Tuesday, June 4, 2013

Beach Bum Pt. 2: The Four Pillars of Permanence

Straight from the Nagger's Beak

As a manager, I am constantly reminding my associates to ask questions. Most of us grow up with the idea that there is "no such thing as a stupid question", which was likely planted into our brains "inception-style" by teachers around the globe. While I think this notion is a powerful catalyst for emboldening timid participants, to say that stupid questions don't exist is like saying that fat-free ice cream is healthy or that watching Mythbusters is educational. It makes you feel better, but simply isn't true. There are two types of stupid questions: questions that there are no real answers to (how much wood would a woodchuck chuck..?), and questions you already know the answer to. One of the most frequently asked questions I hear (and ask) falls into the latter category: "Is this permanent?"

The most common answer to this question - "everything is permanent until it changes" - almost directly aligns with my investment strategy (and ironically my dating strategy - though that one worked itself out). So how do you identify permanence in an investment? How do you get to know a company in the up-close and personal way that we got to know Neal and Phyllis?

The Four Pillars of Permanence

Every investor that is looking to beat the market is typically looking for two things: growth potential and permanence. Determining growth potential requires extensive research into the industry or market as well as the companies' R&D (research and development) plans. Even with the research, putting money into a security entirely focused on growth potential is somewhat of a gamble. So instead, focusing on permanence over growth can be a far better long-term strategy. There are four major areas that I look to determine if an investment will last the long-haul - the four pillars of permanence:
  1. Pillar #1 - Economies of Scale: Does the company have depth and diversity? Some of the key factors to look for here are large caps, age, and free cash. If you are thinking, "that sounds like my grandparents", you're probably on the right track. A large, tenured company with substantial cash on hand is a good sign of permanence. A couple other things to look at are a.) how many industries the company is exposed to and b.) a current ratio of >2. This shows the diversity of the company and its ability to pay off short-term debt. Think Microsoft 
  2. Pillar #2 - Dividends: Companies that pay dividends do it for one of two reasons: either they can afford to pay dividends or they are forced to pay dividends. Those that fall under the latter category (such as mREITs, for tax purposes) are not always bad investments, but are certainly more subject to volatility than companies that choose to pay investors. A stable dividend and a history of dividend growth can personify a safe investment - just make sure the earnings have been growing with the dividend! There is a great article that bolsters these first two pillars here.
  3. Pillar #3 - Inelastic Goods: Companies that do not depend on certain social or economic conditions are often the most stable investments. Utilities companies are far less exposed to the woes of the economy, as they provide a service that most people will choose not to cut out of their budget. Southern company, one of the nation's largest utilities, only lost about 30% of its value in the market crash of 2008-2009 and has since bounced back nearly 100%. This is compared to losses of 60-75% across consumer and commodity shares like Honda Motor Company and Alcoa Aluminum. Other companies that fit the mold of "inelastic sales" are grocers (Kroger, Whole Foods, Walmart), tobacco (Altria, Lorillard) and healthcare (Eli Lilly, Johnson and Johnson) amongst others.
  4. Pillar #4 - Strength (or lack) of Competition: In medieval times, castles would be surrounded by deep trenches, often filled with water or sharp, precarious debris, designed to ward off or cripple enemies or rivals. Today, the most frequent use of the word "moat" is in describing the position a company holds within a certain industry. For example, a company with a narrow moat is one that does not have a significant buffer ahead of its competition. For wide-moat companies, think in terms of large companies with only one or two major competitors - like Coca-Cola (KO). The benefit that these companies hold is that they can see competition coming from miles away and use their gargantuan strength to either jump ahead of it or absorb it.
Fig. 1 - The Four Pillars

Putting the Pillars to Use
So now we will use the pillars to analyze three different companies that are currently on my watch list: Western Union (WU), Smith and Wesson (SWHC), and  Qualcomm Inc (QCOM). 

All three companies have a strong pillar #1, although Western Union has a much lower proportion of total cash available to current liabilities. Both Western Union and Qualcomm are strong in pillar #2, where Smith and Wesson is lacking. Western Union is the only company that did not see significant impacts to profits during 2008-2009, putting it up into the "inelastic" tier, where the other two fell short. Pillar #4 showed Western Union and S&W with fewer major competitors, and therefore less competition. It must be taken into account that S&W has a greater number of privately owned companies directly competing with it in the personal security sector. The telecommunications market is very crowded these days, but Qualcomm has a nice foothold as the industry leader and LOTS of cash - giving it a fairly wide moat. 

In conclusion, I like all three of these companies (which is why they are on my watch list) but I can only recommend Western Union and Qualcomm at this time. The lack of dividend with S&W is dangerous, especially with all the question marks surrounding gun control these days. The moat is not wide enough and the biggest competitor is the government (scary!). Western Union and Qualcomm seem well-positioned for continued growth, both in the stock price and the dividend.

Disclaimer: I have positions in LO, KO, WU, and may initiate a position in QCOM within the next 72 hours. The Four Pillars of Permanence are not a guarantee of permanence and are subject to the same Generally Accepted Accounting Principles that brought down Enron. Remember - everything is permanent until it changes!

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