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

Analyzing Sectors

Hardware

  • Hardware industry is one of those who can’t made economic moat easily, technological advances and price competitions are the factors which make it tough.
  • What drives the hardware industry?
    • Due to technology evolution, cost for developing hardware become low; that is now you can buy more powerful computer at lower rate than earlier
    • Here, all the benefits are transferred to end users
    • Moreover, economy has changed its focus to service (from manufacturing), therefore, investment in manufacturing become less attractive than in IT
    • There is relationship between hardware and software; hardware makes software able to work easily, and good software increase the demand of hardware

  • Hardware industry dynamic
    • Cyclicality is crucial dynamic is hardware industry, in times of financial prosperity, companies are able to spend on IT, but in tough times, they want to squeeze everything they can
    • Consumer spending on IT is even more prone to swings, it is not necessity for average people
    • Hence proved, demand of hardware is volatile; hence companies who have produced more in the hope of high demand, may end the year with lots of inventory and fall in their product’s price

  • Economic moat in hardware
    • High customer switching cost – due to volatile demand, to have bread-and-butter customer is necessary
    • Low-cost producer – high competition and price competition make low cost producer the king of the market
    • Intangible assets – company often use patent and brand name for their better operation
    • The network effect – hardware needs to operates with other hardware and people who can maintain it; when another hardware arises, it makes difficult to operate (need other people to operate) and hence, network effect is there in hardware industry
  • Hallmarks of success for hardware companies
    • Durable market share and consistent profitability
    • Keep operational and marketing focus
    • Flexible economic – the best hardware firms have revenues and costs with well-matched timing and levels that can be changed

Media

  • How media company make money
  • Media company make money by delivering content in the public; the content and the way of delivering message varied in the sector
  • User fees
    • Business model here can vary upon primary source of revenue
    • Some company rely on one-time user-fees (which we pay to see movies or to read a novel), they usually have volatile cash flows because they’re heavily affected by success of that product
  • Subscriptions
    • Subscription-based business is better than user fee based because it is predictable and companies get payment in advance, although they can’t book that in revenue, they can use that to fund operations
    • These firms have high fixed assets, gives them operating leverage; but they need to make large capital investment for their operations

  • Advertising revenue
    • Companies with advertisement-based revenue can earn decent profit margins, because they have operating leverage as costs of advertisements are fixed and companies can make more advertisements with same fixed assets
  • Economic moat in media
    • Monopolies, license and deregulations
      • Companies with monopoly in any sector of media is able to make consistent profit, the only risk they have is regulations, which is being offload by big firms by their maintained relationships
      • License is great way to keep competitors away; usually it is profitable in television and radio broadcasting companies, they can’t enjoy monopoly but small number of participants have license, which keep competitors away
      • Deregulation help some companies as they can increase their range of service and can become more profitable
  • Publishing profits
    • Companies in publishing business are great investment opportunity
    • These companies have monopoly, for example, companies in newspaper publishing generally have monopoly in city or town, hence they can raise their price without hesitated for customer defection
    • They also have benefit from economies of scale and operating leverage as their fixed costs will remain same for more sales too
  • Broadcasting and cable
    • Companies in radio, broadcast television and cable television tend to have some benefits
    • As we saw the benefit of license which keep away competitors; deregulation also helped them by wider their range
    • They make most of money by advertisements, which have programming fixed costs; here, they earn by attracting crowd and high number of audience and more stations to publish make their profit high as they earn more on same fixed cost
    • Cable industry was earlier enjoying monopoly, but now they have competitive pressure; It is high capital-intensive industry, lead to lots cash expense
  • Investing in entertainment industry
    • As we discussed, this industry highly depends on user fees which are one-time fee, which lead them to volatility in cash flow and low profit margins
    • Industry have high barrier to entry, it takes high capital to make films, television series etc. and they constantly have to predict the taste of audience for their success
  • Hallmarks of success for media firms
    • Free cash flow – free cash flows to the company suggests that company’s products are in demand, company is working efficiently or there is little capital investment need in company, all of them make company lucrative
    • Sensible acquisitions – if media company is able to make sensible (small) acquisitions, it is increasing its scale of their operation
    • Be aware of large acquisitions, which generally fails, and note that company should be able to acquire another company without having so much loan on their balance sheet
  • Risks in the media sector
    • Many media companies are still being controlled by a family, which sometimes can’t make decision in the benefit of shareholders
    • Media firms sometimes have cross-ownership holding – i.e. another company has right to contribute in company’s decisions
    • Be wary of the firm which reward executives with ridiculous compensation

Telecom

  • Telecom sector have high competition, non-existence of economic moat, dependency on regulations and high capital intensity
  • Telecom economies
    • Building and maintaining a telecom network is extremely expensive and require lots of capital, moreover, requirements of ongoing capital investments are also high, which end up making low asset turnover
    • This requirement creates barriers to entry in the industry
    • Falling EBITDA indicates company is not able to efficiently operate and it will be tough for it to pay interest obligations
  • Economic moat in Telecom
    • Mostly telecom companies do not have any economic or competitive moat
    • Companies with huge customer base usually have their hands up, although they can’t increase price due to competition pressure
    • Companies have perfect competition and near-zero pricing power
  • Hallmarks of success for telecom industry
    • With the high need of capital investments, free cash flows become more important to see in the firm
    • The future of the industry depends on regularity and technological changes, which means financial strength and flexibility are likely to be what separate successful companies from unsuccessful ones

Consumer Goods

  • Consumer goods companies are good investment avenues and they are like heaven during economic downturn as people will keep buying their necessities even during downturn
  • How companies make money in consumer goods
    • They produce products and sell them – a traditional profit-making way, they sell it direct to customers or distributors or to supermarkets
  • Key strategies for growth
    • Steal market share from competitors, usually by introducing new products, but sometimes that innovated product can’t make company’s efforts worthy and company have to leave it
    • Grow by acquiring other consumer goods companies, i.e. company can wider its range by doing it, but success of strategy depends on price paid to acquire company
    • Reduce operating cost, which will happen if company have lean and flexible manufacturing structure, best way to reduce costs is large-scale restructuring, which will end up reducing cost in long-term (cost cutting is important, but taking it to extreme may make company unable focus at factors like revenue growth)
    • Sell products overseas, companies who faces top-line growth can sell their product in overseas market more effectively; there is currency risk, but companies know how to manage it
  • What’s not to like in consumer products
    • Increasing power of retailers – big retailers are able to sell goods more efficiently, which makes companies dull as investment avenue
    • Litigation risk – not all companies have to face it
    • Foreign currency exchange risk
    • Expensive stocks – due to strong brands and reliable financial performance, consumer goods companies often trade at premium valuation
  • Economic moat in consumer good
    • Economies of scale – giant players of the industry enjoy such massive economies of scale, and due to their network and product range, it is tough for small companies to enter
    • Big, powerful brands – consumer product companies spend lots of time and money to build relationship with end buyers, brands which have relates themselves with end users have the widest economic advantage
    • Distribution channels and relationship – companies can’t sell their products directly to end users, hence companies with good relationship with distributors, wholesalers, super markets, retailers have huge advantage
  • Hallmarks of success for consumer good companies
    • Market share – companies who covers large share of market with valuable brand name are great investment opportunity, and these firms generally tend to have this market share for long-term
    • Free cash flow – i.e. CFO minus CAPEX, it useful metric to analyze companies, as consumer good companies need capital to reinvest in their business; companies with free cash flow can distribute it as dividends and buy-back
    • Belief in brand building – spending on advertisement and branding is good practice, which is necessary to build large market share
    • Innovations – see the firms who consistently introduce new products and take benefit of firstly introducing that product; companies who can innovate and sell new products consistently are best options, check whether company is re-introducing product with some innovation (not too remarkable); moreover, companies must educate end users of new products with all its characteristics

Industrial Materials

  • Business model here is simple, they buy raw materials and produce inputs and machinery that other films use to meet their customer demand; it is old fashioned business who make tangible assets
  • We can classify the sector in two subsectors
    • Basic material – such as steel, chemicals etc. (they don’t have pricing power)
    • Value-added goods – such as equipment, heavy machinery etc. (they can charge premium for their product – value added price)
  • These company’s textbook ratios like asset turnover and all can ravel many things about company
  • But the industry is cyclical, and can’t make more money for buy-and-hold customers
  • The problem with cyclicality
    • Economic cycle has expansion and contraction, at the time of expansion, companies have more demands, they recruit employees and there is demand of more machines for their production, hence industrial materials business also sell more
    • But in contraction, demand for all sectors are low, companies look for cost-cutting and they sometimes need to sell some of their equipment; hence no demand of inputs and raw material make these companies sad
    • Dealing with demand swings and very thin profit margin make them uncertain; the business which is efficient producer, with the lowest fixed cost can remain profitable in downturn too
    • Some business diversifies their business to stand profitable in tough times
  • Economic moat in basic materials
    • Economic moats are tough to achieve as most of these firms produce commodities, with no or very low pricing power; to produce at low cost is only advantage they can get, which will give them benefit of economies of scale
    • These industries have barrier to entry as it is high cost procedure to produce commodities; firms with high capital invested – high fixed cost, and low margins can’t give high returns
  • Economic moat in industrial materials
    • Technology and competitive advantage
      • With thin profit margin, companies here can’t grow their top-line faster, hence can improve their bottom line by reduce cost (by new production techniques) of making and differentiate their products (hedge against downturn) as new product innovation can grow internal sales
      • Successful R&D can add value to company’s product; but companies should spend for R&D to improve their own product and reduce costs
      • Product improved by company should have low cost and best quality, which make customers unable to substitute them – in highly competitive market, this is best achievement
  • Hallmarks of success for industrial materials
    • In this industry, firms with the best use of asset are attractive
    • There are two ways to stay profitable (when counting ROIC)
      • High profit margin
      • High asset utilization
    • Due to high competition, profit margins can’t be increased by firms; hence, asset utilization is only way to earn more than competitors
  • Total asset turnover (TATO) – ratio which measure efficiency of the company, which is only way here to grow top-line
    • Fixed asset turnover (FATO) – FATO is better ratio than TATO because, industry is highly depended on its fixed asset to earn revenue, hence tells more about company’s efficiency
    • Inventory management – calculate in how many days a firm can sell its inventory and days’ sales outstanding (AC receivables divided by sales and multiplied by 365 days); if company’s inventory is increasing, that indicates company is not able to sell it effectively and producing more than demand, which will end up selling them on lower rate; increasing days’ sales outstanding with increasing inventory says that company is pushing its inventory
    • Operating leverage – firms with high fixed cost can earn more on same cost by increasing their volume
    • Whether firm is regular at dividend payment or not
  • Red flags
    • Debt – as the industry’s revenue is cyclical, it become tough for companies to pay interest obligations in downturn, operating leverage becomes worser in slowdown as fixed costs are same
    • Pensions – older companies may provide defined benefit plan, hence high amount of underfunded pension plan can be trouble for the company
    • Acquisitions – poorly planned acquisitions are enough to destroy shareholder’s wealth
    • Chasing market share – many firms with operating leverage try to gain market share by cutting their prices, but they usually forget efficiency; market share is good when you have decent TATO and FATO

Energy

  • Energy can be produced by many ways, but nothing can come close to challenge the dominance of oil and gas as a source of energy
  • From the ground
    • Finding oil and gas is called exploration and production, needs huge capital investment
    • OPEC countries provide oil worldwide and they have pricing power as there is no one who can stand as their competition
    • Companies who are operationally does exploration and production, feels trouble in low demand as they have high fixed costs
  • To the pipelines
    • After lifted petroleum from ground, it has to transported to refineries and then to end users; pipeline play important role in transportation
    • It is very useful asset for companies to own; Sometimes, energy companies have their own pipeline and sometimes they borrow it from another companies

  • To the refineries
    • Once oil and gas make it to the refineries (it is said to be downstream), it breaks up them into its component parts, and make them ready to use for end consumers
    • Refineries is not profitable business in long-term, and it is cyclical

  • To the consumers
    • Other portion of downstream is marketing, which include marketing fuels for industrial uses and consumer uses

  • Providing the service
    • Companies sometime outsource few processes like drilling and all from another companies
    • Oil companies have to suffer for profits, they earn more only when demand and price are high; industry is highly cyclical
  • The impact of commodity price
    • Till now we can say that the price is the most influencing factor for the industry, as they usually have fixed costs and operating leverage, price is the factor which influence company’s financial health
    • With high demand and increasing prices, they have ability to convey good returns to their customers
  • Economic moat in Energy
    • Organization of petroleum exporting countries (OPEC) – OPEC control world’s one third oil supply, hence they have a power to manipulate commodity prices for the entire industry benefit
    • Economies of scale – it plays important role in the industry and low-cost producer can earn relatively high than competitors
  • Hallmarks of success for energy companies
    • Strong financial track record – i.e. whether company is making profit after such years of operation or not
    • Clean balance sheet – as companies operates in cyclical industry, it is necessary to have debt-free or low debt balance sheet to stand fit against downturn
    • Reserve replacement ratio greater than 1.0 – if companies are pumping more than its findings, reserves will shrink;
    • Shareholder friendly uses of cash

  • Risk in the energy sector
    • One biggest risk can be OPEC losses its influence, it can affect long-term profitability of companies in this sector
    • There is always political risk with energy sector
    • Finally, there is chance that world can find another great source of energy

(First and third risk is not usual, hence investors can continue their journey with energy companies)

Utilities

  • Utilities companies are usually treated as safe heavens as an investment avenue
  • Electricity primer
    • Oil and gas are core source of energy, but electric primer
    • The electric utility business can be divided into 3 parts: generation, transmission and distribution
    • Generation
      • These are the operation that run power plants and generate electricity
      • Generation today have full competition as electricity is a pure commodity and there is low barriers to entry
    • Transmission
      • This is the business who transport electricity over long distance; they have high barrier to entry as it requires high and upfront capital investment
    • Distribution
      • They provide the service of provide the electricity to individual homes and businesses
  • Regulation
    • Regulation is single but most important factor shaping utility sector
    • Companies in the sector face heavy regulation and changes in that has dramatically altered the competitive dynamics of the industry
    • Regulation decides how utilities are structured, what degree of competition will be allowed and what rates will be charged
  • Financial characteristics of utility
    • Utilities carry a great deal of leverage, both operational leverage and financial leverage
    • They carry operational leverage as they can create more revenue on same fixed cost, but it is not so important as demand of electricity tend to stay stable
    • They carry financial leverage as they can take more debt for their operation, and as they are cash flow generating business, they can pay interest easily
  • Hallmarks of success for utility companies
    • Stable, favorable regulatory structure
    • Strong balance sheet – high cash flows and low debt
    • Sticking to the basics – companies who looked for diversification worsen their core business due to low focus
  • Risk in utility sector
    • First and most horrible risk is regulatory changes
    • Another risk these companies face is environmental risk, which is pollution created by their plant; this type of companies can have more regulations, which can lead to higher costs
    • Finally, there is liquidity risk to the if they are unable to roll over their debt

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/

Previous portion of the book summary : Analyzing Sectors
https://aakashandmeet.wordpress.com/2020/05/27/summary-of-the-book-the-five-rules-for-successful-stock-investing-3-4/

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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