Investmentmoats.com is one of the most popular personal finance blogs. Kyith has kindly agreed to this interview and had taken time to carefully craft the answers that would be beneficial to you. I am grateful for that!
So let me give you a warning, this is going to be an info-packed article of 3,000 words. And yes, you should read this several times to sink in the message.
Why the name “Investment Moats”?
When i first start it is about trying to find a name for the blog and in my search I came across the term economic moat. Moat is a well fortified castle with a deep water bank surrounding the castle. It is how we should view our asset, or investments. I hope that readers would be able to leverage valuable information from my blog to create a rock solid investment portfolio.
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Is the term “moat”, inspired by Warren Buffett? Does he have any influence on your investment approach and philosophy?
Yes it is very much influenced by Warren Buffett, but after some time, it is reading the book Little book that builds wealth by Pat Dorsey that seemed to drive home the benefits of finding businesses with a franchise model. These are businesses that can consistently earn a stream of cash flow that is resilient in different external business conditions.
When I got started, I read the Intelligent Investor by Benjamin Graham, who Buffett looks up to. To be fair most of what i gathered from Buffett is rather high level. It was only later when I read some of the shareholder letters of Berkshire Hathaway that I gained more insights to reflect upon.
My approach is definitely fundamental based, but I have too much respect for these guys to consider myself a value investor.
Tell me more about the Pat Dorsey’s franchise model concept.
Pat Dorsey’s book is good for novice investors like myself to gain a general view of what are considered economic moat or franchises. The ability to earn consistently good free cash flow. Thats how I interpreted it.
He makes it easy to digest economic moat as four broad categories:
- Cost advantages
- High Switching Costs
- Network economics
- Intangible Assets
These franchise abilities might be easily recognizable or difficult. Sometimes it is just luck whether you manage to understand it better than others, or sometimes you con yourself to believe that there is such a moat.
Some would consider lowest cost producer to have a moat, or a brand to have a moat or a good manager to be a moat. They are rather weak competitive positions or perhaps there is no competitive differentiation at all.
If you are producing at the lowest cost you might have an edge, but it will be some time before people catch up to you. Rig builders like Keppel and SembMarine come into mind. The Chinese ship yards first takes the ship building from them, and now the simple rigs. They have to keep moving up the technological curve which is now the LNG industry or more advance rigs, which takes more time for the others to gain that competency.
A brand is only good if for the same item, people are willing to pay a higher price for it. Fasternal comes to my mind in that for the same screws people are willing to pay more for it.
The true cost competitive moat according to Pat is when the cost position comes because you have a geographical or constrain advantage, say, you are able to produce X crop at much better yield because for some reason the weather in your country cannot be replicated in other parts of the world.
High Switching Costs
In terms of switching costs, there are some businesses whose customers find it difficult to switch away from them due to fantastic competency unavailable in the market place or its just too tedious to do. Some examples that comes to mind locally is Silverlake, a provider of bank software solutions. They sell these systems to the banks, and because banks value business continuity and their systems as their edge over their competitors, they don’t want to switch around if its working for fear they cock up the whole show. They would rather continue to use Silverlake’s solution and this would mean a constant flow of maintenance recurring free cash flow. Same for perhaps aircraft maintenance for SIA Engineering Company. If you develop a reputation for reliable repair, the customers would rather stick with you then go for a cheaper option with questionable competency.
Network Economics is more prevalent in the tech space where an addition to an ecosystem exponentially enhance all within the ecosystem. Apple’s iOS ecosystem comes to mind. If you want to kill Apple, you got to start from scratch and even then you might not succeed. A local example is ESRI, the geo spatial subsidiary of Boustead. ESRI distributes their geo-spatial solution around the region, and in the mapping world, if you are a project manager and choose which mapping system for your requirements, would you go for one where its good or another incumbent where you can readily find engineers in the market who are brought up learning ARCGIS (ESRI’s mapping system). The company have already started seeding students in University doing their school projects with this. Plus to finish the project, there are readily more resources to help the developer faster finish the development then some other mapping system.
Intangible assets are in this case certain regulatory or patents that creates a high barrier to entry. This would be something intangible such as media in Singapore where it is highly regulated (Singapore Press Holdings), Telecommunication frequency spectrum allocation, drug patents.
In most franchise models, they tend to have a rather consistent free cash flow or earnings, and very resilient Return on Invested Capital (ROIC) or Returns on Assets (ROA).
How do you find companies with moats?
Unfortunately, I don’t really always buy the good moats ones. The reason being that sometimes if you see a $100 bill on the ground, chances are, someone would have taken it and its not there at all!
I usually prospect a business based on these criteria,
- Understanding the business that we are buying
- More due diligence, risk management
- Trading price of the business and different valuation approaches
Understanding the business that we are buying
Its not true that after identifying the moats qualitatively and we are done. We often self snook ourselves by thinking there is a moat, or no moat by doing things qualitatively. At the end of the day, the figures in the financial statements should substantiate the moat. You can’t have some moat stock and continue to see the gross margin’s consistently being eroded, or that return in invested capital wildly fluctuating.
I don’t start always looking for moats. I sometimes start looking for exceptional free cash flow or consistent earnings. If they can have that for 10 to 15 years, they must be doing something right. SIA Engineering Company, Vicom and Singpost show something like that. Not all business shows a good yearly free cash flow (at most alternate years, negative free cash flow should reverse positive), so sometimes I look for consistent Earnings Before Interests & Taxes (EBIT). EBIT is good as depreciation counterbalanced by maintenance Capital Expenditure (CAPEX).
You can have a business like Ezra or Capitaland that sells you a good qualitative story everytime, but when you look at their annual statements, their free cash flow is bleeding yearly. Order book business have lumpy cash flow. Its something that I am rather lousy at, or that as minority investors, I have absolutely the worst visibility. There are other shrewd investors that does well with those, but not me.
I take a look at the profit, free cash flow growth, and unleveraged metrics such as ROIC and ROA. I also look at how cash is being build up, or burnt and what the heck they do with the profit and free cash flow.
End of the day, understanding the business that we are buying means understand what kind of goose we are buying, whether its a white, grey or golden. In terms of prospecting its recognising a combination of the following
- a business that has a consistent cash flow but not much moat (UMS)
- a business that has a consistent cash flow with a good moat (Singpost)
- a business with mediocre to poor past cash flow, but its liquidating value is attractive (Fischer or Memtech)
- an orderbook based business that might be good or bad (vard, construction business)
- a business managed by good capital allocators, tycoons (Straits Trading, Ow Chio Kiat,Ho Bee)
- things I don’t understand
Knowing the goose tells me whether I want to continue looking into it or not. Sometimes it just doesn’t fit what I am looking for. Just like I say, I am rather lousy with orderbook business so unless I force the lazy me to do something about it, let’s just avoid the disappointment.
More Due Dilligence and Risk Management
This is rather related with the previous point in that it enables us to make sense of the business, but more than that, we try to use the experience that we gather along the way to manage risk. The more you disprove something is bad, the likelihood you have a rock solid stuff.
This entails trying to scan through everything on the internet you can get about the business. This may include investing a small amount to go to the Annual General Meeting (AGM) and get a feel, or speak to Investment Relations (IR). Talk to your network of people in the industry if its possible. Try to ascertain if your hypothesis is correct or not. Perhaps you are being overly optimistic or overly pessimistic.
Try to think from the owner’s perspective, and evaluate if they been good operators based on their past acquisitions, divestment, owner purchase and divestment. You can see that in perhaps Kingwan, Second Chance, Singapore Shipping and some really questionable ones in UMS. It helps you size up the goose further.
As a minority share holder, you can perhaps check for the past years whether what they have given you (dividends, buy backs, bonus shares) is much more than what they have taken from you since Initial Public Offering (IPO money, rights issue).
Trading price of the business and different valuation approaches
A friend told me value investing is making sure you don’t lose money. Looking at your downside rather than the upside. Take care of the downside and let the upside take care of itself. I have been trying to do this. If valuation is easy, then there will be a lot of winners.
The problem here is that valuation is changing due to the business. And it depends on your idea whether it is a golden goose or not.
There are usually more than one metric being used, and different metrics work for different geese.
In general, I use the PE, EV/EBITDA, DCF, XIRR more. The devils are in the details. For example, second order issues like what earnings or EBITDA to use and what is an appropriate discount rate and cash flow to assume?
Would you be able to elaborate some of the challenges when using these metrics?
If the business is a franchise, you probably felt its fair to pay 18-20 times PE for it. A franchise can grow at 10% for the next 10 -15 years. That is above average. A mediocre business can’t grow like that. In 5 years, your purchase price the PE of 20 gets cut by half to 10 times. If based on the trading price you can buy that franchise for 20 times or less, you probably will grab it. How often you find a business that consistently get 10-20 years of good growth? Its rare. We are probably talking about a McDonald’s kind of business.
If you pay a PE of 20 times for a consistent cash flow business with no moat, then perhaps its risky, because in the near or far future, that business might face a structural issue that can result in a few years of really poor cash flow or it might affect them as a going concern. You are probably paying too much.
Finding margin of safety(MOS) is about not losing money, and it ties closely about the earnings, free cash flow and discount rates used. It’s difficult to find a business that despite a recession, their earnings or free cash flow is just as good as when the economy is booming. Earnings usually moves to peak and then moderates down. There is a tendency for folks to look at a company with low PE and think they got a good MOS. The nature of the earnings might be that the business is operating at peak of their business or that its an orderbook business doing very well, when in the future their orderbook will look dramatically different.
A low PE, EBITDA in that case becomes high. You just self snooked yourself.
It is the same for DCF. DCF is rather unreliable because there are too many variables that make it unrealistic, you are assuming cash flow growth rate is consistent, you are assuming you can predict the future opportunity cost well to get a right discount rate. It is perhaps why Buffett prefers a simple PE measure then these complex DCF.
I still use DCF, but not alone. usually I alternate with these to layered and see if we purchase it now, it is undervalued, fair valued or overvalued. The earnings and free cash flow used is usually conservative. A good figure would always be the drab earnings and free cash flow in 2009, where most companies were having a really hard time.
If the DCF, PE and EV/EBITDA with such conservative earnings are close to current prices, yet we know they can provide consistent profits, we have a good idea that is our downside protection. This may be as bad as it gets. Can we live with the 5-6% dividend yield in that scenario? if we can then we buy and anything better is a bonus.
If we loosen the MOS, then we expand the growth projection and see how high the upside is, but we always are realistic that we keep checking back whether that growth scenario eventually takes place.
Things are not passive, you watch it well.
Based on the description of your stocks analyses, I assumed you subscribed to the bottom-up approach to build your stocks portfolio. Do you observe any portfolio rules? For example, diversification, expected portfolio yield or gains, etc?
As for portfolio approach, that has always been my weak point. Probably leaving 30% aside for opportunities. There are no industrial diversification or what, its basically owning things based on as much value i can find. In other words, try to own good “fixed deposits”. If they happen to be all airline stocks then so be it. I tend to have a 6% yield target but with a strict criteria that they exhibit fixed deposit behaviours when bought at certain prices, or that the economics of it ensures at the bare minimum 6% is earned with the hope of not losing any capital. I will relax this rule if i felt i understand the growth model and that i can sell a higher growth stock if its not working out, or that I don’t fully understand it. I can accept a < 6% dividend yield or no yield if its free cash flow is put into good deployment buy a good capital allocator. If you have a group of value investors helping you to deploy cash and you trust them, then why take the money? It is likely they are going to do better than you unless you think you are better.
You mentioned you leave 30% aside for opportunities. I supposed the 30% is in cash? And I also supposed this is not a strict percentage which you observe, and is dependent on the opportunities available at the point in time.
Its a rough target to have cash but thats because I am not doing a stocks and bonds allocation. If there are reasons to be greedy then I go 100%, it reflects the level of skepticism in the markets usually.
Any advice for fellow investors?
I am not sure what should I advise budding wealth builders. The problem is that when you are new to this, you might not be aware of a few things. Really whether you want to participate actively into this or that you want to have none of this.
It is all too easy to be inspired by Rich Dad Poor Dad, or some Value investing seminar, trading seminar that you feel empowered that you are above the average. If everyone is above the average, then who is below it. There can only be 50% above or 50% below.
Most will need to figure out that to do this well, they probably need to invest time and effort to learn their respective wealth building methods, be it trading or investing. They also need to be able to suffer from failures and learn the lessons well so that they emerge more successful.
Its easy to nod the head and say you understand this. I did the same thing and it was only through ordeals that I realized that we aren’t actually listening to what experienced investors taught us.
For those that are not prepared to put in the work, there is always the more simple way of forming a basic stocks and bonds ETF portfolio. Learn the basics of passive ETF investing and understand the philosophy to make it successful. The philosophy is very important here, because to execute it is very simple, but to stay with it and to frame your brain to see it through takes some training. An appreciation of behaviour psychology through reading, reflecting on your own bias can help tide you through.
Also, some of them may have stronger human capital, in that getting a raise beats vexing their brain on wealth building.
End of the day the equation is simple: Spend Less + Earn More + Build Wealth Wisely. Start Building Early. Channel More.