CWS Market Review – August 24, 2021

(This is the free version of CWS Market Review. If you like what you see, then please sign up for the premium newsletter for $20 per month or $200 for the whole year.)

The S&P 500 closed at another all-time high today. The index is up nearly 20% this year, and we’re not even at Labor Day.

This comes at an interesting anniversary. One hundred years ago today, the Dow Jones Industrial Average closed at 63.90. That was the low point of a nasty bear market that began on November 3, 1919 when the Dow closed at 119.62.

This was a difficult and ugly time for the country. There had been several labor and race riots during the Red Summer of 1919, and in 1921 there was the infamous Tulsa Massacre. The country suffered a long recession that started in early 1920 and didn’t peter out until the summer of 1921.

As is often the case, bad times meant it was a great time to invest. The U.S. was about to embark on the Roaring Twenties. Americans became enthralled by new technologies like radio and movies (and even talking movies!).

The stock market started to boom. Less than one year after the low, the Dow broke 100. By 1925, it hit 150 and by 1927, the Dow topped 200. It nearly doubled again by the summer of 1929. (After that, things got a wee bit problematic.)

Still, the Roaring Twenties was a great time for investors. There were some cracks showing in the façade. Florida, for example, experienced a massive real estate bubble. This was lampooned in the Marx Brothers’ first movie, The Cocoanuts.

Groucho: You can have any kind of a home you want. You can even get stucco. Oh, how you can get stuck-oh!

The Dow had a fantastic run lasting eight years and ten days. The Dow rose nearly sixfold in that time. The index eventually peaked at 381.17 on September 3, 1929. While that was the high, the market didn’t break for another seven weeks. Interestingly, market crashes usually don’t happen at the peak. Instead, they happen on downward slides from the peak.

In this issue, I want to address a topic that I’m often asked about: how I go about selecting stocks to invest in. I like to find companies that have a competitive advantage. Warren Buffett refers to this as a company that has a strong “moat” protecting it. This concept is sometimes misunderstood, and I wanted to take some time to explain what it properly means.

Finding a Competitive Advantage

With investing I like to find companies with a distinct competitive advantage. Here’s a good way to think about this (I’m heavily borrowing from our friends at Investopedia for this example).

Let’s say you have a lemonade stand and business is going well. You suddenly have an idea. Normally, your stand buys lemons each morning. Instead of doing that, you decide to buy a bunch of lemons at the beginning of the week. Your supplier gives you a bulk discount.

Let’s say this cuts your cost of goods sold by 20%. In terms of economics, this is a huge deal. In fact, an innovation like this is what all business is about. This means you can cut your prices by 20%, thereby gaining market share, and it will have zero impact on your gross profit margins. This is great news for you and your business.

As much as we love this, there’s one small problem. While it’s a great idea, it’s just an idea—and one that can be easily copied by your competitors. Once they discover the secret, your advantage is gone.

Now let’s say you come up with a second idea. You invent a revolutionary new lemon squeezer that’s so good, you get 20% more juice out of each lemon. Once again, this is a huge deal in terms of business economics. You’re effectively cutting your costs of goods sold by 20%, and again, you can pass those savings on to your customers with no impact on your gross margins.

But there’s a crucial difference between the first example and the second. In the second case, you can patent your lemon squeezer. That means you can line up state power to enforce your invention monopoly. The idea in the first example isn’t protected the same way. (In reality, you’d probably license your technology and draw a revenue stream.)

The second example shows the kind of company I look for. I look for firms that do things that no one else can do. Several stocks on our Buy List have strong competitive advantages. In particular, I think of companies like Moody’s (MCO) or Fiserv (FISV).

Check out our tenfold gain in Fiserv.

Keep the Competition Out

Harvard professor Michael Porter has said that a business is first and foremost concerned with differentiating itself and keeping competitors out. Ideally, you want to have a business with high barriers to entry and low barriers to exit, and you want to differentiate yourself with whatever it is you do. You can do that by exclusivity or by price. That’s your competitive advantage. Once you get that, then you get better managers, better advertising and a stronger brand name. But it starts with a competitive advantage.

I think people often have difficulty with the concept of competitive advantage because they want to see sinister forces at work. And make no mistake: I do believe the tempering forces of free enterprise can sometimes break down and give a particular firm a lasting advantage that has nothing to do with its own inherent merit. It could be that they were in the right place at the right time. Or they can use their excess profits to lobby the government to protect their advantage.

For example, many years ago, the Japanese government gave AFLAC (AFL) a monopoly on selling cancer insurance, and this translated into a huge market share today. Naturally, this is unsettling to those of us raised on the idea that the world wants a better mousetrap. But the truth is, it doesn’t. It wants the one it’s heard of. Just like in politics, the incumbent holds a lot of power.

Here’s an example. One of my friends who works with the U.S. Navy explained to me that there are only a handful of shipyards left that are capable of building modern, large-scale ships for the Navy. These shipyards have become, in effect, government sponsored quasi-monopolies. I doubt anyone wanted that to happen, but things turned out that way.

This is an important point that Warren Buffett has often discussed. Nowadays, Buffett is the “aw shucks” face of nice-guy American capitalism, but it wasn’t always this way. In the 1970s, he and Munger bought the Buffalo Evening News.. The Buffalo Courier-Express, a rival newspaper, did everything it could to make them seem like evil out-of-town capitalists. Buffett was beaten up hard in the press, and I think that episode has stayed with him ever since.

In the court case that followed, the opposing lawyer used Buffett’s words against him:

Warren Buffett once said that owning a monopoly newspaper was like owning an unregulated toll bridge. His words were, “…in an inflationary world, a toll bridge would be a great thing to own if it was unregulated.” When he was asked for his rationale, he said, “Because you have laid out the capital cost. You build the bridge in old dollars and you don’t have to keep replacing it.” He was then questioned whether he used the term “unregulated” to mean the ability to raise prices. Buffett said, “That is true.”

It sounds rough, but that’s about the best description of a competitive advantage I can think of. With that said, how do you know if a company has a strong competitive advantage? There are a few characteristics that typically show up.

What Does a Competitive Advantage Look Like?

Oftentimes, the company we’re looking at has a consistent operating history. Sales and earnings edge higher nearly every year. There may be bad years, but the positive trend is clear.

This tells me a few things about the business. First and most obviously, it’s a growing enterprise with a steady demand for its products. It also tells me that management is probably on the ball. That’s because in a dynamic marketplace, you need to make a lot of small corrections to keep the ship moving.

A company with a consistent operating history also probably has a loyal customer base. Never overthink a business. You can make a lot of money selling the same thing to the same people. Ask Starbucks (SBUX

The coffee shop went public in 1992 at $17 per share. Since then, it’s split 2-for-1 six times. That comes to 64-for-1 which means the adjusted IPO price is about 27 cents per share. SBUX closed today $115.08.

Lastly, investing in companies with a consistent track record is an easy way of reducing risk. I’m not a fan of “oil well” stocks. These are companies that appear flat broke but are pinning all their hopes on some deal that may never come. There are too many of these stocks around. When in doubt, I always prefer a stock that grows its business each year.

Tying back to what Buffett said before, a company with a strong moat should also be able to raise prices. This is a subtle rule, so let me explain what I mean.

You’ll notice that I didn’t say I look for companies that do raise their prices. Rather, the key is finding ones that, if the need arises, can raise their prices.

Think about the items in your home or office. Now imagine which ones you would still buy even if they raised their price by 10% or 15%. Some items you’d simply stop buying. But not all.

Why? Maybe you’re attached to a certain item. Or maybe it’s an integral part of your day. I have friends who would make their daily Starbucks run no matter what.

A company that can raise its prices most likely has a firm handle on its costs. There’s a risk component as well. No company wants to raise prices, but it’s nice to be in a position where they can do so if need be.

Ability to raise prices is often a sign that a company has a dominant position in its market. I often think of Harley-Davidson (HOG), the legendary hog stock and former Buy List member.

Is Harley-Davidson a monopoly? Well, in the legal sense, of course not. There are lots of motorcycle companies. Yet Harley is a brand so differentiated that it can be thought of as a pseudo-monopoly. Harley buyers would never view their hogs as just another bike. Harley is quite aware of this (a good portion of their revenue is apparel).

I also like to see a company that is the dominant player in a niche market. A company doesn’t have to own the world to be successful. Owning the best autobody shop in town, or the best Thai restaurant in town, can be a great business.

Why? Because the firm is doing something no else can do. In business, there’s a term called “switching costs.” This refers to the cost for a consumer to change his or her preference. With toothpaste, folks aren’t so picky. With eating habits, people can be very picky. Ross Stores (ROST) is a good example of a company with fairly tight margins (net income margin is around 10%), but high switching costs. Ross’s customers like it exactly where it is.

For a business, you want to be the dominant player, even if it’s in a very narrowly-defined market. Think of the ratings agencies. If you want to float a bond, you pretty much have to deal with Moody’s or S&P.

On our Buy List, we have Broadridge Financial Solutions (BR). This is the dominant player in share-voting proxies. This is the kind of business not one person in 20 ever thinks about, but it fills a concrete need. You can spot a dominant player because it often has modest debt levels, wide operating margins and strong cash flow.

I want to touch on First-Mover Advantage. This was a huge idea in the 1990s, and I think it served as unrecognized fuel for the Tech Bubble. The idea also goes by the name Winner-Take-All.

The idea is that an early entrant could establish an industry standard which remains in place simply because it’s already there. It’s not better—it’s just there. I can’t tell you how many times I was told that some Internet stock was just like the QWERTY keyboard.

In the 1990s, Microsoft was an obvious example of a first mover that became enormously successful, but investors wanted to see where the next standard would be. There was even a magazine called the Industry Standard. Wikipedia tells us that “in 2000, it sold more ad pages than any magazine in America.” Unfortunately, the magazine went belly-up in August 2001.

While being a first mover can certainly give one a competitive advantage, it doesn’t mean it will last. It’s also a bit more complicated than being first. For example, it’s nice to have lots of upgrade cycles.

I hope this issue has helped you better understand what competitive advantage is, and how it can help your investing. If you want to see a list of companies with competitive advantages, you can see my Watch List (subscriber only). Another good resource is the holdings of the VanEck Vectors Morningstar Wide Moat ETF (MOAT). I don’t always agree with them, but at least we’re looking for the same things.

I’ll have more for you in the next issue of CWS Market Review.

– Eddy

P.S. If you haven’t had a chance, you can subscribe to our premium newsletter. It’s only $20 a month or $200 a year. Please join us!