtered out so much in the first two phases, if your gut tells you here that you don't feel comfortable with this or that company, don't invest.
Look at the competition What does your company do better than the competition? If several companies from one industry made it into your selection, compare the numbers. ROCE in particular is also a great way to compare companies in the same industry.
So, that's it for now. I'm going to enjoy the Croatian heat for a bit now. 🥵
Are you interested in part 3?
Thanks for your feedback, I hope you enjoyed the post!
❤
-Tom
(And THANKS to all the ccf nominations in the last post to et al. @RoronoaZoro
@Hannes_SK and all the others)
Sources (besides those mentioned in the text):
https://www.investopedia.com/terms/g/grossmargin.asp
https://www.morningstar.com/investing-definitions/economic-moat
https://finance.yahoo.com/news/warren-buffett-explains-moat-principle-164442359.html
No investment advice