Summary of the book “The five rules for successful stock investing” (3/4)

Analyzing Sectors

Health Care

  • A person can survive without coffee and movies, but health care is one of the few areas of the economy which is directly linked to human survival
  • Health care is necessity, hence firms engaged in this industry generally have good earnings; big firms don’t have to compete for price; they have high and consistent demand; country’s health care expense it raising year-by-year, which shows potential in health care industry

  • Economic moat in health care

    • Health care companies often get benefited from economic moat in form of high start-up costs, patent protection – keep competitors at bay, significant product differentiation and economy of scale
    • It is tough job to start a firm, invest a dozen of money, do R&D, and compete with firms who are delivering their products in market from many years, and users also don’t want any substitute of the product; moreover, they have patent to protect their products; hence companies have very wide economic moat; all of it take out lots of cash and money for new entrants

Now we will analyze health care’s some big industry who covers significant part of whole market

  • Pharmaceuticals
  • Big and branded pharma companies generally have wide economic moat and top-notch profit margin and high free cash flows
    • But innovation is not easy, it is very costly and long process to invent a drug, and one third of the innovation every return their cost of development; hence, pharma companies pumps money into R&D without guarantee of return
    • Political pressure is one of barrier which can lead margins down

  • Demystifying the drug development process
    • Discovering drug is costly and take many years; sometimes they are discovered by mistake, and other times they do only after an exhaustive process – takes years and millions
  • Preclinical testing
    • Testing a drug discovered on animals called preclinical testing
    • It takes years to find on which to test and more years to improve it; then companies have to filed application to FDA – food and Drug Administration
  • Human clinical trial (phase 1)
    • In the first phase, drug is being tested on a group of health volunteers with decent safety, to see the effect on human body; it also takes millions as cost of development, clinical trials and communication with FDA
  • Human clinical trial (phase 2)
    • Here, drug is being tested on larger population affected with targeted decease, with safety, and many times half of the drugs fail here
  • Human clinical trial (phase 3)
    • In this phase, drug is tested on much larger population with a long-time view, safety is still a concern; it also takes out money – to provide number of drugs
  • After all of phases, a drug need many approvals – from FDA and other – to market the drug; FDA committee discuss and decide whether it is appropriate or not; and if company at last get “not-approvable” letter, its painful; to re-fill application, company have to wait or make more researches on that drug – which take more millions
  • Patens, intellectual property rights, and market exclusivity
    • After the approval of the drug, it can be marketed by the company
    • Company enjoys 20 years of patent protection, i.e. for that 20 years, no other entity can market same chemical compound
    • But 20 years are not really this much; these 20 years starts from when drug is identified, many years are eaten away by testing and approvals
    • Generic drug competition
      • After paten expire, competition for the drug arise, companies can provide drug on lower rate because they don’t have to spend millions on developing it
      • Hence, if you think to buy pharma company’s share because they have close to monopoly like place for a particular drug, all these will ruin after patent expires
  • Hallmarks of success for pharmaceuticals company
    • Blockbuster drugs – selling drugs at high rate driven by high demand can make profits handsome
    • Patent protection – all drugs eventually lose patent protection, but a firm which can manage these losses can provide cash flows to its investors; if company is ready with its second drug after losing patent protection on first drug, profits will never come down
    • A full pipeline of drugs in clinical trials – firms who are discovering more drug at one time can be beneficial as they will save testing costs
    • Strong sales and marketing capabilities
    • Big market potential – drug that treats condition of large percentage of population typically have better potential, as more people will need to use that
  • Generic drug companies
  • Generic drug companies are who copy branded company’s drug after their patent protection get over; these firms used to have high margins and ROIC
  • Here, the first company to file legitimate patent challenge against a branded drug enjoy 180 days of market exclusively; but after the competition come, only low-cost manufacturer will stay ahead
  • Biotechnology
  • Best biotech companies can generate a lot of free cash flow; usually these are aggressive investor’s choice, but to choose a best one, they require skill, some understanding of science and a lot of luck
  • Biotechnology firms are younger and faster than pharma firms, and they discover new drugs faster by biotech (not by chemicals – done by pharma companies)
  • Hallmarks of success for biotechnology company
    • Think about biotech firm in 3 categories – established, up and coming and speculative
  • Established
    • These are firms with high profit and market cap, high free cash flows and large drug developments
    • Check whether a firm,
      • Have plenty of cash in hand for R&D
      • Have an enough salesforce that they don’t need to acquire another firm for marketing
      • Stock price in trading on 30-40 percent margin of safety to its fair value
  • Up and coming
    • Many biotech firms are on cusp of success, but have more capability to prove them, firms have to spend a lot for testing and all; hence it worth if these firms can form partnership with big-pharma firms
    • Investors should ask the following question to reduce their risk
      • Does the company have enough cash for testing?
      • Have larger pharma or biotechnology firms are willing to join with the firm?
      • Does the stock price trade at enough margin pf safety?
  • Speculative
    • These are newer biotech company, which seems risky for the investors
    • Undoubtedly they have technologies and are able to generate profits, but their profit and success are many years away
  • Medical device company
    • These are the companies that make the hardware for medical procedure
    • Increase in need of medical instrument and long-life expectancy drives demand in this sector; and is spur demand for medical device companies
    • These firms also have economic moat – economies of scale, high switching cost and long-term clinical histories, patent protection also keep competitors at bay
    • But they are not risk free, they need to do R&D to keep their customer untouched by competitors
  • Hallmarks of success for Medical device company
    • Salesforce penetration
    • Product diversification – companies can reduce their risk by offering wide range of high margin products
    • Product innovation – looking for new product introduction is better than to spend on R&D
  • Health insurance/Managed care
  • Here they earn money by underwriting medical insurance, and they bear the risk of rising medical costs in the future
  • Hallmarks of success for Medical device company
    • Effective medical cost management and underwriting
    • Minimal dual option business
    • Large mix of fee-based business (larger the base, lower the risk)
    • Minimal exposure to government account

Consumer Service

  • It is tough to find a firm with wide economic moat in retail sector; the only way retailer can earn a wide economic moat is to do something that customer purchase from them, not from their competitors, which can be done by offering unique products and lower prices
  • But it is tough to do as unique products don’t stay unique forever
  • Companies we see everyday
    • Most of these companies’ product are being consumed everyday by us; companies that provide the best overall service at a competitive price survive and thrive, who don’t, they disappear
    • These are the firm who usually have high turnover
  • Restaurants
  • The restaurant industry can be split into quick-service-restaurants (fast food) and full-service- restaurants
  • The long-term outlook of the industry is pretty bright, as meal at restaurants are becoming more preferable
  • Investing in restaurants: Understanding the company life cycle
  • Leases helps a lot for the industry as even though restaurant is successful and has brand name, it may not work well in some area of condition, hence taken a lease – not debt – for the place makes them comfortable to wrap that branch
    • Leases helps a lot for the industry as even though restaurant is successful and has brand name, it may not work well in some area of condition, hence taken a lease – not debt – for the place makes them comfortable to wrap that branch
    • But like other business, restaurants can’t grow aggressively forever
    • At the peak, they start new branches, and if they are making same – good – amount of cash flow from all the stores, that means customer like what they get and want more
    • These firms have to keep their customer interested to stay as profitable
  • Hallmarks for successful restaurants
    • Successful restaurants already have attractive concept, so firm is good who have seen difficulties
    • Investors need to determine if a restaurant’s concept can be repeated in other geographic areas
    • Older chain must stay fresh, without having to reinvest themselves
  • Retail
  • Retail stores are going tough as concept of mall – super market – have steal customers – with innovations and efficiency – from them
  • Investing in retail: Understanding the cash conversion cycle
    • Cash conversion cycle is enough to distinguish between good and bad retail firm, as it tells how quickly a firm sells good, how fast it collects payments (receivables) and how long it can hold on to the goods itself before it has to pay suppliers (payable)
    • The cash conversion cycle is,
  • Retailers want to sell their goods as fast as possible, collect payments as fast as possible, but pay suppliers as slow as possible; firm who successfully do so receives payments for the good even before it pays for that good
    • Low inventory turnover says firm have out fashioned goods on its shelves, lead to clearance sales and decreasing stock price
    • Receivable turnover is least important part of cash conversion cycle as most retail firms collect payment at the time of selling goods
    • Days in payable outstanding interact how well the firm is negotiating with its suppliers
  • Hallmarks of successful retailers
  • Here firms have great competition, hence first impression decides the life of business, if customer got best services and comfortable atmosphere, they will stick to the firm
  • Keep an eye out for store traffic
  • Successful retailer has a positive employee culture
  • Retails firms have low margins, store and inventory management is crucial here, there are no barrier to entry
  • One can make profit in consumer service sector if they enter early here
  • Have a look at company’s balance sheet, which generally looks great as company works on lease; lease is not bad but you as an analyst need to look at company’s lease obligations

Business Services

  • Companies in business service sector are varied as the businesses they serve; as these companies operate in relative obscurity, it deserves more attention
  • These businesses can be divided into 3 major subsectors
    • Technology-based
    • People-based
    • Hard-assets-based
  • Outsourcing trend
    • Fueling the growth has been popularity of outsourcing – the practice of offloading noncore tasks to third parties
    • Business-to-business services have grown significantly, and outsourcing make so much sense for many businesses, as it saves time, money and extra efforts
  • Economic moat in business service
    • In this business, size matters, as business can take leverage by wider their range of offering products, and having fixed cost model they can decrease their price per unit; brand is important factor here
    • Industry have some barrier to entry as new firms have to build infrastructure and name to make profits, lead to high expenses, and though firms who already have their brand name are there as a barrier
  • Technology-based business
    • Here companies leverage technology for their business; when these companies get cheap, it can be great opportunity for the investor as this is the business who gives high returns
    • Industry structure
      • Technology-based-businesses often offer outsourcing services
      • For example, a mom-and-pop store who want to build electronic payment system for its store have to build whole technology-infra to provide service to its customer; but as business service firms are there, they outsource the work to these firms and firms usually serve to many stores, hence cost for stores comes relatively low; hence, it gives convenient to customer
      • Businesses here don’t have to compete for price; Businesses tend to have low capital investment requirement, as they already have setup and cost of that decline over years
      • Companies here benefit from both economies of scale – as they have fixed setup cost which get divided into number of services they provide – and operating leverage – as firms have economies of scale, their profits rise faster than their revenues
      • These two characteristics lead to high free cash flow generation
      • As this industry have barrier to entry, and years of service make them able to receive payment in so advance, hence if they are available cheap, they are worth buying
  • Hallmarks for success for technology-based business
    • Throw of cash
    • Enjoy economies of scale
    • Report stable financial performance
    • Are exposed to fast-growing market
    • Offer of complete range of services
    • Have strong sales capabilities and access to distribution channels
  • People-based business
    • These are companies who rely heavily on their employees to deliver their services, like advertisement service, consultant or advisor etc
  • Industry structure
    • Here, businesses earn by leveraging their employee’s time in their business
    • Growth for these businesses come from hiring skilled employees; training to new hirers is important
    • Employee’s salary is a big fixed cost for this industry, in slowdown, they are able to cut their costs
    • Businesses have close competitors here who provide almost same services
  • Hallmarks for success for technology-based business
    • Differentiation of offering
    • Providing a necessary and/or low-cost service – customer who get decent price will never go for another firm
    • Organic growth – look for internally generated growth instead of growth comes from acquisitions
  • Hard-asset-based business
    • Here, businesses depend on big investment in fixed asset for their business
  • Industry structure
    • Hard-asset-based business requires fixed assets for their growth, and for more growth, they simply need more assets, which requires a lot of capital; hence, businesses need external funding for their additional infusion of capital
    • Financial leverage is good here as fixed assets are funded by external borrowing, which earns revenue
    • Here, competition is intense, profit margin is thin and high operating leverage can swing firm from widely profitable to bankrupt
  • Hallmarks for success for technology-based business
    • Cost leadership – because firms have high fixed costs, firms with operating efficiency have strong advantage, for that, check company’s asset turnover, operating margins, ROIC – and compare it with industry average
    • Unique assets
    • Prudent financing – as we talked high debt is not always bad, but check whether the debt can be serviced by free cash flow

Banks

  • Earlier we talked about bank’s position in the economy; they are the funnel in capital formation process
  • Bank’s model is simple, it receives money from deposits, and lend it to borrowers, the difference between the rate of lent money and rate of interest which have to pay to depositors is bank’s revenue
  • Banks are market maker – liquidity provider – as depositors never go to meet lenders to lend them, and at the time of liquidity crunch, central bank is there for them as a “lender of last resort” to snatch them outside crunch
  • What makes one bank better than another bank; Banks who have wide geographical reach and risk diversification, banks who can attach more deposits (CASA), is better
  • It’s all about risk
    • Banks manage three types of risks, and they get paid to manage those risks as they can do it more cheaply, the risks are; banks generally faces credit risk, liquidity risk and interest rate risk
  • Credit risk
    • Credit risk is a core part of lending business, which can be estimated by analyzing balance sheet, loan categories and NPA – non-performing asset – trend
    • But problem is these all numbers are historical, we don’t now what it will be
    • Banks manage this risk by divvy up (diversify away) the lending amount among many companies, geographies, industries; and banks who do this task greatly, makes money for its investors
    • One of the biggest challenges of investing in banks is spotting credit risk; look at the trend
    • Fast growing bank’s (as compare to competitors) should have more attention as it may possible that this is the growth from over lending
  • Liquidity risk
    • Banks are being paid for liquidity service
    • Banks have liquidity risk as they take money from depositors and lend it for short-long term, but what if all the depositors want their money back but bank don’t have money as it has lent it, it is call as asset liability mismatch, which is liquidity risk
    • One need to be familiar with the types of loan lent by banks who wants to invest in banks
  • Interest rate risk
    • Interest is avenue of earning for the bank
    • If bank is asset sensitive – i.e. interest rate on asset will changes more quickly than rate on liability –, rising rates will be profitable, but if bank is liability sensitive (falling rates will benefit banks), rising rate can create trouble (as interest margins will get lower)
    • Impact of interest rate risk is complex, dynamic and varies institution to institution
  • Economic moat in banks
    • Huge balance sheet requirement
      • There likely is no industry more capital-intensive than banking, which usually earns directly on their asset; hence, having large asset base is economic moat for banks or financial service providers
    • Economies of scale
      • Huge capital requirements are the fact that banking offers huge economies of scale
      • That means if bank ‘A’ is earning 4% net interest margin on 100 Rs, it will be 4 Rs, and if bank ‘B’ is also earning 4% but on 1000 Rs, it will be 40 Rs
    • Market oligopolies
      • Usually few banks in the country have significant market share, which make other bank’s pricing power weak
    • Customer switching
      • Another key advantage is that banks tend to have very loyal customers; most people don’t change their banks, even if they feel they’re being nickeled
  • Hallmarks of success for banks
    • Strong capital base – simple metric here is equity to asset ratio – higher the better; it is necessary to look at this while analyzing a lender
    • ROE and ROA – it is good to look at bank’s return on equity and return on assets, and we should consider bank good only if they have higher ROE and ROA than industry average
    • Efficiency ratios – it shows operating costs as a percentage of sales, good to have a look at bank’s efficiency ratio
    • Net interest margin – higher the better, generally it is linked to loans category of the bank
    • Strong revenues – look at net interest margin, fees as a percentage of revenue, fee income growth

Asset Management and Insurance

  • Like banks, asset managers and insurers make money on other people’s money
  • Asset management is lucrative for investors, as last name of the list of asset manager earns good returns; Insurance industry is competitive
  • Economic moat of both of these industries are not much different, but insurance companies – due to high competition – can’t easily make economic moats

Asset management

  • With huge margin and constant fee income, asset managers are money making machine; and it can present truly outstanding investment opportunity if they are selling at right place
  • What make asset managers tick?
    • Asset managers manage people’s money for a small part of their asset as a fee
    • There is no need of high capital investment, asset manager’s real asset are their fund managers, and hence compensation charges are their main expense
    • They don’t require higher assets or employees for higher turnover, hence are blessed with economies of scale, i.e. they can wider their range and revenue without incremental capital investments
    • They create wide economic moat by diversification – in products and customers – and stickiness of asset – i.e. money stays with the firm even in tough time
    • Diversification – asset manager spread their investment reach all around the market, not only in equity, but in debt, money market, hedge fund etc; this diversification allows them to overcome market – even in bad times
    • Asset stickiness – investors want to stick with company once they have relationship, and even in bad times, they want to stay with firm, government regulation discourages cashing out early
  • Asset management accounting 101
    • One single metric can tell about firm’s operations in this industry is AUM – asset under management; as companies earn fees income on this AUM, it tells us how good or bad company is working
    • Unlike banks and insurance, big losses in this industry born by customers; big loss for a firm is decrease in AUM, but these firms are cost flexible in nature, which remain their position in industry
  • Key drivers of asset management companies
    • The AUM is biggest driver of revenue here; but here, asset managers charge high fees for equity management and lower for debt, hence high sales of debt schemes will increase their AUM, but won’t increase fees income to that extent
    • We need to check the source of changes in AUM, it can be market movements – increase and decrease in price of securities
    • But a firm shouldn’t rely on market movements to increase AUM
  • Inside the back office
    • Custody and asset service are sidekick of asset managers, as they are good way to outsource the boring work of keeping track record of assets
  • Hallmarks of success of Asset Management Companies
    • Diversity of product and investors
    • Sticky assets – asset manager who attract buy-and-hold crowd, including institutional investor and retirement savers can have consistent growth
    • Niche market
    • Market leadership – high barrier to entry and economies of scale make bigger firm to have leadership as smaller ones don’t have pricing power

Insurance

  • They usually earn money when the option available for their customers can’t be exercise; they play riskier game as if the number of options exercised will rise, they will be in problem
  • Insurers usually have low margins, low return on assets and low returns on equity
  • Insurance accounting 101
    • A fact of the industry is insurer don’t know how to price that policy as they don’t know how it eventually cost
    • Insurance company basically have 2 sources of revenues
      • Premiums and fees
      • Return from investments
    • They have 2 expenses
      • Benefit and dividend paid to policyholder
      • Amortization of differed acquisition costs
    • This is no moat business – except some brand who covers significant part of market
    • They operate on a thin and risky margin
  • How they make money?
    • When insurer sells a policy, it accepts financial risk in exchange of premium, and make a common pool, and so able to create diversified portfolio
    • Insurers also enjoy a particular business advantage, i.e. they receive premium in so advance than it has to pay for claims, it is called float
  • Key drivers for insurance companies
    • Unpredictable costs make them less effective to set prices
    • They don’t have pricing power due to low entry barrier
    • There is cyclicality in insurance business, which make them and investors unpredictable about their operations
  • Hallmarks for success for life insurance companies
    • Prudent premium growth rates – insurer who can earn little more margin than industry is good, as we can say it have a brand name
    • ROE consistently above the cost of equity
    • High credit rating
    • A diverse investment portfolio and a proven risk management culture
    • Low-cost operator – here, lowest cost provider will enjoy highest profits
    • Strategic acquirer
    • Specialty insurer
    • A record of financial strength – analyze a firm how it has worked the time of disaster
    • Management team with significant wealth invested in the business

Software

  • Software companies have to spend a lot at the time of creating software, but after their success, they create tons of cash flows; as there is low inventory management and low account receivables
  • Software companies have excellent growth as companies will keep buying them as they make their business easy
  • Segments of the software industry
    • There are many segments, but a common theme is most are oligopolies, i.e. market leaders usually show consistent growth
  • Operating system – Operating system runs the other programs on a computer, and here also, companies who have brand name and market leaders have significant part of market
    • Data base – Database software collects data; high switching cost make the segment attractive as firms who uses database don’t want to shift to newer one who have new and different characteristics
    • Enterprise resource planning (ERP) – ERP help businesses by lowering the burden of back-office work, but it didn’t show high growth as many firms already have installed ERP
    • Customer relationship management (CRM) – CRM is software which keep track of client data, which creates selling opportunities and improves customer satisfaction
    • Security – security is serious concern at companies, this software protects firms from stealers and hackers
    • Video games – it is electronic arts, but industry is cyclical with new platforms emerging every few years
  • Economic moat in the software industry
    • Due to rapid technological changes and low barriers to entry, wide moats are tough to make in software industry
    • Hence, investors have to face difficulties while investing in software firms; look for the following
  • High customer switching cost
    • It makes it tough for customer to switch its product to another company without significant hassle
    • Network effect
      • That is if company’s software is being used by most of firms or many firms, it makes other firms to use it as whole market is working with that software
    • Brand names
      • Some firms have managed to create their brand names in some area of work, i.e. firms use that software name to define that work
  • Software accounting 101
    • Software companies have simple capital structure with low debt; here are some metrics which can only find in software companies than other
  • License revenue
    • License revenue is best indication of current demand of the software; moreover, it’s profitable source of revenue as it takes nothing to provide software to another firm after it has been developed
    • Hence, it gives firm high revenue without any extra costs
  • Differed revenue
    • Tracking differed revenue tells how much cash company is receiving in advance for its service; it is common in software industry but high number of differed revenue present good picture of company’s operation and its product’s demand
  • Days sales outstanding (DSO)
    • It tells the number of days company takes to collect its revenue
    • Formula is receivables / (revenue / number of days in the reporting period)
    • We have to look at the trend of DSO; declining DSO indicates that company is collecting payment faster than earlier
  • Red flags
  • Revenue recognition changes
    • As software firms have high amount of differed revenue, they can report them as revenue to inflate their profits; revenue Is to be recorded when risk and rewards are transferred and it is earned
  • Questionable transaction
    • Transaction like investing in a firm whom they sell their product and so fourth should have special attention while analyzing a software company
  • Hallmarks of success of software firms
    • Increasing sales – increasing sales indicates that company have risen the demand of its product or it has increased prices without losing business or it has loyal customer base
    • Long track record – look for companies who have thrived during multiple business cycles and have solid return during both the peak and the slowdown
    • Expanding profit margin – companies should be able to expand their margins over time; specially look for high license revenue, which shows economies of scale for the firm
    • Large installed customer base – companies should have large sticky customer based who want to stay with the firm for a long time
    • Great management – management and software makers are the worthiest assets for software firms
  • What is not to like about software firms?
    • The software industry is highly cyclical, and have huge hit during slowdown
    • The reason is many people take software as discretionary cost, hence at the time of hit, they cut IT spending
    • Moreover, software industry generally have high valuation due to their clean balance sheet, but cyclical nature make them unattractive avenue to invest

Previous portion of the book summary : Analyzing a company all around
https://aakashandmeet.wordpress.com/2020/05/10/summary-of-the-book-the-five-rules-for-successful-stock-investing/
&
https://aakashandmeet.wordpress.com/2020/05/27/summary-of-the-book-the-five-rules-for-successful-stock-investing-2-4/

Further portion of the book : Analyzing Sectors
https://aakashandmeet.wordpress.com/2020/05/27/summary-of-the-book-the-five-rules-for-successful-stock-investing-4-4/

Published by Aakash and Meet

I am Aakash Raotole I am currently doing Bcom from Dr. Patel and Rb Patel commerce college I am currently studying at finnacle investment academy Recently done distance internship with windrose capital, Pune - for a period of 14 weeks I am Meet Bhatt Completed HSC in commerce Now studying finbridge program at finnacle investment academy and Bcom externals I had completed CFA institute's investment foundation course and distance internship with Windrose capital, Pune - for a period of 14 weeks

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