How recognising value can help you construct a robust portfolio of quality stocks
The fundamental question that drives long-term investment decision makers is how best to allocate their capital for optimal returns.
So, for those investment managers or fund-of-fund managers investing in the equity markets, their ability to recognise and allocate capital to valuable companies, or align themselves with fund managers that can, will drive investment performance over the long run.
In this article, I have outlined my approach to recognising valuable companies. This is a framework of thinking based on investing as though the entire business is being purchased, as opposed to viewing a stock as just a price that fluctuates on a stock exchange. When we invest, we back companies, not stock prices.
Investing in valuable companies is profitable
The pursuit of allocating capital to valuable companies is driven by the objective of profit and investment performance, it is not a theoretical exercise of proving corporate best practices.
A portfolio of valuable companies will hold up much better in market downturns and be more resilient against incoming disruptive competitors. Since company value drives stock price in the long run, being able to recognise these valuable companies is highly profitable.
A valuable company
A valuable company is one that provides a product or service that its customers want and find value-adding to their lives. How badly the customers want their product or service is a key driver of how valuable a company is.
It’s no surprise that Apple, currently the world’s largest company, produces the product that everyone in the world cannot live without. Accordingly, its stock price appreciation has also been phenomenal.
However, not all value is equal. Consider the common everyday fidget spinner. The low-friction plastic toys that seemingly defy Newton’s laws.
They are currently wanted badly by many, but yet their manufacturers will certainly not make great investments in the long run. The distinction is that a valuable company provides a product or service that is useful and will remain valued by its customers.
There are many ways in which a company can remain valued by its customers and I think about these in two broad categories – internal and external.
An analogy to illustrate these categories is that of an enterprising fisherman who is standing next to other fishermen at the side of a river. The enterprising fisherman decides to bring a longer fishing rod to access fish that other fishermen can’t reach.
The ploy works well initially, the enterprising fisherman manages to catch more fish. However, the other fishermen standing nearby realise and they too bring a longer rod next time. Eventually all of the fishermen realise and any ongoing advantage to the enterprising fisherman is neutralised.
This analogy describes internal value. The enterprising fisherman improved his chances by internally creating an advantage independent of the other fishermen. However, internal value alone is temporary as competitors imitate and eventually erode any such advantage.
In contrast, external value is an attribute that suppresses or discourages competitors and enables a company to remain valued by its customers.
If the enterprising fisherman established exclusive ownership of a longer rod and no other fishermen had access to this special rod, then he would have generated tremendous external value.
External value is often referred to as an economic moat, these are rare and those that have it are hard to dethrone in the business world.
As investors, we want to find these companies and back them to the fullest.
Ways to spot a valuable company
Many companies innovate and develop internal value. But as we can see, a truly valuable company is one that remains valued by its customers over the long-term. This edge can only be sustained if they have an external advantage over its competitors – an economic moat.
Extensive literature has been written about economic moats since Warren Buffett first introduced the concept. Pat Dorsey, formerly of Morningstar, did extensive research on this topic and wrote a book called The Little Book That Builds Wealth. In it he summarises the following types of economic moats to look out for in valuable companies:
1) Economies of scale
These valuable companies have developed a supply chain advantage that enables them to deliver their products or services at a lower cost to their rivals. An example of one such company is Inditex. The Spanish clothing company best known for the brand Zara is able to mass produce fashion at a lower cost and faster turnaround time than its competitors such as H&M and Uniqlo.
This advantage comes from being able to negotiate lower manufacturing and logistics costs. Operational leverage means that each new piece of clothing produced costs less than the previous item.
2) High switching costs
A company with this economic moat has a captive customer base. The cost of switching away is too great and customers are locked in to using the products or services of these companies.
An example of a company with a captive customer base is Oracle. The software company has developed database programs used by many corporations. It is too costly and risky for large corporations to migrate their databases once they have been established in Oracle. Similarly, medical equipment suppliers have a captive market as it is often too risky to trial unfamiliar medical equipment and put patients’ health at risk.
3) Network effect
A company can create an effective monopoly by connecting different customers through the use of its products. The network effect is commonly observed in valuable technology companies that have created platforms for users to interact. Examples are Facebook, Ebay and Uber. As more users sign on, the network of customers becomes more appealing for new users to sign on. Stock exchanges such as NASDAQ or the Australian Securities Exchange (ASX) have also created an economic moat by monopolising the market for buyers and sellers of stocks.
4) Intangible assets
This type of economic moat is distinctly different from the accounting concept of intangible assets. Intangible assets in the sense of economic moats can be:
Unique corporate / governance structure
We believe that this is the most commonly overlooked form of economic moat. From our experience, the structural set up of a company is the DNA for the overall success of the business.
We find that companies led by brilliant founders have an advantage in the way they are set up that enables quicker response to their customers and an unrelenting focus on reinvesting in their own business. This type of economic moat has a strong multiplier effect when combined with other forms of economic moats. To us, it is no surprise that five of the world’s six biggest companies are still founder-led.
Government approvals / licences
Exclusive government approvals for companies create a barrier to entry for other competitors to freely enter the market. These are valuable intangible assets – think Transurban, which has exclusive government rights to operate and maintain toll roads around the world.
Intellectual property
Patents, trademarks, and copyrights protect innovative companies from imitators. Pharmaceutical companies such as Sanofi and GlaxoSmithKline aggressively protect their patent pipeline. Apple has a portfolio of patents protecting its designs. Intellectual property protection eventually does expire and for this reason we consider this to be a temporary form of economic moat.
Brand
Iconic brands have created a deep-rooted psychological association with its customers. This is a powerful economic moat that lasts generations. Nike and its Swoosh logo have created a strong emotional connection with aspiring sports people around the world.
LVMH, the French company behind luxury brands Louis Vuitton, Moët and Hennessey have created a brand that loyal customers aspire for. Different brands have created associations to different customer emotions. The stronger the emotion, the stronger the affinity the customer has to the company.
Geographical advantage
As Mark Twain once said “Buy land, they’re not making it anymore”. This advantage is easily recognisable and most common in infrastructure or real estate stocks. From experience, the effectiveness of this type of moat has diminished with the rise of technology and for this reason we favour other types of moats.
Profit from valuable companies
The source of value has evolved and will continue to evolve just as business models have over time. But the fundamental framework for spotting value will continue to apply as long as businesses exist.
Constructing a portfolio of valuable companies is a sensible method of securing pleasant returns over the long-term. Sound businesses with economic moats are likely to remain valued by their customers despite incumbent competitors and other external market changes. As long as a company is valued by its customers, its value will be retained, and its stock price will follow eventually.
For the enterprising investor, there will exist an even greater opportunity to profit during certain windows when the stock price trades below its true value. These windows exist when the market panics and the herd forgets about the true advantages a company has.
These opportunities offer an attractive deal to purchase a slice of a valuable company at a low price. It is in these windows that the enterprising investor should distance themselves from the crowd, invest heavily, and watch the returns compound over the long-term.
Lawrence Lam is founder and portfolio manager of Truslam Investment Management.
AUTHOR
Industry Expert
Recommended for you
After years of low rates, three younger fixed income specialists have shared how they navigated “one of the toughest environments for investment decision-making” in the form of their first interest rate hiking cycle.
The global nature and geopolitical threats involved in investing in emerging markets can mean the job of an emerging market manager entails additional challenges than its developed markets counterpart.
Australian financial advice firms are increasingly looking towards outsourcing as a tool to optimise their business, two industry professionals share, freeing advisers to focus more on client-facing duties.
Retaining new entrants in the advice industry as they complete their Professional Year is a key focus for advice firms in 2024, with younger generations increasingly valuing workplace culture more than ever.
