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How to determine best of breed

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December 24, 2010 – Comments (23)

When investing, as opposed to just picking undervalued companies (which I do), my favorite way to trade/invest (mostly because of how easy it is) is to find a sector I consider undervalued (or has enough momentum) and buy the best etf for that sector (based on chart performance) or (and i like this one more) buying the best company in its sector.  For some its obvious...PM for tobacco, KO for soft drinks (I guess PEP is comparable too), MCD for fast food, NKE for sneakers, VFC (coh too, but that is more specific)for clothing, and STD for European banks.

But how do you find it for other fields?  I have been told for example SLB is BoB for oil.  I have been told this is because of:

1) Best brand- how is that determined in a field with no taste?  Simply whoever has the least screw ups?

2) Best management- how is good management determined, other than a lack of scandals?  Is this ROI, ROA, ROE?  Or what?

3) Best market share- how do people know what % of the market a company has for its products?  Where is this information available?

4) Anything else?  How do you determine that a company is the best of its breed?

 

This is something I have thought about considerably and would love to know anything and everything.  Thanks!

23 Comments – Post Your Own

#1) On December 24, 2010 at 11:06 PM, 100ozRound (29.50) wrote:

Are you familiar with the term "economic moat"?

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#2) On December 24, 2010 at 11:42 PM, Valyooo (99.51) wrote:

100ozround,

Yes I am.  However, I am not sure how to determine it in a field I am not involved in (if its not something I eat, wear, or use, or in finance, for instance, oil)

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#3) On December 25, 2010 at 1:03 AM, rebello15 (< 20) wrote:

I'm interested in ways of researching / finding this out as well and would like to see any kind of answer

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#4) On December 25, 2010 at 10:32 AM, truthisntstupid (93.37) wrote:

One thing to look for is a consistently high gross margin year after year.  A company that can realize a high profit on its product after all the costs directly related to producing that product year after year most likely has a competitive advantage, and doesn't have to lower its prices and compete in price wars. 

In Warren Buffet And The Interpretation Of Financial Statements:  The Search For A Company With A Durable Competitive Advantage by Mary Buffet and David Clark this is just one of many clues to watch for in the financial statements. 

I will list more later today; after I wake up more and get done with Christmas dinner.

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#5) On December 25, 2010 at 12:31 PM, Valyooo (99.51) wrote:

@truth; merry christmas!

Is all of that stuff available in 10-q's?

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#6) On December 25, 2010 at 6:34 PM, truthisntstupid (93.37) wrote:

merry Xmas, Valyoo

I just got home

No, really, all you need are the financial statements for a great many clues.

First thing at the top of the income statement is revenue, from which cost of goods sold is subtracted to arrive at gross profit. 

Gross profit, by itself, tells us nothing. Gross profit is just how much money the company made off total revenue after subtracting the costs of the raw materials and labor directly involved in making the goods. 

Cost of goods sold doesn't include indirect costs such as sales & administrative costs (advertising, etc), depreciation, or the interest costs of running the business.

But when you dividend gross profit by revenue you get gross margin.   A company with a consistently high gross margin most likely has a durable competitive advantage, which means it's free to price its products/services well in excess of its cost of goods sold.  Without a durable competitive advantage, the company would be forced to compete by lowering its prices, which, naturally, lowers their profit margin and their profitability.

Companies with gross margins of less than about 40% tend to be companies in highly competitive industries, where its extremely hard for one company to create and maintain a sustainable competitive advantage over its competitors.

Return on assets

Current assets + long term assets = total assets.  Divide net income by total assets, and you have return on assets, which tells us how efficiently the company is putting it assets to use.  Higher is better - maybe.

But maybe not.  Not always.  Capital can present a formidable barrier to entry by new competitors.   At the time Warren Buffet And The Interpretation Of Financial Statements was written, KO had $43B in assets and a return on assets of 12%.  On the other hand, Moody's had $1.7B in assets and a return on assets of 43%.

Great economics for Moody's.  But one thing the book points out is that Buffet has figured out that a really high return on assets could indicate a possible vulnerability in the company's durable competitive advantage.

As the book says, raising $1.7B to take on Moody's is far more within the realm of possibility than raising $43B to take on KO.  Moody's underlying economics is a great deal superior to KO's, but its competitive advantage is far weaker because of the lower cost of entry into its business.

There are many such little snippets of "conventional wisdom" that when looked more closely, are revealed not to be as simple as a black-and-white, "this is good, that is bad,"  rule.

Dividing total current assets by total current liabilities to get the Current Ratio - the higher the current ratio, the easier the company can pay its liabilities when they come due.  A current Ratio of more than is supposed to be good; anything below 1, bad.

But while a current ratio is an important consideration in examining the liquidity of a marginal or average business, it's pretty useless in revealing whether a company has a durable competitive advantage.

Companies with durable competitive advantages often have current ratios below1.  What happens is that their earning power is so strong they can easily cover their current liabilities, even while they pay out generous dividends and make stock repurchases, both of which diminish cash reserves and help pull their current ratios below 1.

Valyoo, I'm not smart enough to remember all this well enough to come up with it off the top of my head, but enough time spent studying it does indeed make it enough a part of me that it does indeed come back to me well enough to use when I'm looking at financial statements.

I enjoy learning this kind of stuff immensely, and when I look at some of my supposedly "dead picks" in my CAPS portfolio I know I will get the last laugh - in time.

If you're interested in getting started learning all this, there is no better book than the one you've been reading parts of for the last few minutes.

Warren Buffet And The Interpretation Of Financial Statements by Mary Buffet and David Clark.

Merry Christmas! 

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#7) On December 25, 2010 at 6:54 PM, Starfirenv (< 20) wrote:

Troot's in the house. Best my Foolish Brother. Glad you didn't change your name . Pretty solid. Keep on! Peace and a silver lined new year!

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#8) On December 25, 2010 at 6:58 PM, truthisntstupid (93.37) wrote:

Starfire

Backatcha!  Merry Christmas!

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#9) On December 25, 2010 at 7:40 PM, truthisntstupid (93.37) wrote:

I just read what I wrote.  Look, a little self-deprecation is one thing.  Too much self-deprecation is another.  Instead of saying I wasn't smart enough to remember a lot of what I wrote off the top of my head, the actual truth is none of this is that hard.  And while it does surface when I need it to in order to arrive at an opinion on a stock, it isn't always on rapid recall and easy to put words to when it's been a few months since I read the book and I haven't been studying as much as I'd like.

And in spite of all the people that will argue, I still maintain that picking outstanding companies is easy.  It's just a matter of reading and studying, and knowing that the market's opinion will sometimes differ from your own....sometimes for a good while.

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#10) On December 25, 2010 at 8:54 PM, goalie37 (90.84) wrote:

You mentioned PM and KO as "obvious" best of breeds.  What makes them obvious is their brands.  The financials of these companies are stellar, but what we see first is the qualitative part of the business.  My view of best of breed is that the company must excell in every aspect of it's operations, and that includes the "story."  

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#11) On December 25, 2010 at 9:31 PM, Valyooo (99.51) wrote:

Truth,

thank you so much.  i have that book.  but i have 25 books to read and i am trying to finish my last semester in college, so i didnt get around to it yet.  I have soooo much to learn. I hope I can do it all within the next 2 years

@goalie, I agree.  but its harder to tell with oil and mining companies

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#12) On December 25, 2010 at 10:06 PM, truthisntstupid (93.37) wrote:

Valyooo

You're welcome!  I'm sure you'll do well at whatever you apply yourself to.  I believe you're smarter than I was at your age.  For over thirty years I was an "investing bookworm"  that loved to read about investing, and was within a couple semesters of my BA in accounting at one point, before a major upheaval in my life ended that.  The stupid part?  Never saving money and doing something with all that knowledge.

You're doing something.  Be careful who you hang out with and how you spend your time.  Be successful.  Don't put off saving because you've buried yourself alive in debt.  Don't....be....me.

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#13) On December 25, 2010 at 10:12 PM, NOTvuffett (< 20) wrote:

Merry Christmas Truth

 

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#14) On December 25, 2010 at 10:16 PM, truthisntstupid (93.37) wrote:

Merry Christmas NV!

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#15) On December 25, 2010 at 10:25 PM, Valyooo (99.51) wrote:

Did you enjoy it all though?

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#16) On December 25, 2010 at 10:36 PM, truthisntstupid (93.37) wrote:

I've been around the world a couple times.  I've flown over the polar ice cap.  I spent the best two years of my life on a little bitty island that sits right on the equator in the middle of the Indian Ocean.  I couldn't understand why everyone else hated it there.  It was called Diego Garcia.

I got to do some pretty cool things during my 3 years in the army and my 9 years in the navy.

It's just too bad that I couldn't have realized way, way, back then that money is a lot more fun to have than it is to spend.

 

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#17) On December 25, 2010 at 11:23 PM, goalie37 (90.84) wrote:

@ Valyoo - I missed the part in your original statement about oil companies, and I would guess that applies to all industries where the product differs very little from one producer to the next.  Very bad x-mas eve hangover still going lol.

My own solution to that question is something I am not down to a 100% science on either.  It seems to me that in an industry such as that, there might be a few companies who are all exceptional.  In that case, why not buy more than one?  

In a diversified portfolio, it shouldn't make a huge difference whether you own one oil company or two.  In the case of KO, you are making a prediction on the sales of their brands, not the beverage industry in general.  With oil, the investor has to factor in the commodity to a much greater degree.

Like I said, I'm not 100% sold on my argument either.  Thanks for bringing up this topic.  Maybe I can get some help on it too. 

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#18) On December 26, 2010 at 2:54 AM, Valyooo (99.51) wrote:

Very true about underlying commodity.  In mining stocks, that is the only driver, there are just different betas (overgeneralization).  Good points, especially about buying multiple.  I guess you could buy whichever chart is best during a long period of time

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#20) On December 26, 2010 at 9:50 PM, goalie37 (90.84) wrote:

If charts and beta work for you, then that would be a good way to do it.  I'm far too ignorant when it comes to technical analysis.  

I hope in my last comment that I didn't sound like I was advocating indexing of any kind.  This discussion was about best of breed, and indexing to me is a sure way to put at least some of your money in worst of breed lol.  I just meant that in an industry like "big oil" you will find more than one company that could be described as a world-dominating blood sucking vampire with lots of cash. 

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#21) On December 27, 2010 at 12:52 AM, Valyooo (99.51) wrote:

Haha, point taken

@truth, wow , sounds like you have a very interesting life.

Is Diego Garcia possible to travel to or is it mainly only military people?

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