What I've learned about investing

June 1, 2007
What Ive learned about investing

Reflecting on seven years as an investment analyst
We all talk of businesses that can achieve brand and consumer loyalty, and businesses that seem able
to retain a strong competitive position over long periods, as being superior investments. But we often fail
to see the fundamental implications of such a statement. For one, such a statement is not a statement
about accounting or classical economics. It is about the characteristics of a business that give it a
durable advantage, and, therefore, a superior return on invested capital.
My reflections on successful investing, based on this analysis, are these:

1. When looking to invest, select a business with durably good economics
Select businesses with brand ownership with durably brand-loyal customers
When a business owns a brand that commands brand loyalty regardless of premium pricing, or even
better, commands brand loyalty because of premium pricing, then that business will have good
economics. Such a business will have the same input costs as its competition, but if selling its product at
a premium to a loyal following, then the returns of this business will be above average.
Which type of brands command brand loyalty regardless of premium pricing? The common occurrence is
when the brand name stays with the product up until the moment of consumption. For example,
beverages are typically drunk from the can or the bottle, and everyone can see which can or bottle the
consumer is drinking out of, so if the consumer decides to choose the inferior brand, everyone can see
them consuming an inferior brand, and this is embarrassing for the consumer. Therefore consumers will
typically stick with the premium brand in areas such as beverages because it is embarrassing not to do
so. There are many other areas where the brand stays with the product up until the point of consumption,
and these areas command brand loyalty also. These other areas include: ketchups, jewelry, chocolates,
credit card brands, yoghurts, chewing gum, cigarettes, take-away food and drink, toiletry and cosmetic
products, and newspapers. In contrast, let us compare this to purchasing a product where the brand does
not stay with the product at the point of consumption. A straightforward example is bread. By the time
bread gets to consumption it has come out of its branded packet, gone through the toaster, been
buttered, and made into a sandwich, and then delivered to the lunch table on a plate. The packaging and
the brand has long been left behind in the kitchen. So it is a quite different choice for the consumer
purchasing bread to the consumer purchasing beverages. In the case of bread the consumer can choose
the cheaper bread brand, and yet at the point of consumption no one will know any better so long as the
taste is comparable. There is little embarrassment possible from buying the cheapest bread brand and
therefore it is hard in the case of bread to create a brand that commands brand loyalty regardless of
premium pricing. Other areas where it is difficult to achieve such brand loyalty because the brand is
separated from or kept private at the point of consumption include starch-based foods, fish, fruits, socks,
petrol, electricity and other household utilities, airline flights, copier paper, and taxis.
Another area where brand loyalty is durable regardless of premium pricing is where the brand exists in an
area where a high level of trust is required. In this case consumers prefer to stick with the brand they
know rather than experiment with a new brand even if it is cheaper. Examples of areas commanding trust
include condoms for example would you want to try a cheaper brand but run the risk that it did not
work? Other areas where trust is important include restaurant review guides, financial investment and
advisory products, vitamin and healthcare products, and specialist equipment for example climbing
equipment brands.
We are looking only for brands where the brand loyalty is durable. There are brands in technological areas
that command loyalty at a point in time, and fit the prior criteria of being visible at the point of
consumption, for example in mobile phones. But the brand loyalty is not durable here because the
consumer views the premium brand as the one with the best technology, not the one with the best name
or premium price. So consumers will switch loyalty as the technologies evolve. For durable loyalty it is
important to find a brand in an area which is not likely to undergo technological change. There are several
areas worth mentioning where brands have strong loyalty at any one time, but where the loyalty is not
likely to be durable because of inevitable technological change. And businesses in these areas will be
much less likely to have durably good economics. These areas include: mobile phones, automobiles,
computers, televisions, and audio playback devices.
Select businesses with a secret in manufacture
A second feature that gives a business good economics is if the business possesses a secret in its
manufacturing process. Such a business, much like a brand-owning business with brand-loyal customers,
can price its product at a premium. In this case, however, the product can be priced at a premium not
because the consumers will remain loyal even in the face of cheaper competition, but because there can
be no competition if the production of the product is based on a secret process. Examples of businesses
that exploit this include some beverage businesses that use a secret formula to create their drinks, other
specialist consumer goods businesses, and some manufacturing businesses.
Select businesses that have an enduring position as a lowest cost producer
A third feature that gives a business durably good economics is if the business has found a durable way
to be a lowest cost producer. If a business can bring its products to the market at the lowest cost, yet
still sell its products at the same level as the market average, then the business will have good
economics because that business will have below average costs but average selling prices. The
economics need durability, however. An importer, for example, may at a point in time be able to bring a
product to market from abroad at the lowest cost available. However, this low import cost is not
necessarily durable import costs may rise in the future.
There are several ways nonetheless in which a business can lower its cost base in a durable manner
versus the competition. Most straightforward is if the business has established dominant market
leadership. In this case, then its above-average buying power is likely to lead to below-average buying
prices, creating a below average cost base that can be sustained so long as market leadership is
sustained. A further way can be identified in retail businesses by owning its real estate a retail business
lowers its cost base in a durable way. Because of the lack of rental payments that such a retailer would
have to face, it can establish an enduring position as a lowest cost producer.
Select businesses that have a secret in customer retention
A fourth feature that gives a business durably good economics is if the business possesses a secret in
customer retention. If a business is able to retain customers despite above average pricing increases, this
leads to a higher return on capital employed from higher selling prices without volume declines. A
common way in which this is achieved is by getting the customer to sign long-term contracts at the initial
time of purchase but contracts that allow the business to put through subsequent price increases whilst
still locking the customer in. Rental contacts are an example of this. Other examples include the
contracts put forward by alarm installation businesses, elevator and lift service businesses, and corporate
travel management businesses. There are also other secrets in customer retention. One is if the product
is addictive. Caffeinated drinks, cigarettes, for example have addictive qualities, as do gambling
businesses.
Select businesses with ownership of required and unreplicable infrastructure
A fifth feature that leads to durably good economics is if the business in question owns an unreplicable
and necessary piece of infrastructure. Examples include a unique high street location, a piece of transport
infrastructure such as a port or an unregulated toll bridge, a theme park, or a vineyard in a location
recognised as superior. So long as the infrastructure is necessary, unreplicable and unregulated, then
overtime the business in question will be able to raise the fees that the infrastructure is generating, and
those that pay the fees either the customers or the tenants will have no choice but to accept the
higher pricing.
Select businesses in industries that exploit a natural oligopoly but are not profit regulated
A sixth feature that leads to durably good economics if the business exists in an industry that exploits a
natural oligolpoly but is not profit regulated. A good example of an industry which is a natural oligopoly, or
where only a limited number of players are allowed to compete and new entrants are restricted, yet the
profits of the industry are not regulated, is the defence industry.
Defence is a core responsibility of the government and it is one responsibility that the government will not
want to be handled by foreign businesses. That means that native businesses employed in this segment
are already immune from foreign competition. However, the government also will require a limitation on the
number native of businesses that serve it in defence, because the material being worked with is very
sensitive and the government needs to continually monitor who has access to this material. So the
government will itself enforce a natural oligopoly in the defence sector limiting the number of businesses
to a handful of trusted local businesses. This leads to good and durable economics for those
businesses.
Select businesses in industries where accounting fails to communicate full business profitability.
The seventh and final characteristic that leads to a business possessing durably good economics is if the
business operates in a sector where the accounting standards fail to communicate the full profitability of
the business. The impact of the full profitability not being disclosed is that potential competitors do not
appreciate the full profitability of being in the area of the market that the business operates in and
therefore the number of new competitors entering the market is reduced.
It is not desirable to invest in businesses that are deliberately misleading investors through improper
accounting. These types of businesses should be avoided. However, it is also the case that it is hard to
set accounting standards that accurately depict economic reality in all segments of business activity, and
this creates the opportunity that we are concerned with. Two of the most important cases relate to the
expensing of advertising spend and the depreciation of freehold real estate. Lets consider each of these
in turn.
In the first case, money used to pay for advertising is fully expensed as it is spent, and this treatment of
advertising spend leads to a profit understatement. Advertising spend is somewhere inbetween an
investment and an expense. It is neither one nor the other, but the accounting standards treat it as a full
expense. Advertising campaigns increase the economic goodwill associated with a brand, yet the
accounting standards do not account for this there is no legal requirement placed on the auditing bodies
to value the gain in economic goodwill achieved by a business. This seems perverse when we remember
that the legal courts of our nations are commonly confronted with the necessity of valuing the loss of
goodwill, and of calculating damages to goodwill, in cases of corporate dispute. If the courts can attest
that the loss of goodwill represents an economic loss, then an increase in a company's goodwill is an
economic gain, or a profit. Yet this is not a profit reported by companies because accountants do not
audit the increase in a company's economic goodwill. This situation has arisen perhaps because putting a
value on a gain in economic goodwill is imprecise if not impossible. And the auditing profession is
concerned with that which is precise and possible. There is not an easy resolution to this problem from
the perspective of the auditing profession. However, it presents an opportunity for investors because it can
have a significant impact on the difference between the reported profits of a company and the true
economic profit. Consumer goods businesses for example may spend up to 10% of revenues on
advertising each year. Should this spend not be expensed, but capitalised, and then appreciated and
amortised over a number of years a more realistic treatment the reported profitability of these
companies would be significantly higher.
In the second case, non-core real estate holdings generally lead to higher real profitability than is reported
also. There are several aspects to accounting standards that mean that the profits reported from real
estate owning businesses do not reflect the full reality. Firstly, it is common accounting practice seen
as prudent to depreciate freehold real estate assets over 40 years, or by 2.5% a year. This means that
if a business owns 100 million of real estate, it will write down the value of that real estate by 2.5 million
a year. So the reported profits will be 2.5 million pounds lower every year than it would have been had
the business owned no real estate. The accounting write-down of real estate is nonsense economically
speaking, however. Well maintained real estates appreciates, rather than depreciates. A further point on
real estate is that not only do the accounting standards enforce a non-sensical annual write down of real
estate, but they also ignore the annual appreciation of real estate. If the value of a businesss real estate
holdings increases, then the increase in value is a profit. However, this profit is not disclosed by
businesses owning real estate where real estate is not their core business. The profit disparity becomes
more significant when dealing with a retail business developing property, as many retail businesses do in
their normal course of business. In this case the property is bought at an undeveloped price, and then the
property is redeveloped to the retail fascia. Both the redevelopment profit and the appreciation profit
remain undisclosed.
Therefore, businesses spending significant sums on advertising or with significant non-core real estate
holdings are likely to have higher real profits than their reported profits. And in both cases the undisclosed
profit is not taxed, additionally leading to a tax-efficient model. This leads to good economics because it
limits competition within the industry since most potential competitors will assess new investments
based on the rate of return available based primarily on the reported accounting standards only.

2. Invest in businesses with durably good economics but which also are well run, financially
strong, innovators, visible, and at a price that makes financial sense to you
Select a business that is well run
Firstly, it is important to pick a business that is well run and run in the interest of its shareholders. It is
unfortunately possible for a business to have good economics yet not be run in the interest of its
shareholders. In the most extreme case, this is manifested in fraud and is illegal. But in less severe
examples it manifests itself in management laziness and gradual business decline. So how can we
ensure that the business we are considering investing in is well run? The way I recommend is to look at
the track record of a business, much like you would consider the track record of a person when
assessing their suitability as a business partner. A well run business with good economics should have a
track record of delivering a high and stable return on equity every year, without using material debt and
without issuing shares. The return on equity is the profit the company makes after tax divided by the net
shareholders funds. A well run business with good economics should have a consistent track record of
delivering a return on equity in excess of 15%, year in, year out. There is no quick way of assessing a
companys track record other than going through each annual report and manually completing the
calculation. Generally I recommend calculating the return on equity for the last 10 years to get a good
picture. If a business fits the criteria for having good economics but does not have a good track record of
returns on equity, then special cases aside it is unlikely to be being run in the interests of its
shareholders and should be avoided.
Select a business that has a strong financial position
Secondly, it is important to pick a business that has a strong financial position. There are two reasons for
this. Firstly, to protect against bankruptcy risk. But secondly, because a strong financial position puts a
business in a position to innovate and take the appropriate operational risks to grow the business.
Select a business with a good track record in innovations
Even businesses with durable products and brands are subject to changing market conditions, and
innovation is key for long term survival. Normally businesses with a good track record as innovators will
tell you about their innovations in their annual reports. Reading the management commentaries in recent
annual reports is therefore necessary to establish if a business has a good track record in innovation.
Look for a business that has highly visible operations
Any investor has to spend part of their time checking up on their investments. But it is much easier to do
this if it is easy to see what the business is doing as part of your everyday life. A business dealing in
exotic financial derivatives is virtually impossible to check up on as part of your day to day life. But a
business selling chocolate bars, for example, is likely to be a lot easier to check up on. To be confident in
your investments you must understand them, and it is easier to understand them if you can see what
they do from day to day. It is also the case that nasty things like fraud are less likely to occur at
businesses that are very public in what they do, because the temptation to defraud investors is much less
in businesses operating in a highly visible way. If something is going wrong at a business, it is best to be
able to be the first to see it yourself because you interact with that business in your day-to-day life, rather
than to have to make special time every month to take time to research that business to make sure all is
ok.
Make an investment at a price that makes financial sense to you
Try to find businesses that you think you can hold for the long term. And invest with money that you can
allocate for the long term. As a broad brush approach, if you can buy a business with durably good
economics that meets the above investment criteria and below 15x the earnings that the business will
make in a normal year, then you can expect the investment to perform very satisfactorily over the long
term.

3. Search for investments meeting these criteria in spin-offs, IPOs, corporate restructurings and
other new listing opportunities
To find the opportunities meeting the above criteria, focus on businesses that are newly listed on the
stock market. Spin-offs, IPOs, and corporate restructurings create such opportunities. These are the
companies which other investors dont already understand, so your competition is lower. It should be
relatively easy to ascertain in your own mind whether newly listed businesses meet the criteria of having
durably good economics. However, it takes more time with new listings to ascertain the track record of
businesses. You will have to go through old annual reports, purchase documents from Companies House,
or if the business used to be part of a larger public business you will have to go through the subsidiary
disclosures from the parent business annual reports. Remember though the fact that this bit takes time
is your competitive advantage. It is precisely because the track record of new listings is harder to
establish that new listings with durably good economics are often available to be purchased at attractive
price levels.

Over to you
That is a very short synopsis of what I have learned. I dont presume to write this to offer advice. I have
been reasonably fortunate rarely to receive advice and learnt on the job and through reading.