Hello everyone,
Thank you for the incredibly positive response to my last post and part 1 of my stock picks. I didn't want to keep you in suspense for too long and have finally found a few hours for part 2, in which I would like to give you further insights into my company selection. Enjoy!
I recommend anyone who hasn't seen the last post to read this one first (https://getqu.in/aX61yv/), as the posts build on each other!
Disclaimer: This is my personal investment strategy for my own investment horizon. This strategy is not set in stone and may change at any time. I hope you can take something useful from this for your own strategy, but I do not recommend anyone to copy any of the content without doing their own research. ⚠️
I really appreciate your feedback, sit back, this post has gotten a bit longer again. 😜
Let's start with an overview:
Phase #1 (Part 1 - last post: "All key figures of my stock valuation") ✅
Today I'm going to show you phase #2 and phase #3 where, in contrast to the overview in part 1, there have been a few minor changes (🆕) which 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? (removes Profitability Rank, Mohanram G-Score)
- Financial Strength Rating 🆕
- FCF / Share 10Y CAGR 🆕
- Gross Margin 5Y CAGR 🆕
- Predictability Rank 🆕
Phase #3 (Part 2 - this article)
- 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 of 5Y FCF CAGR with required future 5Y FCF CAGR to achieve the market P/E ratio
- GF Fair Value
- Morningstar Fair Value
Result of part #1:
At the end of phase #1 I have received a first score, which consists of the sum of the points achieved and can reach a maximum of 35. The points from "Margin" and "Profitability / Efficiency" are added up to a "Quality" score.
Phase #2 is reached by all those shares 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 weeded out some companies in phase 1, but only one in four of the companies I have looked at in phase 1 so far has made it into phase 2. Some of you may notice that entire sectors are highly unlikely to make it into 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.
My first focus here is on the MOAT rating, which is essential for me. For this I use the Morningstar MOAT rating.
An "Economic Moat" or in German 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 able to stay 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 (network effect) occurs when the value of a service increases for new and existing users when 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 (intangible assets). These include patents or official licenses, which often provide a competitive advantage for pharmaceutical companies in particular. Brands are another important aspect that enables a company to charge higher prices and makes it more difficult for competitors to enter the market (e.g. LVMH). ™
The third possible competitive advantage lies in a simple Cost advantage (cost advantage). Companies with a structural cost advantage can either undercut their competitors on price and achieve similar margins, or they can charge normal market prices and achieve 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 (efficient scaling). If a niche market is effectively served by one or a few companies (e.g. railroads), it is too expensive and unprofitable for a competitor to build the same line. 🤏🏻
These competitive advantages can be easily recognized by yourself, a paid subscription to Morningstar Investor to get their assessment is absolutely not necessary, just simplifies the whole thing a little. Another good indicator of a competitive advantage is ROIC, which has already been discussed. ⚠️
So why are competitive advantages so important? Everyone is probably aware that the Oracle of Omaha, Warren Buffet, has also 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 the advantage of a MOAT can also be seen in the pure figures - and this is huge. The average 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.
Morningstar also indicates a trend for some companies and distinguishes between positive, stable and negative.
I award points accordingly. A Wide&Positive MOAT gives 5 points, Wide&Stable 4.5 points, Narrow&Positive 3.5 points, Narrow&Stable 3 points. A negative trend results in a deduction of one point for a Wide-Moat, 2 points for a Narrow Moat and the same for no competitive advantage.
The influence of the MOAT is therefore 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 there is only one company which, according to Morningstar, has no competitive advantage, which I see differently.
The next point I look at is the ESG riskto include the environmental aspect, which I believe will become increasingly important in the future. I simply want to weed out companies with too much risk. Morningstar awards 1 to 5 "Globes" (points) for this. Where 5 represents the lowest risk (negligible = negligible), and 1 globe represents 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. Let's now move on to the second part, which deals with the final key figures of my model and the "compounding".
Compounding is a term that is often used by Joseph Carlson and other super investors that I follow and is simply a way of summarizing the overall strategy. Compounding describes the reinvestment of earnings to generate additional profits over time - nothing more than the compound interest effect that we all follow reduced to a company. Compounders are companies with high returns on capital, permanently growing earnings and competitive advantages that guarantee long-term value growth - it is precisely these companies that I filter out in my model.
In this second part of Phase #2 I have picked out some summarizing indicators that take several factors into account and result in a kind of "compounder check" - which is only fulfilled if all indicators match (no scores - only yes/no). For this article, I took a closer look at the available scores and ranks from gurufocus and decided to adjust them slightly. The Profitability Rank was removed because it summarizes exactly the aspects that I have already dealt with and would therefore be duplicated, only the Predictability Rank would have been new, so I removed it as a single indicator. The Mohanram G-Score makes more sense for mainly growth companies and has therefore been removed.
The first indicator here is the Financial Strength value, which is based on three factors: Interest Coverage (the interest coverage ratio) 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 profit by its interest expenses. The higher, the better.
The second factor Debt to revenue - ratio of debt to revenue. The lower, the better.
And the Altman Z-Score - an accurate prediction of defaults up to two years before the emergency.
Based on this, Gurufocus calculates a score of 1-10, for a company with a rank of 7 or higher it is very unlikely to get into distress. Companies with a rank of 3 or lower are likely to be in financial distress. The Financial Strength Rank was integrated because in Phase #1 only considered the debt-to-EBITDA ratio in order to provide a little more certainty. Companies with a score >= 5 are accepted for the Compounder Score. (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 indicator as it also takes stock-based compensation into account, unlike 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 another extra point in the overall score.
Since the score scheme in Part 1 also allows companies with a gross margin <50% to reach Part 2, the CAGR of the gross margin was integrated on a 5-year basis in order to filter out those stocks with 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 metrics from part 1 must also be positive across the board, this is intercepted again.
If this is the case, the compounder check is fulfilled.
The Predictability Rank is a final "key figure" that gurufocus has developed itself. In this, they assess the predictability of companies based on the consistency of their sales per share and their EBITDA per share over the last ten financial years and examine the correlation between share performance and the predictability of the business. The idea behind this is to make Warren Buffet's statement that he wants to buy companies with "predictable and proven earnings" more tangible. For this purpose, stars from 1-5 are awarded, which are added to the overall score in my model. For a Predictability >3 stars one 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 ticked off.✅
As a result of phases 1 and 2, we now have an overall score and a compounder check (true/false). All companies with a total score >= 30 and a positive compounder check are now selected for my Investable Universe and reach phase #3.
Phase #3 deals with the part that is extremely neglected by many in my opinion. I can't write too much about this as there are no figures or specific procedures here, so I would just like to give you a few tips. The most important question that everyone should ask themselves is:
Do 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 some Instagram posts, look at the investor relations, the management...
Listen to your gut feeling - that's right - gut feeling, at least in one direction. You have 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, then don't invest.
Look at the competition What makes your company better than the competition? If several companies from one industry have made it into your selection, compare the figures. ROCE in particular is also an excellent way to compare companies from the same industry.
So, that's it for now. I'm going to enjoy the Croatian heat for a while. 🥵
Are you interested in part 3?
Thanks for your feedback, I hope you enjoyed the post!
❤
-Tom
(And THANKS to the many ccf nominations in the last post to a.o. @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
