Beyond the Figures.

Paul V. Azzopardi

When we invest in a company for dividends or bond interest we have to feel pretty confident that the company is going to return to us more cash than we put in. 

There are two kinds of expected cash inflows.  We can expect a capital gain if we believe another market participant will in future pay us more than we paid for the stock or bond.  Or, we can expect this cash inflow to come from the company’s assets, either because it is making a profit or because we have rights over the company which forces the company to pay us even if it is making a loss, such as bond covenants.

These two expectations give rise to two broad schools of thought and investment styles - broadly described as “trading” and “investing” – each of which has its own knowledge base, disciplines, and approaches.  Any one investment approach may of course have elements of both styles.

With income investing for dividends or interest, we are very concerned with the long-term success of the underlying company because it is unlikely for us to even reach break-even if the company is short lived. 

TRACK RECORD

One way to approach this problem – will the company I am investing in today be here in five, ten years’ time? – is to look at its track record because although the past never repeats it does go through the same motions. 

Many investors, therefore, look at the past, particularly at the financial statements, to gain a sense of comfort.  Figures are persuasive because they appear to be precise.  Many financial figures, however, depend on various assumptions and cut-off dates and, even if they were indeed precise, a company could have had a glorious past but faces a dismal future.

Financial analysis of the past can therefore take us only so far.

BUSINESS ANALYSIS

Rather than look only at the financials and the past, we have to look at a company in its totality, as a dynamic entity within a changing economy.

What makes us believe the company will survive and thrive in the future?

In order to answer this question we have to go beyond financial analysis and analyze the business itself, via a business analysis.

THE BUSINESS TRIANGLE

In business, there are three things you have to get right: 

1. the product, 
2. its marketing, 
3. the finances.              

Imagine a triangular table with Product, Marketing and Finance at each corner.  The most important role of management is to keep the table on an even keel.

A company with excellent marketing and finance but with weak products cannot make headway.   Customers are going to use the product and if it flops they will stay away, or, even worse, bad mouth the company.

A company with great products on the shelves and good finance but weak marketing will see others eat 

its lunch because it is not adequately communicating the utility of its products.

But products take money to develop and you can barely do any marketing without money, so good financial management is essential.

The Business Triangle is our first step towards examining a business beyond the financials.

In summary, does the company you are investing in have adequate finance, competitive products and effective marketing?  And are these three corners of the triangle balanced?

FERTILE SOIL

Although essential, Product, Marketing and Finance will not deliver growth if the company is confined to a market in which it is very difficult either to expand sales or increase profits.

Before investing in a company you must not only make sure that it is competing effectively but that it is earning good returns for its efforts. 

Two examples will make this clear.  

Utilities cannot charge whatever the market will bear since their prices are set by regulators.  The rationale for this is that utilities provide an essential service but operate on such a big scale, and involve such a high capital expenditure, that it very difficult for a new firm to compete with an incumbent.  If you are considering investing in a utility and it happens to have an unfriendly regulator, you would probably be better off investing elsewhere. 

Soft drinks are another example.  It is very difficult for one of the main brands to increase the price of its pop significantly because it will immediately lose market share.  Significantly higher sales can only be achieved by looking for new markets.  If one looks at the history of Coca-Cola (symbol: KO), it always thrived best when it was penetrating new markets, first the United States, then Canada, followed by South America, continental Europe, and recently being re-introduced in developing Asia, a total of  around 200 countries.

In assessing a company, therefore, try and assess whether its Product, Marketing and Financial strengths are likely to be sufficient to take it into new markets, even new countries, in the future.

THICK SHELL

In order for a company to thrive in a market, it must have competitive advantages and it must be able to protect these advantages over the years.    The better the company is able to protect and enhance its advantages, the more it will thrive.

An assessment of a company’s competitive advantages and how these are protected is therefore an essential step in evaluating the likelihood of its long-term success.

Although tomes have been written on this subject, we can say that a company has a competitive advantage if it is profitable.  Profit results from revenues exceeding cost.   In general, the stronger a company’s competitive advantages, the higher its profitability.

What are the main sources of competitive advantage?

We need to ask:

1.     What does the company do to earn a profit? 

2.     What are the company’s inputs, processes and outputs?

3.     What advantages does the company have in acquiring the inputs, processing, and delivering the outputs?

4.     Can the company retain these advantages?  Are they protected by a thick shell?

5.     Can the company enhance these advantages?

What we call “advantages” always boil down to being what economists call “favourable terms of trade”.  The company is acquiring, processing or delivering something on better terms than others. 

These favourable terms of trade should enable the company to make super-profits, i.e. profits over and above those needed for the company to remain in business considering all the opportunity costs of the resources it uses.

What are the sources of these favourable terms of trade?   Some of the most common sources are listed in Exhibit 1 but one has to keep in mind that companies often have one or more advantages fuelling their inputs, processing and outputs.  It is the combination of these competitive advantages and how they are made to work together that determines a company’s overall competitive strength and how sustainable its profit is likely to be.

Each company has to be analyzed individually and in the context of its industry.  A lot of valuable information can be found in a company’s “Management’s Discussion & Analysis” document,  Management Information Circular, Annual Reports, and industry publications. 

THE CORE OF DIVIDEND INVESTING

MacDonald’s Corporation, profiled in Exhibit 2, has a high return on equity and profit margins derived mainly from fast foods,  an intensely competitive business with few barriers to entry.   In spite of this, a study of the company shows how MacDonald’s has built strong competitive advantages in all aspects of its business, on the input, processing and output sides. MacDonald’s has been paying a dividend since 1976 and managed to increase it every year since then.

One has to analyze a company’s financial figures to assess its current position and its track record.  But in order to make a good investment, we need some way of getting a sense of what’s likely to happen in the future.  Dividend investors are lucky because in so far as we can get any predictability on which to prop our decisions, the business model provides one of the best platforms. 

Looking beyond the financial figures at the competitive advantages of a company therefore goes to the core of dividend investing.  A future dividend is as good as future profits and future profits will only materialize if the company retains, grows and puts its competitive advantages to work.

Exhibit 2

Competitive Advantages Example:  McDonald’s Corporation (Symbol: MCD)

MCD operates restaurants, 33,510 of them in 119 countries as at the end of 2011, from which it obtained a return on equity of 38% and a net profit margin of 20%.  Reading these figures one realizes that MCD must have built tremendous competitive advantages!  And it did.

The inputs are mainly food, labour, equipment, restaurants and advertising.  MCD organizes the purchase of food, equipment and advertising from the same sources thus lowering costs.  It develops and patents equipment and the setup in each restaurant is such that employees need no special skills, so they are paid correspondingly.  MCD acquires and sells restaurants for its own account and engages franchisees who are willing to join the company because its restaurants are successful.

A lot of effort is devoted to creating striking and memorable advertising.  This helps build not only the brand’s market share but its “share of mind” as well.

The hamburger looks quite simple but the processing at MCD is extremely sophisticated.   Restaurant layout and food processing evolved over the years to reach a high efficiency, products are designed according to the markets in which they are sold, restaurants are supervised without dampening franchisees or managers’ enthusiasm, and managers are developed internally at Hamburger University.

The brand is extremely strong, products are adequately diverse and competitively priced, quality is even, and restaurants are well-placed in cities, town and villages across the world.  Main menu items are permanent but the menu changes regularly so there’s new food and beverages to try. 

MCD has therefore put together strong competitive advantages on each of its three critical areas: what it buys, how it manages and processes its operations, and what it sells.  It has also been very successful in seeking out synergies between different competitive advantages and operations.

In my opinion, MCD is also likely to retain these advantages since food is essential for human survival, the company delivers the product at a low price but at a substantial profit, it is innovative and responsive to shifting consumer desires, and continually improves its operations.  It is extremely difficult to compete with the company because of its strong brand, culture and the location of its restaurants.

Throughout its history the company has striven to continually improve its competitive advantages and to apply them to new markets.  These efforts continue to this day and we can therefore feel pretty confident that MCD will continue to maintain and improve its competitive advantages and keep growing its earnings in the years to come.

Exhibit 1

Sources of Favourable Terms of Trade

·       Environment:

o   Geography (mills were built near rivers; ships need deep harbours; certain kinds of trees grow only in British Columbia and Scandinavia; Champagne);

o   Government and regulation (supply agreements in Ontario limiting the quantity of eggs that can be produced; the controlled distribution of liquor; utilities need approval of new rates; governments usually control the sale of water in bulk).

·       Barriers to Entry:

o   Patents, copyrights and trade names built into strong brands (“Coca-Cola”, “McDonald’s”, “Wiser’s Whisky”, Harry Potter novels, US Patent # 174,465 for the telephone issued to Alexander Graham Bell in 1876 );

o   High entry costs such as auction prices paid by telecoms for electromagnetic spectrum, plant and equipment required by utilities creating “technical monopolies”,  high outlays and costs of land points for bridges;

o   Professional associations;

o   Trade secrets.

·       Management:

o   Superior management (this advantage is likely to be short-lived);

o   A culture of good corporate governance (essential for risk control and to put back a company on the right track after it encounters difficulties; likely to last longer than superior management)

·       Profitability (usually, the higher a company’s profitability, the better it can protect and defend its competitive advantages)

·       Networks:

o   Information networks (investment banks’ knowledge of businesses and financial conditions in their markets )

o   Delivery networks (cable companies able to deliver data to each house)

o   Sourcing networks  (information sources to procure scarce resources)

o   Physical networks (railway companies benefitting from eminent domain powers)

·       Nature of the product or service:

o   High switching costs for suppliers or users (a manufacturer producing specialized part for one aerospace company;  users trying to switch IT systems)

o   Maintenance dependence  (users of specially designed software systems)

o   Suppliers with low bargaining power (suppliers of bulk chemicals)

o   Buyers with low bargaining power (patients at hospitals)

o   Cultural products (tartan for Scottish kilts; Lipizzaner horses of Austria)

o   Perishable and unstable products (fresh fish; certain explosives)

o   High complexity (banks; hospitals; national politics)

Paul V. Azzopardi BA(Hons)Accy, MBA, FIA is a VP and Portfolio Manager with Pro-Financial Asset Management Inc.  He is the author of three books including “Behavioural Technical Analysis” and is an Instructor at the School of Continuing Studies, University of Toronto, for the “Choosing Income Investments” course.  pva@pro-financial.ca, Tel: 905 815 6903

(Disclosure:  Long  KO, MCD)

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