The Five Rules for Successful Stock Investing: Morningstar's Guide to Building Wealth and Winning in the Market

by Pat Dorsey

Relying on Earnings for the Whole Story At the end of the day, cash flow is what matters, not earnings.

One hint: If operating cash flows stagnate or shrink even as earnings grow, it’s likely that something is rotten.

Investor’s Checklist: Seven Mistakes to Avoid • Don’t try to shoot for big gains by finding the next Microsoft. Instead, focus on finding solid companies with shares selling at low valuations. • Understanding the market’s history can help you avoid repeated pitfalls. If people try to convince you that “it really is different this time,” ignore them. • Don’t fall into the all-too-frequent trap of assuming that a great product translates into a high-quality company. Before you get swept away by exciting new technology or a nifty product, make sure you’ve checked out the company’s business model. • Don’t be afraid to use fear to your advantage. The best time to buy is when everyone else is running away from a given asset class. • Attempting to time the market is a fool’s game. There’s ample evidence that the market can’t be timed. • The best way to reduce your investment risk is to pay careful attention to valuation. Don’t make the mistake of hoping that other investors will keep paying higher prices, even if you’re buying shares in a great company. • Cash flow is the true measure of a company’s financial performance, not reported earnings per share.

Economic Moats INVESTORS OFTEN JUDGE companies by looking at which ones have increased profits the most and assuming the trend will persist in the future. But more often than not, the firms that look great in the rearview mirror wind up performing poorly in the future, simply because success attracts competition as surely as night follows day. And the bigger the profits, the stronger the competition. That’s the basic nature of any (reasonably) free market—capital always seeks the areas of highest expected return. Therefore, most highly profitable firms tend to become less profitable over time as competitors chip away at their franchises.

The concept of economic moats is crucial to the way Morningstar analyzes stocks because a moat is the characteristic that helps great-performing companies to stay that way.

To analyze a company’s 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 shareholders’ equity? This is the true litmus test of whether a firm has built an economic moat around itself. 2. If the firm has solid returns on capital and consistent profitability, assess the sources of the firm’s profits. Why is the company able to keep competitors at bay? What keeps competitors from stealing its profits? 3. Estimate how long a firm will be able to hold off competitors, which is the company’s competitive advantage period. Some firms can fend off competitors for just a few years, and some firms may be able to do it for decades. 4. Analyze the industry’s competitive structure. How do firms in this industry compete with one another? Is it an attractive industry with many profitable firms or a hypercompetitive one in which participants struggle just to stay afloat? Analyzing economic moats is complicated because there are a nearly infinite number of solutions to the problem of consistently making a buck when your competition wants to take it away, but the process is interesting for precisely the same reason.

Does the Firm Generate Free Cash Flow? If So, How Much? First, look at free cash flow—which is simply cash flow from operations minus capital expenditures.

(We’ll go over free cash flow more in Chapter 5. For now, just go to a firm’s statement of cash flows, which you can find in its quarterly and annual financial filings, look for the line item labeled “cash flow from operations,” and subtract the line labeled “capital expenditures.”)

Firms that generate free cash flow essentially have money left over after reinvesting whatever they need to keep their businesses humming along. In a sense, free cash flow is money that could be extracted from...

Next, divide free cash flow by sales (or revenues), which tells you what proportion of each dollar in revenue the firm is able to convert into excess profits. If a firm’s free cash flow as a percentage of sales is around 5 percent or better, you’ve found a cash...

Strong free cash flow is an excellent sign that a firm ha...

What Are the Firm’s Net Margins? Just as free cash flow measures excess profitability from one perspective, net margins look at profitability from another angle. Net margin is simply net income as a percentage of sales, and it tells you how much profit the firm generates per dollar of sales. (You can find sales and net income on a firm’s income statement, which should also be in each of its regular fi...

What Are Returns on Equity? Return on equity (ROE) is net income as a percentage of shareholders’ equity, and it measures profits per dollar of the capital shareholders have invested in a company. Although ROE does have some flaws—which we discuss in Chapter 6—it still works well as one tool for assessing overall profitability. As a rule of thumb, firms that are able to consistently post ROEs above 15 percent are generating solid returns on sh...

What Are Returns on Assets? Return on assets (ROA) is net income as a percentage of a firm’s assets, and it measures how efficient a firm is at translating its assets into profits. Use 6 percent to 7 percent as a rough benchmark—if a firm is able to consistently post ROAs ...

Consistency is important when evaluating companies, because it’s the ability to keep competitors at bay for an extended period of time—not just for a year or two—that really makes a firm valuable. Five years is the absolute minimum time period for evaluation, and I’d strongly encourage you to go back 10 years if you can.

Building an Economic Moat

When you’re examining the sources of a firm’s economic moat, the key thing is to never stop asking, “Why?” Why aren’t competitors stealing the firm’s customers? Why can’t a competitor charge a lower price for a similar product or service? Why do customers accept annual price increases?

When possible, look at the situation from the customer’s perspective. What value does the product or service bring to the customer? How does it help them run their own business better? Why do they use one firm’s product or service instead of a competitor’s? If you can answer these questions, odds are good that you’ll have found the source of the company’s economic moat. In general, there are five ways that an individual firm can build sustainable competitive advantage:

1. Creating real product differentiation through superior tec...

2. Creating perceived product differentiation through a trusted brand or reputation 3. Driving costs down and offering a similar product or service at a lower price 4. Locking in customers by creating high switching costs 5. Locking out competit...

In general, any competitive advantage based on technological superiority—real product differentiation—is likely to be fairly short. Successful software firms, for example, can generate huge excess returns because they have high profit margins and they don’t need to spend much money on fixed costs such as machinery. However, the duration of those returns is typically very short because of the rapid pace of technological change. In other words, today’s leader can quickly become tomorrow’s loser because the barriers to entry are so low and the potential rewards so high.

Industry Analysis Our last step is to investigate the industry in which the firm operates. Let’s face it: It’s just plain easier to make money in some industries than it is in others. (Ask the CEO of any airline company.) Although the attractiveness of an industry doesn’t tell the whole story—after all, Southwest Airlines has made plenty of money for shareholders—it’s important to have a feel for the competitive landscape. First, get a rough sense of the industry so you can classify it. Are sales for firms in the industry generally increasing or shrinking? Are firms consistently profitable or does the industry go through periodic cycles when most firms lose money? Is the industry dominated by a few large players, or is it full of firms that are roughly the same size? How profitable is the average firm—are operating margins fairly high (more than 25 percent) or fairly low (less than 15 percent)? (An operating margin is income from operations as a percentage of sales. I discuss such financial ratios in more detail in Chapter 6.) You can answer some of these questions by looking at aggregate statistics—average growth rates, average margins, and so on. However, averages can’t tell you everything, so be sure that you examine a number of individual companies. An easy way to do this is to look at a list of companies in the industry you’re researching sorted by sales or market cap, and examine a dozen or so to get a feel for the industry. You don’t need to do detailed analysis at ...

Investor’s Checklist: Economic Moats • Because success attracts competition as surely as night follows day, the most highly profitable companies tend to become less profitable over time. That’s why economic moats are so important: They help great companies stay that way. • For concrete evidence of an economic moat, look for firms that consistently earn high profits. Focus on free cash flow, net margins, return on equity, and return on assets. • After you’ve looked at these specific measures, try to identify the source of the company’s economic moat. Companies generally build sustainable competitive advantages through product differentiation (real or perceived), driving costs down, locking in customers with high switching costs, or locking out competitors through high barriers to entry. • Think about economic moats in two dimensions: depth (how much money the company can make) and width (how long it can sustain above-average profits). In general, any economic moat based on technological innovation is likely to be short-lived. • Although the attractiveness of an industry doesn’t tell the whole story, it’s important to get a feel for the competitive landscape. Some industries are just easier to make money in than others.

The Language of Investing

The Basics As an investor, you’re mainly going to be interested in the balance sheet, the income statement, and the statement of cash flows. These three tables are your windows into corporate performance, and they’re the place to start when you’re analyzing a company.