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What is value investing?
To put it simply, it is about buying good businesses at sensible price.
Value investors love good businesses.
But, they only want to buy it when the price is good as well.
When is a price a good price?
It’s when good businesses are undervalued.
So, let’s first look at what constitutes a good business in the value investor’s eyes.
To determine whether or not it’s a good business, we examine the three areas below:
- Economic Moats
- Financial Performance
(1) Economic Moats
For those of you who don’t know what economic moat means, it’s actually a term coined by Warren Buffet himself.
According to Investopedia, here’s the definition of economic moat.
“Economic moat refers to a business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.”
To find out if a business has economic moat, you can ask yourself these two questions:
- What are the products and service?
- Can it sustain and grow for the next 10 to 20 years? And why?
Why do we ask these questions?
Because the answers will tell if the business stand against the test of time and continue to thrive in changing business environment.
According to Morningstar, there are 5 types of economic moats:
- Intangible Asset
Intangible assets are assets that are not physical in nature.
They can become a company’s competitive advantage when the company can use them to block competition or allow the company to charge more.
Examples of such intangible assets are brands, patents, licenses, government approvals and etc.
- Cost Advantage
Companies can gain cost advantage through economies of scale.
It allows them to sell their products at the same price as their competitors for more profits. At the same time, it gives them the option to undercut their competitors.
A good example is Walmart.
With more than 6000 stores worldwide, it keeps its cost low through scale efficiency. Also, it gives Walmart tremendous bargaining power with its suppliers.
- Network Effect
The network effect is present when the value of a service increases as more people start to use the service.
It’s very easy to spot network effect.
One classic example is the telephone. As the number of users increase, the value to each user also goes up.
Online social networks, such as Twitter and Facebook, works in a similar way. It increases in value to each member as more members join.
- Switching Cost
When it’s costly to switch to other brands or the company’s competitors, then it can be considered as a competitive advantage as well.
Let’s look at some examples.
Cellular service providers lock in their customers by asking them to sign a year-long contract. If they cancel their contract before its contract expiration date, they will incur a heavy penalty.
- Efficient Scale
When a company serves a market that is limited in size, new competitors may not have an incentive to enter. Incumbents generate economic profits, but new entrants would cause returns for all players to fall below cost of capital.
For example, natural geographic monopolies such as airports and pipelines enjoy efficient scale as a competitive advantage.
(2) Financial Performance
Next, we will look at the financial performance of the business.
First of all, is the business generating net profit year after year?
In other words, is the business making money every year?
Value investors only want to invest in consistently profitable businesses.
Secondly, is the business highly leveraged financially?
To put it in another way, is it taking on more debt than most of its competitors in the same industry?
Especially when economy is not good, a higher than usual debt ratio is a warning sign to look out for.
Thirdly, does the business have a consistent positive cash flow or a negative cash flow?
If there is greater cash inflow than cash outflow, then it has a positive cash flow. Otherwise, it is negative cash flow. Positive cash flow is required for business to stay afloat. It’s the lifeline of any business.
Just imagine you are running a business.
At the end of the day, you don’t have enough money to pay your employees’ salary. How is your business going to continue operating?
So, cash flow is a very useful indicator to look at when you are trying to assess a company’s financial performance.
When it comes to investing, there is always risk.
For businesses, there is risk as well.
Here are different types of risks to consider:
- Regulatory Risk
Does the company sell products and services that are regulated?
When its products and services are regulated, any change in government policy might have an adverse effect on the business.
For example, public transport companies face a lot of regulation in the way they operate, such as how much they can charge. So, if there is a change in the fees they can charge, it could affect their business performance in a negative way.
- Inflation Risk
Can the company raise price with inflation?
Does the company have pricing power?
If yes, that means it can raise price without losing its customers to competitors.
For example, it is difficult for airlines to raise price without driving its customers away.
- Science & Tech Risk
Does the company sell products and services that can be replaced? Or does the company require constant R&D to survive?
A very good example is Nokia.
Once a giant in the mobile phone market, Nokia almost became bankrupt when the smartphone came out and made its handsets obsolete. If it had focused on R&D and stayed in tune with the industry trends, it would be a different story now.
Another example is CD/DVD player.
No one uses a CD/DVD player any more because it is so easy to just watch it from your mobile or desktop. All your favorite shows and music are literally at your fingertip.
In summary, value investors are always looking for good businesses with economic moat, good financial performance and low risk. What good businesses have you invested in? Please share with us in the comments below.