Investing Classroom: Thinking like an analyst

Four basic questions
The answers to these questions for restaurants, or for any business, can be found by asking four very general questions to kick-start the analyst thought process:

1. What is the goal of the business?

2. How does the business make money?

3. How well is the business actually doing?

4. How well is the business positioned relative to its competitors?

Once you start thinking in these terms, and sharpen your observational skills, you'll be well on your way to thinking like an analyst, constantly on the hunt for investment opportunities.

The goal of restaurants, for example, is to feed customers. This seems pretty straightforward--although some restaurants have also tried to combine meals with entertainment to mixed success--but don't just assume a business's purpose is obvious. Be sure you have a good idea of what it's really trying to achieve. Then ask if it makes sense for this business to try to achieve this objective. Does it make sense for a restaurant to also entertain customers, for example?

Once you have a good idea of what the business is trying to do, think about how it makes money. In our restaurant example, how much does the food in the restaurant actually cost? Can the restaurant charge more for its food because of a pleasant ambiance or because it is providing entertainment? Is the restaurant trying to sell a lot of meals at a low price, or is it attempting to sell fewer meals but at a much higher profit per meal?

Then ask yourself, "How well is the business doing?" Don't worry about picking up any financial statements just yet; rather, focus on observing what you can about the business. Back to our restaurant example, think about where you choose to eat and why. Has your favourite place been around a long time? Are there lots of locations for your favourite restaurant? Are they busy, with people in line or in the car park? Are they in good locations? Do they seem to get a lot of repeat business? Do they seem to have a better calibre of waiting staff? How fancy are the interiors? As a potential investor in this or similar businesses, all this stuff counts.

If you think you have a pretty good understanding of the business's performance, at least as an observer, spend some time thinking about how well it functions in its industry. In other words, assess the competition.

Is there a lot of competition in its industry? With restaurants, there certainly seem to be a lot of choices, but what about an entirely different industry, like computers? Are there as many types of computer companies as there are restaurants? Not by a long shot. Does that mean that the computer industry isn't as competitive as the restaurant industry? Not necessarily. Instead it might mean that competition functions very differently. Since it takes a tonne of capital to start up a computer company, and not so much to start up a restaurant, maybe there is more risk in computer manufacturing? Maybe finding new products is also more difficult? Maybe one of the only ways to compete in the industry is on price? Asking these kinds of questions can give you a good idea of how well a specific business is positioned to cope with the challenges it may encounter.

At this point it may seem like we're going a little nuts generating questions, but thinking like an analyst involves observing the business world and asking questions to understand how it works. Thankfully, there are also experts who have done a lot of this thinking already, and many of them have developed useful frameworks to help organise our thinking even more.

If we think back on the four questions we mentioned earlier, we should be able to get a good handle on a business's goals and on its performance just by reading about it and studying its financial statements. It's really the last question, the one in which we consider how well a company is positioned relative to its competitors, where we might need some more help.

Finding a framework: Moats
It's a bit strange to think that an image typically associated with the Middle Ages might offer a framework for stock analysis. As we've already seen, in order to really think like an analyst, it's important to consider factors beyond just the numbers. After all, our quest is to find exceptional companies delivering outstanding performance, in which case we may need to put forth extra effort to find that "Holy Grail".

One helpful concept is that of an "economic moat." And while you may not hear it used as often as terms such as P/E ratio or operating profit, the concept of an economic moat is a guiding principle in Morningstar's stock analysis and valuation. Eventually the idea may gain more of a following since we think it is the foundation for identifying companies that create shareholder value over the long term. In the meantime, we'll just consider ourselves lucky to have a framework that can separate really great companies from the merely good ones.

What is an economic moat?
Quite simply, an economic moat is a long-term competitive advantage that allows a company to earn oversized profits over time. The term was coined by one of our favourite investors of all time, Warren Buffet, who realised that companies that reward investors over the long term have a durable competitive advantage. Assessing that advantage involves understanding what kind of defence, or competitive barrier, the company has been able to build for itself in its industry.

Moats are important from an investment perspective because any time a company develops a useful product or service, it isn't long before other firms try to capitalise on that opportunity by producing a similar--if not better--product. Basic economic theory says that in a perfectly competitive market, rivals will eventually eat up any excess profits earned by a successful business. In other words, competition makes it difficult for most firms to generate strong growth and profits over an extended period of time since any advantage is always at risk of imitation.

The strength and sustainability of a company's economic moat will determine whether the firm will be able to prevent a competitor from taking business away or eroding its earnings. In our view, companies with wide economic moats are best positioned to keep competitors at bay over the long term, but we also use the terms "narrow" and "none" to describe a company's moat. We don't often talk about the depth of a moat, yet it's a good way of thinking about how much money a company can make with its advantage.

To determine whether or not a company has an economic moat, follow these four steps:

1. Evaluate the firm's historical profitability
Has the firm been able to generate a solid return on its assets and on shareholder equity? This is probably the most important component to identifying whether or not a company has a moat. While much about assessing a moat is qualitative, the bedrock of analysing a company still relies on solid financial metrics.

2. Assuming that the firm has solid returns on its capital and is consistently profitable, try to identify the source of those profits
Is the source an advantage that only this company has, or is it one that other companies can easily imitate? The harder it is for a rival to imitate an advantage, the more likely the company has a barrier in its industry and a source of economic profit.

3. Estimate how long the company will be able to keep competitors at bay
We refer to this time period as the company's competitive advantage period, and it can be as short as several months or as long as several decades. The longer the competitive advantage period, the wider the economic moat.

4. Think about the industry's competitive structure
Does it have many profitable firms or is it hypercompetitive with only a few companies scrounging for the last pound? Highly competitive industries will likely offer less attractive profit growth over the long haul.

Types of economic moat
After researching hundreds of companies, we've identified four main types of economic moats.

Low-cost producer: Companies that can deliver their goods or services at a low cost, typically due to economies of scale, have a distinct competitive advantage because they can undercut their rivals on price.

High switching costs: Switching costs are those one-time inconveniences or expenses a customer incurs in order to switch over from one product to another. If you've ever taken the time to move all of your account information from one bank to another, you know what a hassle it can be--so there would have to be a really good reason, like a package deal on an account and mortgage for example, for you to consider switching again.

Companies aim to create high switching costs in order to "lock in" customers. The more customers are locked in, the more likely a company can pass along added costs to them without risking customer loss to a competitor.

Surgeons encounter these switching costs when they train to do procedures using specific medical devices, such as the artificial joint products from American medical-device companies Zimmer or Stryker. After training to learn to use a specific product, switching to another would require the surgeon to forgo comfort and familiarity--and what patient, much less surgeon, would want that? Additionally, because the surgeon would have to be trained to use a new, competing product, he or she would also have to contend with lost time and money resulting from not performing as many surgical procedures. Clearly, with certain products and services, the switching costs can be quite high.

The network effect: The network effect is one of the most powerful competitive advantages, and it is also one of the easiest to spot. The network effect occurs when the value of a particular good or service increases for both new and existing users as more people use that good or service.

For example, the fact that there are literally millions of people using eBay makes the company's service incredibly valuable and all but impossible for another company to duplicate. For anyone wanting to sell something online via an auction, eBay provides the most potential buyers and is the most attractive. Meanwhile, for buyers, eBay has the widest selection. This advantage feeds on itself, and eBay's strength only increases as more users sign on.

Intangible assets: Some companies have an advantage over competitors because of unique nonphysical, or "intangible," assets. Intangibles are things such as intellectual property rights (patents, trademarks, and copyrights), government approvals, brand names, a unique company culture, or a geographic advantage.

In some cases, whole industries derive huge benefits from intangible assets. Consumer-products manufacturers are one example. They build profits on the power of brands to distinguish their products. Well-known PepsiCo is a leader in salty snacks and sports drinks, and the firm boasts a lineup of strong brands, innovative products, and an impressive distribution network. The company's investment in advertising and marketing distinguishes its products on store shelves and allows PepsiCo to command premium prices. Consumers will pay more for a bag of Walkers crisps than for a bag of generic crisps. As the value of a brand increases, the manufacturer is also often able to be more demanding in its distribution relationships. To a large degree, brand power creates demand for those chips and secures their placement on store shelves.

One final thought about economic moats: It is possible for some companies to have more than one type of moat. For example, many companies that use the network effect also benefit from economies of scale, because these companies tend to grow so large that they dwarf smaller competitors. In general, the more types of economic moat a company has--and the wider those moats are--the better.

The bottom line
Successful long-term investing involves more than just identifying solid businesses, or finding businesses that are growing rapidly, or buying cheap stocks. We believe that successful investing also involves evaluating whether a business will stand the test of time.

Moats are a useful framework to help answer this question. Identifying a moat will take a little more effort than looking up a few numbers, but we think understanding a company's competitive position is an important process for determining its long-term profitability. And as we’ve stated in earlier lessons, how well a company's stock performs is directly related to the profits the firm can generate over the long haul.