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Why it pays to fill your portfolio with companies that have high return on equity.

Photo of Roger Montgomery By Roger Montgomery, Skaffold

Irrespective of whether the sharemarket rises or falls in 2012, you can do well long term by investing in these simple steps or truths:

1. Over the long term, share prices follow the correctly calculated intrinsic value of a company (see figures 1 and 2).
2. Buy businesses with rising intrinsic values - their true worth (figure 1, not figure 2).
3. Intrinsic value is a multiple of book value, also known as equity, based on the profitability of that book value.
4. Profitability is best measured by return on equity.
5. Buy businesses with high rates of return on equity.
6. For high rates of return on equity to be sustained by a business, it needs a sustainable competitive advantage.

Therefore, to find businesses whose share prices will rise in the future, you must fill your portfolio with businesses that have a sustainable competitive advantage.

Figure 1. McMillan Shakespeare's rising share price (the yellow line below) followed rising intrinsic value (the straight blue line), according to my research tool, Skaffold.

McMillan Shakespeare's rising share price - 2004 to 2012


Figure 2. Telstra's intrinsic value, (the straight blue line below), has not risen in 10 years. Neither has the share price (the orange line); it's lower than 10 years ago.

Telstra share price chart - 2002 to 2012


Figure 1 and 2 show that a portfolio of businesses with rising intrinsic value can easily beat the majority of investors who are in conventional blue chips. True blue chips, however, are companies with rising intrinsic values and sustainable competitive advantages.

Whether it is the strength of their brand names, the characteristics of their products, or the strength of their distribution systems, the best businesses have a combination of factors that give them enormous competitive advantage that creates a protective barrier or moat around their business castle.

Companies without advantage

In contrast, the mediocre company battles every day because it has no such advantage.

Large fund managers who fear their returns will diverge from the major indices must invest in inferior companies lest their share prices rise and the manager misses out.

As a private investor, you can follow the approach of a small boutique fund such as Montgomery Investment Management, and focus on businesses with distinctive features and identifiable competitive advantages. By concentrating on a few, easy-to-understand businesses, and with the right tools, you can build a market-beating portfolio.

Montgomery uses Skaffold as its valuation tool, to identify and acquire businesses that it believes it understands, that have attractive and sustainable underlying economics, and are run by managers with a demonstrated record of superior performance.

If you can understand business economics and can find 10 to 15 sensibly priced companies that have the important long-term competitive advantages I describe in this article, you have what you need to beat the market over the long term. I would go so far as to suggest that broader diversification - adding a 16th best company - is unnecessary and could hurt your results and increase your risk.

Return on equity tells us much

Wonderful businesses have high rates of return on equity, a powerful ratio because it says so much about the business, its management and balance sheet.

It is relatively easy to run a screening process on listed companies to find those that have generated high rates of return on equity. But the numbers you will be looking at are generally historical. They can give an indication of the position of the company and its strengths or weaknesses in the past, but are not always an accurate prediction.

If the historical returns on equity have been stable for many years, as well as high, then a prediction is a little easier, and the numbers could be a reasonable guide to the future. But these examples do not dominate the sharemarket lists. For most companies, the return on equity for the next few years will look nothing like those reported for the past few.

What forces are at play?

In thinking about what the future return on equity may be, understand what forces are producing those high returns today and ask what could come along and change them? This part of investing requires no calculators, spreadsheets or equations. Sit back and think: why is this business so good and what makes it so special? If someone with very deep pockets wanted to enter the industry, could they damage the performance of this company?

High returns on equity are not normal. They are unusual and difficult to maintain because competitors want to take away some of the money the most profitable company is making.

When a company is generating high returns, newcomers will want a piece of the pie - if possible, start a business in competition. If there are no barriers preventing or making it difficult to start a new business in that particular industry, it is likely that any high returns on equity that you see being produced today will be unsustainable.

As more and more competitors enter the market, the returns get lower and lower for everyone.

Think about it this way: If a company can generate a 40 per cent return on its equity every year, this should attract competitors - many competitors. When they arrive they will offer the product or service at a cheaper price. The incumbent company may respond by lowering its own price to maintain its market share, but its return on equity is likely to decline. Therefore, a company that can generate a 40 per cent return on equity for a long time is special.

The high rate of return on equity should, in theory, have been competed away unless the incumbent has developed something intangible that causes people to prefer its store, and pay more - something truly valuable.

What is competitive advantage?

There are assets the company has built up over years, such as a great reputation, that cannot be obtained easily, replicated, duplicated or imitated by a competitor. The company with true barriers to entry has something more than hard assets that can be purchased.

These "barriers to imitation" are intangible and cannot be valued by an auditor or accountant. They may be due to culture, managerial competence, information advantages, property rights, years of simply providing a superior product or service, or a combination of all of those. Perhaps competitors simply do not understand why the superior company does so well, so it would be next to impossible to imitate.

Whatever the characteristic or combination, the company has some form of what is known as economic goodwill or a sustainable competitive advantage, which allows it to outperform.

The best companies to own are those with little or no debt, bright prospects and high rates of return on equity, driven by a sustainable competitive advantage. And importantly for their owners, a business that can raise prices each year allows a company to increase profits without requiring additional injections of capital.

Good long-term investment results will accrue to you if the majority of the companies in your portfolio have important competitive advantages that are enduring. Even better results will accrue if you buy those businesses when they are cheap. But for now it is important to understand the main drivers of high rates of return on equity.

JB Hi-Fi as an example

It was not hard to conclude that JB Hi-Fi was a better investment than Clive Peeters. When the guy at the Apple store tells you the cheapest place to buy a Mac is JB Hi-Fi, you have to conclude it has some important business advantages that keep people going back. Indeed, consumers have told me they would rather wait until JB Hi-Fi has a product in stock than risk paying too much by being impatient.

A mediocre company has no such advantage, no compelling reason for people to buy its product or service.

This is one of the big things that investors, market commentators and advisers miss, because they are talking about or trading shares rather than thinking about businesses. Most investors are consumers and so most have a reasonably good grasp of the things that drive consumer behaviour. You will make some mistakes, but if you stick to businesses with high rates of return on equity, little or no debt, and where you can identify a competitive advantage, you will minimise, to a great extent, the most important risk - permanent loss of capital.

The 'why' is most important

In considering the sources of competitive advantages, remember that what you seek is a reason for the already demonstrated high rates of return on equity. That will help you to determine its sustainability. If one of the sources has been in play for a few years but high rates of return on equity are not present, then no valuable sustainable competitive advantage exists.

Great competitive advantage allows a company to do something that lesser companies cannot: charge more for the same product or service than the next guy.

One source is a reputation for quality or desirability that encourages people to pay more. Intangibles like this cannot be readily imitated. Be careful though. A truly valuable competitive advantage only exists if more can be charged or if lower sourcing costs can be sustained. People may be willing to pay more for a Pandora bracelet, for example, than another charm bracelet, or more for an Apple iPod or iPhone over another MP3 player or mobile phone.

Another source of competitive advantage is regulation or government policy. This could be in the form of legislation that entrenches the existing competition, for example, to ensure the big four banks in Australia cannot merge. Or where government accreditation is required before participation in a business venture that is likely to emerge, following a review of private colleges offering English courses to international students. Or a company might be able to charge less for its toxic waste disposal services because it has a right to dump in more convenient locations, whereas competitors have to cart heavy but low-value materials long distances.

Customer inertia

Banks highlight a competitive advantage in their relationship with their customers. How often have you changed banks? Despite widely publicised dissatisfaction with banks, few people actually switch banks. It is called customer inertia and it is a very real source of competitive advantage because the banks can charge more without fear of losing customers.

There is a perception that banks are all the same anyway. And that the perceived costs of switching are higher than the perceived benefits.

High personal switching costs also exist when a business provides a product or service that is critical to the customer's business; or the product or service is integrated with the customer's process or procedure; or the customer has invested in long-life assets provided by the business.

There are other, less-obvious companies that also benefit from customer inertia, and to a greater or lesser degree have the ability to charge more without fear of losing customers. Few have the entrenched long-term stability that banks enjoy but at enjoys similar benefits, as does MYOB, Xerox and, until recently, Reckon with its accounting and business administration software. Computershare enjoys the benefits that accrue from high switching costs.

A major source of enduring competitive advantage is scale or size. When scale leads to higher profit, multiple sources of competitive advantage - wide moats that protect the business against competitors - spring up.

As companies get larger they benefit from greater buying power. This produces higher profit margins, allowing the company to invest in better systems and processes. This lowers costs again, allowing increased profit margin or reduced prices charged to customers. Sales increase and greater buying power emerges to start the cycle again. This cycle is known as the "profit loop" and was perfected by the likes of Walmart and Costco in the United States.

It has been adopted here by companies such as Woolworths, JB Hi-Fi and The Reject Shop. Indeed, retailers worthy of investment must demonstrate these advantages along with an established brand, because customer switching costs are low and barriers to entry and barriers to imitation are virtually non-existent.

Think why may be the first place you go to if you are thinking of buying a new home or an investment property. Because you know it will have the most homes listed - because it has the most real estate agents listing their properties. And a real estate agent will tell you they prefer to list on REA's website because more buyers visit it than any other.

Other sources of competitive advantage include exclusive access to intellectual property that is either included in a product or used to manufacture it (Cochlear); customer loyalty, cost advantages from smarter processes that in particular prevent competitors offering a lower price (Woolworths); better buying (The Reject Shop); long-term relationships or simply a historical or legacy advantage, such as the purchase of the plant when prices were much lower.

Others include exclusive access to natural resources (BHP Billiton and Rio Tinto). Local geographic monopolies that dissuade a competitor from setting up nearby (Westfield) can also be a sustainable source of competitive advantage. Brands are often cited as a source of competitive advantage and, arguably, they are most valuable when they have become household word: "Xerox this", "WD40 that", "pine-o-clean these tiles". Instead of paracetamol, people ask for Panadol.

You won't find these valuable assets on a balance sheet, yet they are a truer source of economic goodwill than the accounting goodwill found on balance sheets far more often.

Each source of competitive advantage has its risks. People could simply switch their allegiances from Pandora to something else, the government could change the legislation protecting the fee-generating power of the big banks, or Google could launch a free real estate listing site for agents.

But where you can identify one of these sources, you are in a much better position to beat the market, provided you can also buy the shares below intrinsic value.

About the author

Roger Montgomery is Chief Investment Officer at Montgomery Investment Management and author of the best-selling sharemarket guide book, The Montgomery [Private] Fund is provided by independent Australian fund manager Montgomery Investment Management. Using Skaffold, which estimates the past and future intrinsic values of every Australian company, the Montgomery [Private] Fund delivered significant outperformance, above every major index, to its clients to March 31, 2012*.

Skaffold is also available for DIY and SMSF investors.

*Past performance is not a guide to future returns.

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