Book review: Pat Dorsey’s “The Five Rules for Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market”

His bio per Morningstar: Pat Dorsey, CFA, is Director of Equity Research for Morningstar and author of The Little Book that Builds Wealth and The 5 Rules for Successful Stock Investing.

Book URL on Amazon: http://www.amazon.com/dp/0471686174/ref=cm_sw_su_dp

Overview:

This book is an excellent intro-level handbook for equity investing newbies. The financial analysis segments are a bit too basic for most entry-level investment bankers and research analysts, but his clear explanations of basic equity and financial statement analysis is perfect for the aspiring single stock equity investor. His suggested investing style is pretty much a by-the-numbers Morningstar approach that advises buying shares of companies with competitive economic moats at prices that provide attractive investment returns and acceptable margin of safety (pseudo Warren Buffett style value investing). The book does a good job of explaining what an economic moat is and why it’s important, and lays out some basic rules of thumb that investors can use to identify possible moats. Anyone who’s read their Michael Porter or received their MBA probably won’t find many new ideas on competitive analysis in this book, but the book’s target audience probably doesn’t have that background. Since I like the idea of helping “the little guy” out when it comes to making it easier to succeed at investing (and I read nearly every darn investing book anyone recommends to me), I’ve gone through the book and summarized a bunch of the key takeaways. My notes aren’t comprehensive and don’t cover every chapter in the book, but they probably can help you decide if you should buy the book to explore these issues in further detail.

General/miscellaneous notes:

• “Great companies create wealth, and as the value of the business grows, so should the stock price in time.”
• None of the truly exceptional managers spend time thinking about what the market will do in the short-term.

• Always build-in a margin of safety into all of your investments. You might unintentionally overestimate future prospects for a company. You should have a larger margin of safety built-into investments that are shakier or riskier due to uncertainty about the company or industry.
• Short-term holding periods are inferior to long-term holding periods: you pay higher capital gains taxes and commissions eat up a larger portion of returns, which overall tends to explain why lower-turnover/longer-horizon investors have better results over time.
• Long-term stock performance is “largely based on the expected future cash flows of the companies attached to them” and doesn’t truly relate to short-term trading action.
• If you make a bad investment and your analysis was incorrect, don’t hold on to the position, just sell it. Cut your losses and prevent a major catastrophe and take the tax break on the loss to shield other gains. Use the capital to find something that has more attractive prospects.
• Avoiding losses is extremely important: It takes a lot of winners to make up for a few big losers. A stock that’s down 50% has to then appreciate 100% to get back to flat.
• “The four most expensive words on Wall Street are ‘It’s different this time.’”
• Going against the grain (being contrarian) takes courage, but it can be rewarding. Think for yourself and try to find good bargains based on value versus price. Look at areas of the market (industries, companies) that are out of favor instead of looking at the hottest sector/stock according to the herd/press/public.
• Don’t time to try the market. ZERO funds that Morningstar follows has consistently been able to “time the market” so it’s highly unlikely that you can do it.
• Don’t try to buy ahead of “positive news flow” or “strong relative strength” because it’s speculation based on what MIGHT be instead of what WILL be.
• Cash flow is more important than earnings. Accounting earnings do not equate to cash that the company spends or receives.
• Look at FCF margin to figure out what % of each dollar of sales (on average) the company is able to turn into actual cash that the company generates in profits that are truly “free” for management’s capital allocation decisions.
• His general rule of thumb: he considers FCF margins of 5%+ indicative of a company that could be a cash flow machine.
• He states that “Academic research suggest that a firm’s strategy is ROUGHLY TWICE as important as a firm’s industry when it’s trying to build an economic moat.” [Emphasis added]

Economic Moats:

• Moat describes a firm’s competitive advantage, the moat keeps competitors from attacking a firm’s profits.
• The most profitable firms attract competition, which is why the vast majority of companies see their profitability regress to the mean. They become less profitable over time due to competition (without a competitive advantage and a wide moat).
• Moats allow a small number of companies to post above-average profitability for long periods of time, which can make them superior long-term investments.
• Companies that succeed historically rarely perform well in the future b/c success attracts competition.
• Competitors try to offer a better product (which steals away your customers and erodes market share) or they offer lower prices (which also hurts your market share and hurts industry profitability).
• Two key aspects of an economic moat: depth and width. Depth = how MUCH profits can a company generate using their economic moat. Width = how LONG can a company sustain above-average profitability. Dorsey correctly notes that just being able to segment the duration of a company’s CAP into “a few years, several years, and many years” is extremely helpful in terms of thinking about a company’s prospects over time.

Steps to analyze a company’s economic moat:

1. Evaluate returns on capital over time to see if the company can consistently generate profits that are acceptable and in excess of their cost of capital to create and maintain their enterprise. He considers consistent ROEs of 15%+ indicate a possible economic moat.
2. Evaluate the company’s competitive situation in terms of the industry, its competitors, and what the company does that keeps competition away. Ask why competitors aren’t stealing away customers and why couldn’t a competitor charge a lower price and succeed? Do customers accept price increases, and how often and how large? What value does the product offer the customer? Why use one company’s product and not a competitor’s? Are industry sales generally increasing or is the industry in decline? Are firms consistently profitable or is profitability cyclical? How concentrated is an industry in terms of number of competitors or the influence of key competitors? How profitable is the average industry participant?
3. Estimate and evaluate a company’s CAP (competitive advantage period), which is how long a company can fend off its competitors.

Methods to create a sustainable competitive advantage:

1. “Creating real product differentiation through superior technology or features” and offer customers the best product they can find. The best product usually enables companies to charge customers a premium price, which enables solid profitability. However, Dorsey notes that it’s very difficult to continuously beat out competitors by always having the best product, and it’s expensive to do so, so very few firms can use the “better mousetrap” strategy to create long-term excess profitability.
2. “Creating perceived product differentiation through a trusted brand or reputation” that motivates customers to pick the company’s product faster or more easily. He cites Tiffany jewelry as an example: the famous blue box allows them to charge huge premiums for products that can be reproduced identically from a quality perspective and yet people still pay the Tiffany premium. Point being: the brands that are actually VALUABLE increase a customer’s willingness to pay an above-industry-average price for a product. Additionally, Dorsey correctly points out that some brands are very well established but don’t help a company produce excess profits, whereas some brands actually motivate the customer to pick a certain product or to pay a higher price. I think Warren Buffett’s commentary about Berkshire Hathaway’s business when he first invested in the company is worth reiterating here: Even though Berkshire was an established industry leader in producing suit linings with a large and stable customer base, if they had tried to raise their prices by even a tiny amount they would have assuredly lost business to other companies. Lastly, Dorsey notes that valuable brands are expensive to maintain, and require a lot of advertising expenditures to support (think about Coke or Ralph Lauren).
3. Being the lowest-cost provider of the product by being the lowest-cost producer of the product. This is “an extremely powerful source of competitive advantage” because it takes a long time to develop and is hard to replicate (think of Walmart). In commodity industries like airlines and PCs, products are very hard to differentiate in terms of clearly superior value versus price, which means “low-cost strategies work especially well in these types of markets.” Low cost production advantages come from the development of more efficient processes or reaching larger-scale production that enables lower-cost acquisition of inputs required to produce the end product. Dorsey notes that scale advantages are especially valuable because they’re hard to match because as scale gets incrementally larger the benefit in terms of incrementally lower cost becomes greater (so it’s somewhat self-sustaining). The scale benefit “comes from simply leveraging fixed costs-in other words, spreading the cost of an asset such as a factory across an even-larger sales base.” Clearly, I could have rephrased that to avoid having to use quotes but the author’s words are perfectly to the point. This concept is extremely important to understand: if it costs you the same $1 million per year to run your factory/machine/business, you produce a heck of a lot more profits if you use that same factory to satisfy $5 million worth of sales than if you had $2 million worth of sales, because the “fixed cost” of keeping that factory running is roughly constant.
4. “Locking in customers by creating high switching costs” that discourage them from using a competitors product. Dorsey calls this “possibly the subtlest type of competitive advantage” because you have to fully understand the customer, the sales process, the product usage and life-cycle, and all the other variables that play into why a customer tends to stick with one company instead of using another one. The best ways to create “lock-in” is to make it either very expensive or very time consuming to switch to a competitor’s product, which enables a company to charge more for their product or to hold onto customers for longer-periods of time. Learning and training required by customers for a company’s product creates a lock-in, because the training and familiarity means a competitor has to have a very compelling reason why their product is worthy of starting over with. Three other pieces of evidence that Dorsey states can create lock-in include 1) tight integration of your product into a customer’s business process or their product, and 2) if your product is the “industry standard” like Adobe’s Photoshop (everyone basically HAS to learn to use it), and 3) does a company have long-term contracts with their customers?
5. “Locking out competitors by creating high barriers to entry or high barriers to success” that discourage them from even trying to compete in the industry or raising the likelihood that competitors will fail if they do try. He points out two basic ways to lock-out competition: government regulation that determines whether or not competitors are allowed to operate in an industry/market and patents that legally protect a product from competition for a period of time. Dorsey spends more time talking about the power of “network effects” and how they tend to be a more durable way to lock-out competitors by locking-in customers. A network effect is produced when the more users a company’s product has, the more valuable the company’s product is to each customer. Good examples include eBay and some of the financial exchanges: more buyers and more sellers make the market more vibrant and more valuable in terms of selection, lower price, or ease of transaction.

Some of Dorsey’s suggestions when conducting company financial analysis (for beginners):

• Look at the ratio of depreciation versus capex as a way to see if the cost of maintaining the company’s infrastructure is increasing or decreasing, and it can help spot rising allocation of capital into the business instead of returning capital to shareholders or reducing debt loads.
• Watch accounts receivable and how it changes relative to sales. Is the company booking sales that it hasn’t actually collected money for? Is there a potential accounting issue, or is the company easing its credit/payment terms to try to win new business because competition is increasing?
• Inventory falls into three buckets: raw materials, partially finished goods, and totally finished goods. All or none of them might be worth a lesser amount than the company thinks, or lesser than the value that the balance sheet indicates (although conversely they could clearly be worth more, particularly as it relates to LIFO/FIFO accounting and the trend in industry pricing).
• Inventory is a use of capital. You have to spend money to buy inventory that sits in a warehouse until it’s used in production and then sold, so you spend money before you get paid for a sale. For non-finance pros, this is a very key piece of what we call a company’s “working capital cycle.” The faster a company can buy inventory and sell it to a customer and actually receive cash from the customer, the better the profitability and cash generation of the company. The less time your cash is invested in inventory that has not been sold or has yet to be produced, the longer you can’t use that cash for something else, which is why we call it a “use of capital.”
• Dorsey advises being extremely skeptical of the value of “intangible assets” as listed on the balance sheet. I couldn’t agree more. Because the majority of M&A activity has historically proven that acquiring companies overpay for the companies they buy, the positive value for intangible assets like goodwill is highly uncertain to be justified over time, and it has little “cash” value in the short-term.
• Make sure you fully understand what goes into a company’s COGS (cost of goods sold) so that you fully understand a company’s gross profitability. COGS is composed of raw material costs, labor costs, cost of services to provide the product, and several other pieces. Some of them vary a lot with a company’s level of sales, while some of them might be relatively stable regardless of production volume and sales, which means that gross margins usually do not stay the same as a company expands and shrinks and deals with a dynamic marketplace.
• Be mindful of the difference between the basic and diluted share counts. The diluted share count reflects any stock option or convertible bond that can be turned into actual new shares of the company’s stock, which means that an investor’s % ownership of a business goes down when dilutive securities are exercised/converted. Stock options are still a very popular employee compensation tool these days, and they can materially lower non-employee ownership stakes in economic reality.

Some of Dorsey’s pointers for analyzing a company as an investment and its overall economic prospects: *Note: I’m leaving out a ton of stuff b/c it’s a waste of time for me to type it up, so I’m gonna stick to the more important or less-obvious things.

• Be mindful of the risks and bear case for an investment. What are the risks? What are the best reasons NOT to invest? What’s the PROBABILITY of minor AND major “bad things” happening? Carefully examining the risks and bear case can help you make MORE money if you’re right and the bear case does NOT come true because it can serve as a reference to spot situations when the risk a company faced has actually gone away or is lesser, which might be a great time to add to your position knowing that the overall probability adjusted return is higher.
• Sales growth only comes from 3 sources: 1) gaining more customers in your addressable market or selling more of your product to your existing customers, 2) raising prices for your product, and 3) buying another company to add its sales to your own (inorganic growth).
• Dorsey is correctly very skeptical of corporate M&A. The historical track record indicate that the majority of acquisitions don’t produce gains for the acquirer. M&A made harder by the size of the company being acquired, because it’s more difficult to fully examine its business inside and out. M&A also takes time and money, which means it can be a distraction to your existing business and it costs money to pay bankers and lawyers to get deals done. M&A activity often means the financial statements drastically change after the acquisition is complete, which makes it easier for management to make questionable accounting changes without attracting the appropriate skepticism from investors and analysts, and it also makes analyzing the original business more difficult (tougher to parse-out true organic growth from inorganic growth).
• Dorsey is somewhat skeptical of companies that report lower tax rates or buyback their shares because they may not be sustainable over time. If the tax rate decrease is relatively permanent, I think it’s basically a clear-positive, and if repurchasing shares is a key piece of managements decision to allocate capital by returning it to investors then it’s not necessarily a one-time event.
• Return on assets (ROA) is important to keep tabs on, because it reflects a company’s strategy and cash flow generation capabilities. Companies can either charge high prices to boost margins and maximize the profit the generate from using their assets, or they can maximize volume of production to produce a greater number of cash flows to the company and more frequently “turn over” the company’s investment in assets.
• Return on equity (ROE) is more important to monitor for equity investors because examining the equity portion of the capital structure reflects the portion that is “owned” by common equity shareholders. Companies can issue debt which produces cash to buy assets, but it creates a liability that must be paid off before equity shareholders can benefit from either a firms profits or the value of a firm in the event of its liquidation. That means that financial leverage (using debt) is a key variable in ROE, and is most simplistically assessed by the ratio of a company’s total assets to its equity. Debt is important because it’s essentially a fixed cost of doing business, meaning each year the company has to pay a certain amount of money out to debt investors in the form of interest, and this interest is owed whether the company has a good year or a bad year (and even if a company loses money). That means that there is leverage in taking in money from debt investors and using it to try and generate much more profits, but the big risk is that if profits decline or turn negative then the cost of debt can become an existential issue of business survival. Leverage magnifies gains and losses: it works both ways and raises the possibility of both much better and worse outcomes.
• Return on Invested Capital (ROIC) is the most important piece of analyzing a company’s returns. ROIC reflects the capital a company uses that comes from equity, debt, and quasi-debt produced in the course of doing business like certain types of leases and payment plans. ROIC also measures profits using an after-tax number that ignores the impact of interest on net profits, which means those profits are theoretically available to benefit both debt and equity holders. NOPAT requires some subtle and tricky tweaks (as does Invested Capital) but it’s worth studying if you’re not familiar with it.

Dorsey’s suggestions to spot and avoid financial accounting tricks:

• Watch out for declining cash flow. Monitor FCF as a % of net income to see if accounting earnings are not keeping up with our questionably exceeding actual cash flow.
• Repeated charge-offs can indicate accounting tricks b/c mgmt can hide questionable results or accounting inside a big restructuring charge.
• Frequent M&A: financials get murkier and it can get harder to examine the fundamentals of the existing business.
• CFO departures can signal possible accounting problems, especially if the CFO isn’t leaving to take another opportunity that seems desirable.
• Problems with billing and receivables and payables: watch how AR changes in relation to sales, they should move roughly inline with each other. Keep an eye on the “allowance for doubtful accounts” which is a reduction in accounts receivable made at the discretion of management for bills that they expect might not get paid. Management might be overly optimistic regarding their customers’ ability to pay their bills.
• Gains from investments that are one-time or unusual. They’re usually not sustainable or repeatable.
• Pension problems: if the pension’s assets aren’t of adequate size to service the pension expenses, a company might need to allocate capital to the pension instead of into the business or to returning capital to shareholders. Pension income can also be a problem, because it’s not actual income that’s available to the company or to shareholders, so it can also be an issue. This income is dependent on the performance of stock and bond markets, not a company’s operations.
• Problems with inventory: Overstocked warehouses indicate that either a company is allocating too much capital to inventory or that a company is unable to sell its products the way it has in the past, which means that either the business might face declines or the company might have to discount its product prices to sell excess inventory, which then pressures profit margins.

Some of Dorsey’s tips on investment valuation and returns:

• P/E multiples are not as important as some might think: “Over the entire twentieth century, Bogle found that the 10.4 percent average annual return of US equities broke down into 5 percentage points from dividends, 4.8 percentage points from earnings growth, and just 0.6 percentage points from P/E changes.” The point is, look for dividends and look for growth, and don’t overly rely on changes on company P/E’s when you assess the attractiveness of long-term equity investments. It means you should focus on generating an investment return regardless of what happens with multiples and focus on a company’s fundamentals.
• Don’t rely on Price/book multiples for service firms and only place major importance on P/B for financial firms.
• Examine the cyclicality of a business and its profits, so that you value a firm based on its ongoing results and not the results from one segment of its product/industry/macro cycle. Think about what earnings look like peak-to-peak to assess upside and trough-to-trough to assess downside.
• Cross-reference the FCF yield of a company’s stock versus its corporate bond yields. If the yield of the stock is significantly greater than the yield a company’s paying on its bonds, then it’s a sign that the equity shareholders should expect excess profits to benefit them over time.
• When assessing the value of future cash flows generated by a company, you have to consider the amount, timing, riskiness and volatility of those cash flows.
• When determining appropriate discount rates for determining the present value of a company’s future cash flows, adjust for size (small companies are riskier and have more volatile results), leverage (highly leveraged firms have greater risk of distress), cyclicality (cyclical firms have less predictable cash flows), corporate governance and mgmt skill (trust and demonstrated skill are very important), an economic moat (wide and narrow moats should significantly influence the discount rate), and complexity (the less-certain your analysis is, the higher the discount you should place on a company’s future cash flows).

Dorsey then goes on to evaluate the major business sectors/industries and give an overview of how to look at them, and it’s not worth it for me to summarize each of them because either I personally care about only a few or already know what he’s talking about, or other investors might have different interests than myself.