Book-review: The Five Rules for Successful Stock Investing, Dorsey

A good read on economic moats and introduction to various industries.

If you prefer to read the pdf version click here. (likely better formatting but links may not work in pdf)

(as in my previous book review I focus more on my learnings/insights/personal summary vs writing style etc.)

Introduction: Picking great stocks is tough

Successful investing is simple, but not easy is a timeless adage. Though, during some periods it can certainly seem so like in the 1990s and more recently betting on big tech. But bubbles eventually pop. There is no magic formula (this makes perfect sense, and is great to read here while I read The little Book that still Beats the Market about Greenblatt’s magic formula in parallel on train rides because it is so small – book review here).

The basics for successful stock investing are quite simple:

• Don’t confuse great businesses with great stocks
• It’s the business that matters (over the long-term!)
• Exceptional investors look for Oustanding stocks to hold for the long term
• Short term bets require a lot of trading, resulting in fees and taxes, and a few losers in between
• Successful Stock picking means the courage of betting against the crowd

The book teaches five core principles:

1. Doing your homework
2. Finding companies with strong competitive advantages /moats
3. Having a margin of Safety
4. Holding for the long run
5. Knowing when to sell (I never believed in #neversell and you should neither)

Basic investment process

• Develop a set of investing principles
• Understand the company’s competitive environment
• Analyze the company
• Value the stock

Do your homework means knowing a company inside out and having done enough research. The research process is a cooling off period and takes time. Missing some upside is not that bad if we find and invest in truly great companies. (for hobby investors this is difficult and might even have some adverse effects: spending more time on a company can let us fall in love or seeking a reward (=trading action) on our time spend)

Finding economic moats is what it is all about in the long-term. The size of the moat and reinvesting opportunities is what separates bad and good companies and good from great companies. How does a company maybe to keep competitors at bay and earn consistently fast profits?

Having a Margin of Safety means buying stocks below their fair or intrinsic value offering some protection against errors and uncertainty or, additional upside. One way to get a feeling for the current valuation is to look at historical valuations, ie P/E, P/B. Many companies from worse industries should — if at all — only be bought at considerarble discounts.

Holding for the long haul gives an edge over trading in and out, in which case one needs to achieve much higher gross returns before taxes and fees.

Knowing when to sell is critical even though ideally we buy stocks that we would want to hold forever in the right circumstances. Obviously the one factor is the comparison of price vs value estimates. How the price developed is unimportant on its own. Selling great companies only because they trade a little over our estimated intrinsic value does not make sense, especially considering taxes due, but there is some price we should truly consider to sell at. And of course, investing is about relative selection, so there might some better investments available. Selling down a big winner that makes up too much of the portfolio (ie >15%) is another good reason (even if a bit out of favor recently, in 2020 & 2021).

Seven mistakes to avoid

Just a few big errors can cost you the whole  performance from a few great stock picks. Seven easily avoidable mistakes:

1. Swinging for the fences each time is a recipe for disaster.
2. Believing it is different this time is naive and goes against market history: most things are cyclical.
3. Buying companies which products you love is not wise. Ask instead is this a good business I want to own? Ie, consumer electronics is a tough industry.
4. Panicking when the market is down is neither rational nor a profitable strategy. Going against the grain takes courage, but courage can pay of big time.
5. Timing the market is just playing a game with negative expectation
6. Ignoring valuation can cost us dearly if we do not find the next bigger fool.
7. Relying on earnings when it is (distributable) cashflows that really matter.

Economic moats

Companies looking great, very profitable in the rearview mirror often do poorly in the future becuase of competition.

Evaluating profitability and determining that a company has a moat is the first step: Are returns of capital (ROE, ROA) exceeding ist cost of capital? Do earnings translate into high cashflows? Consistently high profits and net margins?

Determining how a firm built an economic moat and answering how it is able to hold on to its profitability. When examining the sources of economic moats, the most important question to ask is Why? Look from the customer perspective.

• Why aren’t competitors stealing the customers?
• Why aren’t competitors offering a similar product at a lower price?
• Why do customers accept annual price increases?
• What value does the product or service bring to the customer?
• How does it help them run their business better?
• Why do they use one’s firms products/services and not a competitor’s?

In general there are five ways to a firm can build sustainable competitive advantage:

1. Creating real product differentiation through superior technology, features.
2. Creating perceived product differentiation through a trusted brand or reputation.
3. Offering a similar product or service at a lower price and thus driving costs down. Lower costs are usually achieved by a better process or via larger scale allowing for spreading fixed costs over a larger base.
4. Creating high switching costs and thus locking in customers.
5. Creating high barriers to entry or to success and thus locking out competitors.

Switching costs (4) are mostly reasoned on time rather than direct monetary customer considerations. Ie, surgeons trained on artificial joints from Stryker or Zimmer had to Re-train before buying (a cheaper) competitor’s product and would lose productivity during this new training period. Thus, competitors had to offer measureably better products. Good Q’s on switching costs:

• Significant client training needed?
• Is the product/service tightly integrated in the business process and thus critical?
• Industry standard?
• Potential benefit from switching small vs switching costs?
• Doss the firm tend to sign long-term contracts with clients?

How long will the moat last? A moat has two dimensions: depth or how much money a firm can earn from it and width or how long the firm can sustain these above average profits.

Technology companies often have very deep but narrow moats, earnings very high margins until a competitor comes with a better product, which often does not take very long.

The industry determines largely the economics of the business. Managemnet cannot change an industry’s economics at large.

Analyzing management

Excellent management can make the difference.

Compensation should ultimately be skewed to pay for performance to set the right incentives. 

• Changing performance targets downwards
• Does managemnt receive most stock options instead of giving plenty to other employees?
• Excessive use of stock options, incl. (i) options instead of restricted stock (sharing downside) with the former not being expensed while the latter doesn’t, and (ii) founders owning 25% of the firm anyway (more motivation shouldn’t be need here)
• Do executives have skin in the game, that is considerable part of their net worth in the stock

Character includes a broader picture of merely compensation

• Does managemnt use its position to enrich friends and family (related party transactions) ?
• Is the board stuffed with family members?
• Is management candid about mistakes?
• How promotional is management? Toe some extend it is the CEO’s job to rally the troops but there is a fine line between motivating employees and pumping a firm’s stock. His job is worrying about running the company. THe cult of the CEO-as-hero is dangerous.
• Can the CEO retain high-quality talent?
• Does management make tough decisions that hurt (reported) results but give a more honest picture of the company?

Note: Two bullets are of special interest here for me: (1) PGR recently booked an impairment related to the property insurance business because it became clear that results would not be as good (or improve as fast) as initially expected. This seems to be a realistic representation of economic truths. (2) I wondered if CHKP would give some negative examples when they did lose out vs competitiors and provide insights why the lost and the client decided for a competitor’s solution.

Running the business well is of course another key character feature.

Financial performance during a CEO’s tenure is a first thing to look up. If ROE did increase, why?

Follwing through with promised solutions for an ealier identified problem needs to be tracked by us investors.

Does the firm provide enough information to analyse the business? This is especially critical for segments that are not doing too well currently.

Self confidence can be a good thing. Firms that do things markedly different from competitors might do very well. Another indicator is keeping spending on R&D during downturns (not caring about near term EPS).

Valuation

Valuation done right should result in us letting many pitches pass by but also a much higher batting average: the number of stocks I pick that do well vs the ones that do not well, and it limits the risk of a real blow up. (finally dumb me learned what batting average means — yes dear Americans there are ppl that have no clue about baseball or your kind of football and rightly so)

The section on multiples is basically what can be read in Damodaran’s book.

Intrinsic value is DCF valuation.

A Guided Tour of the Market

Sectors that are worth a look include banks and financial services (pay littel for deposits and lend out at higher rates), business services (ultimate catchall area of market, since do not fit in industry oriented wall street analysts, unknown to consumers), health care (strong demand outlook, many moats, careful with biotechs resembling lotto tickets), media (get paid via subscription before delivering anything, moaty).

Healtch care is a non-cyclical sector in general. Consumers might spend less on coffee but healtch care spending is about to be cut last. Often oligopolistic market structures and firms have strong FCF, RoCs. Demografics are a strong tailwind. Often end-consumers (patients) do not care very much about price b/c insurers pay the bill, and or middle-men such as surgeon are locked-in after extensive training. Watch out for patents which enable high profitability but might result in sales/profits falling off a cliff. Firms should be diversified, that also goes for the pipeline. It is expensive and takes long to bring a product to market.

• Pharmaceuticals come with fat margins and returns on capital, but must spend big on R&D. Hallmarks: blockbuster drugs bring scale advantages, patent protection, full pipeline, strong sales and marketing, big market potential.
• Generis drug companies do not have such high margins as pharmaceuticals, but the usually can grow faster since public pressure to rein in healthcare costs, RoC vary depending on exposure to branded drugs, it is about being fast and ultimately the low cost producer.
• Biotechs are risky. 
• Medical device companies make the needed hardware such as pacemakers, artificial hips. Aging population and higher life expectance drive unit sales, since during higher ages replacmenets are needed (a new hip is good for c. 10yrs). Usually come with wide economic moats as barriers to entry since long data history and trained surgeons. Less risk vs pharama since product improvement is evolutionary not revolutionary. Though, high R&D spend needed and product cycle can be short.
• Health insurance/managed: care face widespread regulatory pressure and litigation, usually don’t have wide moats. Managed care organization (MCOs) do risk-based business meaning underwriting health-care (risk of rising costs), and fee-based business which refers to adminstrative services for employers underwriting their employees’ health insurance and is less risky.

Consumer services tend to offer very narrow moats. In effect it is hard to keep customers from wlaking to competitors. Some firms succeeded with distinctive store experiences now enjoying scale advantages, ie Home Depot, Lowe’s, Walmart.

Companies we see everyday like Walmarkt, Target, Walgreens, or clothing stores bring the benefit that we investors can try their products/services vs, ie products from Intel.

Many trends result from both parents working full time, thus requiring reday to eat and easy to prepare meals, and full service stores where they get everything at one location, or drug stores being open 24h. Non-food consumer purchases are mostly discretionary and thus business/stocks are cyclical as well.

• Restaurants can be split into quick service restaurants or QSR like MCD or Wendy’s and full service restaurants or FSR where a waiter serves you. Since preparing a meal for two or more people is almost the same work, eating out in restaurants becomes more attractive. Most new restaurant concepts start with a speculative growth phase in which profitability on the store level is important, but ultimately most concepts fail. It is about how many stores can be operated profitable. Since capital for expansion is scarce, operating leases are common, but, these have debt character and bring risk (financial or operating leverage). And to succeed, older stores have to be refreshed.
• Retail experienced a strong change away from the mall. Double-income households want selection, quality, and reasonable prices, and they want it fast (Walmart, target, Kohl’s).
  The cash conversion cycle in retail is important as are same store sales. The ccc shows how efficiently retailers manage their inventory, collect cash and how good they negotiate (credit terms) with suppliers. Sss report the yoy sales growth only counting stores that existed 1yr ago. This can distort underlying reality since new stores often show growth in their 2nd and 3rd year, which pushes sss upwards.
  Retail is a fickle business, consumers might not give you a second chance, thus stores need to be always clean and fresh. Store traffic shall be high, but no bottle necks shall appear at check out aisles, nor should parking lots be empty. Employee culture is important since you meet and interact with them at the store. Retail in general has no barriers to entry, and thus moats mostly depend on being the low cost leader in a very competitive sector.

Business Services includes a great many obscure high quality firms to hold for the long term. They can be roughly grouped into technology based, people based, or hard asset based.

• Outsourcing is a huge trend since fixed costs can be spread over a larger base and companies can focus on core tasks.
• Size matters in outsourcing especially regarding fixed costs networks. Thus, many companies acquired other to reach critical mass.
• Brand matters as well, ie, payroll processing includes handling personal data and this mögt not be given to a new startup,bjt rather ADP, founded in 1949.

Technology based businesses usually enjoy high margins and good scale advantages, ie processing more payments via a network. Hallmarks are: throw of cash, economies of scale, stable fianncial performance via long-term contracts.

People based businesses like consultancy services are basically a spread business billed our minus wages (and other costs) and do not bring strong scale advantages. Furhter, companies might cut their spending on such services during an economic downturn. Hallmarks are: differentiation or niche, providing necessary or low cost services, organic growth.

Hard assets based businesses can build a moat via unique assets and denser business activity and must often maximize utilization rates (ie FedEx trucks have low cost for additional parcels). Hallmarks are: cost leadership and leading asset turnover, operating margins, ROIC vs peers, unique assets, prudent financing (attn: off-balance sheet financing.

Banks enjoy a special place in the economy handling our money and mostly receiving our deposits for almost nothing (or even less) and lending out at much higher rates. The spread is the net interest margin. Net interest income and net fee income (non-interest) constitute net revenues. This is lowered by bad loan provisions and default costs. Operating expenses are often below 50% of net revenues for good banks. Banking is all about risk managmeent.

• High ROA and ROE but not too high: we should look for banks with high ROA and ROEs but not the highest ROEs. It is quite easy to report very high ROEs for strongly growing banks simply by underprovisioning for for bad loans.
• Book value is a good measure since most assets and liabilities are liquid and trading and/or accounted for at ‘fair’ market prices.
• Moats in banking results from huge balance sheet requirments as one of the most asset heavy industries there is (barriers to entry), there should be good economies of scale (i believe empirical research does not really support this view, maybe b/c of regulation), regional oligopolies can be very strong and are hidden when looking at national market/industry statistics. High customer switching costs result in us much less often switching accounts to a competitor even if we know it is better and cheaper.

Asset management firms charge (relative) fee on assets under management or AUMs and can thus be seen as a leveraged bet on financial markets, since AUM is driven by assets’ price performance and net fund inflows. Since managing double the AUMs down not need double the portfolio managers firms should experience nice scale benefits.

• Asset diversification can smooth results if one asset class (ie equitites) has bad performance
• Asset stickiness is important and can results from tax-sensitive customers
• Niche markets can enhance profitability
• Market leadership, track record and brand can be important

• Custodian firms act as back-office service providers for asset management firms doing the boring but very essential work. It can earn lower fees and posses even higher economies of scale after hefty technology investments. Loan portfolios to their clients can be a risk factor. Larger scale is better.

Life insurance is difficult business due to hte fact that even after the best efforts of actuaries the ultimate costs to the insurer are only known many years and decades after selling ist product. Exiting the business is difficult.

• Variable annuities customers manage their assets on their own (assets on insurer BS offset by equal liabilites)
• Biggest firms can build moats through better brand and distribution.

Property and casualty insurance or P&C provides enormous benefits to customers and the economy thanks to ist risk pooling and transferring mechanisms but the industry itself has poor economics due to a lack of pricing power. That is due to a commodity product that is largely bought on low price, quality is often only accessed or experienced in a bad and seldom event and regulations can hinder price increases (regulation). Furhter, it is a cyclical industry with hard (price increases) and soft periods (race to the bottom). The make money from the underwriting business and investment business (more other posts on insurance economics). Short tail business results in claims being reported and paid shortly after they were caused (ie car accidents). The typical example for long-tail business is asbestos injuries which may be discovered and filed many years or decades later. Longer-tail insurance business can make it worthwhile to increase asset allocations to equities. Hallmarks:

• Low cost operator in a commoditized industry.
• Strategic acquirer of underperforming insurers turning around their business.
• Specialty insurer doing more profitably niche business.
• Record of financial strength: insurance is worthless if the insurer cannot pay.
• A rational management team with higher share ownership caring for value creation.

Software industry is hugely competitive but offers great economics. Developing a leading software product requires high upfront costs but selling an additional unit is almost pure profit. Neither do companies have to build expensive working capital since software is an electronic product. It is great to read an older book here, since it illustrates the inherent change in technology and software: the leading crm player is Siebold (no mention of salesforce) and Oracles has the best database technology, acc. to the book. Hallmarks:

• High customer switching costs (ie trained employees)
• Network effects (ie, companies using acrobat b/c many users have the free reader)
• Brand names (ie, intuit)
• Great Management teams not giving out huge option grants

Technology hardware companies face difficult realities of boom and bust cycles as was explained in Quality of Earnings. Technology is changing fast rendering inventory worthless and resulting in an endless struggle to innovate ahead of the pack. Further, supply and demand cycles result in unhealthy inventory levels. But if we ‘must’ invest in the hardware sector, look for:

• High switching costs (ie telecoms must make sure that network gear works with existing infrastructure and vendors are around in a decade)
• Low cost producer (ie dell’s direct sales model)
• Intangible assets like brand and patents (Linear technology, maxin integrated products: Analog chips do not process data as ones and zeros but measure real world data like temperature, pressure, etc.)
• Network effects: hardware often needs to work with other hardware and be maintained by people.

Successful hardware companies show durable market shares and consistent profitability as signs to fend off competition, keen operations and marketing focus are needed, and proof of internal recognition, since there is no edge in other activities. They better have flexible economics since the industry is so volatile.

Media companies generate cash by producing or delivering a message to the public (video, audio, print) using a wide array of methods: TV, movies, radio, internet, books, magazines, newspapers. The make money via one time user fees (volatile), subscriptions (better) or advertising revenue (high margin via operating leverage but cyclical).

Publishing companies include great investment opportunities. The somewhat historic! prime example here is daily newspapers which operate in kind of regional monopolies and offered great operational leverage. But some publishers of books can alos have very farouable economics since rather fixed costs for production systems can result in great operational leverage with volume growth. This is why acquisitions can be a central part for value creation strategies in the sector (ie, McGraw-Hill, Elsevier).

Broadcasting and cable offered great returns due to FCC licenses and rather fixed costs for the programming they show on which they can maximize viership and thus ad revenue. Further, deregulation allowed broadcasters to own more stations. Some companies burn their solid cashflows in other activities.

Entertainment companies often have large libraries of films or music which re protected from copying and offer good returns since production costs were recorded in the past. Because creating such assets is capial intensive there are barriers to entry. But the bulk of profits goes to high-profile actors, directors and executives. The business is hit driven and betting on big hits is a risky investment strategy since the few big hits might just compensate for the many losers in the industry.

Telecoms earn low and often declining returns on capital since they offer a commodity product: voice/data connections. Their future depends on regulators and they constantly need big capital outlays just to stay in buisness.

Consumer goods include food, beverages, household and personal products, and tobacco; and offers good defensive companies during economic downturns. Despite slow growth of about the overall economy they are usually very profitable. Most industries already saw consolidation due to their maturity. Stealing market share from competitors by introducing new products — many with slight changes from existing products like new flavourse and a few radically new ones which are more risky since consumers have to be edjucated but offer new revenue pools  — are a key ingredient for success. Risks include retailers gaining more power (ie Walmart dominates the US), litigation risks (tobacco), fx headwinds, often expensive stocks. Economic moats include economies of scale, brands, distribution channels.

Industrial materials companies can further be grouped into (i) basic materials like commodity steel or chamicals and (ii) value-added goods as electrical equipment, heavy machinery and specialty chemicals, with the former having little influence on the price and the latter offering higher value to their customers such that he is willing to share of his benefit in form of a premium price. Companies face economic cycles and thus suffer variability in revenues and even higher variability in profitability.

• Basic materials merely offer on economic moat and that is being the lowest cost producer, which can sometimes be achieved via economies of scale. This is often not durable when foreign companies enter the picture and enjoy advantages from geography, subsidies or cheaper labor.
• Industrial materials offers better chances for buidling sustainable moats within concentrated industries via patented technology and higher switching costs (General Dynamics, United Technologies, 3M).

Energy that we use mostly comes from under the ground: oil and gas, but the sector also includes nuclear, hydro, wind and solar. Oil and Gas companies benefit from OPEC managing and artificially increasing prices, but still: these companies have largely fixed costs per produced barrel and earnings very much depend on realized unit prices resulting in high earnings variability for the overall industry. Price reacts strongly to minor supply and demand changes. Some segments see higher earnings variability than other (below, with historic common price levels of below $50). Pipelines have low earnings variability. Oil and gas services operate in a very competitive segment and rarely earn their cost of capital.

• A strong financial track record over a cycle and, for more defensive companies we want to see profits even during periods with lower prices
• A clean balance sheet to survive high earnings volatility
• Reserve replacement ratio greater than 1x
• Shareholder friendly use of cash flows can be expected from good companies in mature industry

Political risks are very common here, especially if companies operate in less stable areas. This book was written years ago … how things can change. Everything is cyclical!

Utilities were once viewed as defensive income plays operating in regulated markets offering guaranteed returns, but deregulation changed the environment, opening up the industry for intense competition in a volatile commodity market with high fixed costs. Depending on (state-) regulation utilities had to separate their businesses or are allowed to operate integrated corporations:

• Generation is operating power plants (coal, natural gas, uranium in, electricity out) and marketing produced energy on (free) markets
• Transmission means transporting electricity over long distances, and earning regulated rates from generators (open access). Fairly wide moats arise from huge barriers to entry (upfront costs).
• Distribution-related companies own and service the last mile of cable to individual households and businesses. Rates are often regulated to subdue regional monopolies that often persits despite deregulation, effectively preventing excess returns (and the creation of shareholder value).

Most utilities carry a great deal of financial and operating leverage, with fuel being the only significant variable cost. The financial leverage often results from the wish to increase ROEs when ROAs and margins were capped.

• A common pitfall is to simply view high dividends as safe when they aren’t.

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