Friday, 5 June 2015

What is a Franchise/Moat?

One of the concepts that I've struggled with is identifying a sustainable franchise/moat.  A reasonably prudent investor, once committed to a stock, wants to ensure that he/she can sleep at night without worrying too much about the possible future path the stock may take. After having committed to buying a stock, it's awkward discovering after the fact that the company in who's shares you've bought is sorely lacking in sustainable franchise/moat.

Ben Graham suggested that investors should be prepared for adverse movement in their holdings, and that a -30% move in any one (or a combination) of an investors holdings is not within the realm of the unexpected.

One method of coping with/synthesizing the risk of adverse movement in any one (or a combination) of holdings is to diversify.  If an investor is sufficiently diversified, he/she may be more likely to cope with adverse movement in any one particular stock in the context of the overall portfolio.  But diversification, in my opinion, is a misnomer and is misunderstood.

An investor who has structured a portfolio predicated on thirst for dividend yield first and foremost may actually end up being un-diversified. Case in point, the Canadian equity space is concentrated in resource/commodity focused stocks, but this exposure may stem beyond the direct culprits in the resource/commodity space in the event of an exogenous event impacting the underlying commodity. Anything in energy services, junior energy exploration, drilling, and production, midstream pipelines, oil sands, and even integrated oils, is now offering dividend yields which are substantially higher than they were before September 2014.

An investor who's primary criteria is a dividend yield in excess of say, 4%, may go about purchasing two energy services companies servicing different sectors of the energy space, one midstream pipeline company, and one integrated oil company or one oil sands company, all offering attractive yields in excess of 4%, and by doing so, may have inadvertently quadrupled his/her concentration of risk. At first glance, although each of the companies offers a distinct product or service, their bread and butter all comes from the same place.

The same investor may then go about purchasing two commercial REITs, one of which has greater than 40% of its property leased to a combination of junior energy producers, energy service companies, and oil sands companies.  Each REIT offered yields in excess of 5.5%.  Easy money right?

The same investor may then go about purchasing a railroad yielding 3%.  Railroads are stalwart, long-standing, oligopolies.  They own millions of kilometres of railyway tracks nationwide and there are huge barriers to entry.  And yet, railroads are dependent on the energy space for a significant portion of their revenues.

The same investor may then go about purchasing a bank stock with significant loans to junior energy producers, energy service companies, and oil sands companies.  The bank stock carries a yield of 4% and has paid uninterrupted dividends for the last 25 years.

If this investor constructed this portfolio well before September 2014, the portfolio may have apeared reasonably diversified.  The portfolio would have included:
  • Two energy service companies servicing different sectors of the energy space.  Perhaps one company operates trucking and logistic services in Western Canada, and the other provides a suite of drilling diagnostic data products.  Each company yields 3.5% and has grown both earnings and dividends combined at 10% over the last 10 years.
  • One midstream pipeline company which has a substantial backlog of pipeline projects expected to add new capacity over the next 5 years, and which  as a result of this supplemental capacity, expects to substantially inrease free cash flow sufficient to repay the cost of funding the new capacity and increase the dividend.  The pipeline yields 4.5%
  • One integrated oil company which has been operating for the last 50 years, and which has weathered previous cycles in the past.  This company yields 3%.
  • Two REITs, one of which has greater than 40% of its property leased to a combination of junior energy producers, energy service companies, and oil sands companies, and the other of which runs self storage facilities in Western Canada.  Both REITs yield 5.5% and have conservative mortgage to property ratios.
  • One national railroad which has been operating for 100 years, and which yields 3%.
  • One bank with significant loans to junior energy producers, energy service companies, and oil sands companies.  The stock carries a yield of 4% and has paid uninterrupted dividends for the last 25 years.
This 8 stock portfolio would have hummed along uninterrupted, paid a yield of around 4%, and showed the investor both capital appreciation and dividend appreciation, all prior to September 2014.

So what could this hypothetical investor have changed in terms of approach?

I believe that the answer comes back to understanding franchise/moat in the context of correct diversification.

Borrowing from Base Hit Investing, here's an interesting anectdotal clip demonstrating the difficulty inherent in understanding franchise/moat:

"Munger talked about moats a couple times during the meeting. The first time he recited a few examples of formerly great companies that had significant competitive advantages, but due to the nature of capitalism, eventually wound up bankrupt:

“The perfect example of Darwinism is what technology has done to businesses. When someone takes their existing business and tries to transform it into something else—they fail. In technology that is often the case. Look at Kodak: it was the dominant imaging company in the world. They did fabulously during the great depression, but then wiped out the shareholders because of technological change. Look at General Motors, which was the most important company in the world when I was young. It wiped out its shareholders. How do you start as a dominant auto company in the world with the other two competitors not even close, and end up wiping out your shareholders? It’s very 

Darwinian—it’s tough out there. Technological change is one of the toughest things.”

Munger had this story when asked to identify a moat:

Question: What is the least talked about or most misunderstood moat?
Munger: You basically want me to explain to you a difficult subject of identifying moats. It reminds me of a story. One man came to Mozart and asked him how to write a symphony. Mozart replied, “You are too young to write a symphony.” The man said, “You were writing symphonies when you were 10 years of age, and I am 21.” Mozart said, “Yes, but I didn’t run around asking people how to do it”."

Bruce Greenwald in "Value Investing: From Graham to Buffett and Beyond", presents an interesting conceptual framework for understanding the concepts under-pinning franchise/moat.

According to Greenwald, sustainable franchise/moat seems to encompass the characteristics of Porter's 5 forces model, such as barriers to entry, pricing power, economies of scale either in  procurement or production, and structural competitive advantage.  The book is fascinating and is a must read for any aspiring dividend investor.  Greenwald goes on to quantify how to caclulate franchise value using a number of approaches (sum of the parts, discounted cash flows, etc).

The point of all of this is that constructing a portfolio of correctly diversified stocks has to include more than a cursory analysis of the prior decades worth of earnings growth, dividend growth, payout ratio, valuation, or even relative valuation.  It has to include consideration of sustainable franchise/moat in order to safeguard against permanent loss of capital.

I believe that a properly diversified portfolio of companies that are not just fundamentally strong, but that also pass the litmus test of "potential" sustainable franchise/moat will allow an investor the ability to cope with/synthesize the risk of adverse movement in any one (or a combination) of their holdings.

In consideration of the above portfolio, I have added the following litmus test checks in italics after each holding (assuming I'm looking to invest in these 8 stocks today).  My litmus test is a simple, "Y" for sustainable franchise/moat, "N", for none, and "?" for maybe.  Notice how this changes the consideration of candidates for a portfolio before committing.  Assume that each of the candidates for consideration has grown eps and dividends at 10% over the last 10 years uninterrupted, and is currently trading at a PE below it's 10 year average PE.

  • Two energy service companies servicing different sectors of the energy space.  Perhaps one company operates trucking and logistic services in Western Canada "N", and the other provides a suite of drilling diagnostic data products "?"  Each company yields 3.5% and has grown both earnings and dividends combined at 10% over the last 10 years.
  • One midstream pipeline company which has a substantial backlog of pipeline projects expected to add new capacity over the next 5 years, and which  as a result of this supplemental capacity, expects to substantially inrease free cash flow sufficient to repay the cost of funding the new capacity and increase the dividend.  The pipeline yields 4.5% "?"
  • One integrated oil company which has been operating for the last 50 years, and which has weathered previous cycles in the past.  This company yields 3%. "?"
  • Two REITs, one of which has greater than 40% of its property leased to a combination of junior energy producers, energy service companies, and oil sands companies "N", and the other of which runs self storage facilities in Western Canada "N".  Both REITs yield 5.5% and have conservative mortgage to property ratios.
  • One national railroad which has been operating for 100 years, and which yields 3%. "?"
  • One bank with significant loans to junior energy producers, energy service companies, and oil sands companies.  The stock carries a yield of 4% and has paid uninterrupted dividends for the last 25 years. "N"
Out of the 8 candidates, I get 4 "no's" and 4 "maybe's".  Not one definitive "yes", which goes back to my initial point.  One of the concepts that I've struggled with is identifying a sustainable franchise/moat.

Why "maybe" in the context of the diagnostic data company, the pipeline, the integrated oil, and the railroad?

Well maybe, the diagnostic data company has a suite of products which it has exclusive copyright over, and which is used by 80% of existing drilling companies.  But perhaps the suite is prohibitively expensive and in the face of falling capital budgets by its customers, sales are expected to drop 30% unless the company drops it's prices.

Maybe the pipeline has firm commitments from producers over the next 5 years and is the only pipeline from the oil sands to the West coast.  But what if 50% of the producers are oil sands juniors?

Maybe the integrated oil company has the lowest cost structure in Canada.

Maybe the railroad has millions of km's of track built 30 years ago and has exclusivity over useage.  But perhaps 60% of the track needs to be upgraded over the 5 years and the track runs parralel to the new pipeline capacity.

All of the above changed the way I think.




2 comments:

  1. It's difficult to find decent yields in fairly priced equities right now. Haha. It appears Mozart was quite the comedic.

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  2. Totally agree, adding to this difficulty is paying almost a 30% premium to buy US dividend quality payers right now which, may (or may not be) fairly priced.

    This leaves us Canadians to scour the Canadian landscape for dependable and hopefully undervalued dividend candidates. If I suggested buying companies like Dollarama (trading at 37x ttm) and Cineplex (trading at 35x ttm), I hope you'd call me crazy.

    I've noticed a good chunk of Canadian bloggers are overweight pipelines, REITS, and energy names without fully understanding the effect of leverage on these companies.

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