In all time of humanity, we have been competing against our self and each other, thriving to become the best in what we do. Wouldn’t it be great to compete on a racetrack against a bunch of old rusty slow cars in your new Ferrari, because you would have a huge competitive advantage against your competitors.
Clearly this is unfair and against the regulations of a car race, so to make in more even, you have to compete in different class with equally suited race cars, so this way it’s more about the driver skills.
In business world it’s different, in business world old rusty cars compete against the Ferrari every day all year long.
If this is legal in business world, why wouldn’t everybody just bet on the Ferrari and get great result. Sadly, it’s not that easy to separate a great company from a less great company as it is to separate a old rusty car from a shiny Ferrari. The industry witch a company operate within does have the same characteristics and can be separated into great industries and less great industries. A great company within a brutal and less great industry will often have a harder time making money then the less great company within the great industry.
To illustrate this, imaging you are racing against time with the Ferrari against the old rusty car, the difference is that the Ferrari is racing on snow and icy roads, while the old rusty is racing on dry summer roads. Even if you clearly have a better vehicle, you will find it much harder to achieve the same result as the old rusty.
Our goal as investors would be to identify great companies within a great industry at a price that makes business sense.
Let’s dig into some real corporations and industries to identify how you can separate it from great to less great. ExxonMobil, a well-known company who I guess many of you know about. ExxonMobil (Ticker XOM) is a major integrated oil and gas company that explore, produce and refines oil, who operates within the basic material sector and has a market capitalization of 334 billion USD.
The basic material sector is straight forward, it produces basic materials like gasoline, oil, gas, steel and so on.
This is typical what we categories to be a commodity industry, what is unique about commodity product is that the only factor customers care about is price. Who bother if they fill up the car with gasoline from ExxonMobil or Royal Dutch Shell, customers can’t see, taste or feel any difference with whoever they buy it from. When price is the only factor, it’s naturally the producer with the lowest prices who win. This create high competition who lower the profit margins for all players in this field.
Let’s now have a look at another company named Intuit (Ticker INTU), Intuit is in the application software industry who is a part of the technology sector in the US market and has a market capitalization of 54 billion USD.
Intuit is a software company primarily for the small to medium sized businesses who focus on accounting, tax and finance preparation software. What makes Intuit so interesting is the high switching cost their product have. Switching cost is one of forces who can create competitive advantage over time, simply because once their software is integrated with the small business owners company its very time consuming to change to another software and may potentially damage the business for some period when changing software take place. A new product have to be significant better and cheaper, in order to make the small business owner change software.
Typical the industry for business software In general often enjoy higher profit margins over longer periods of time due to high switching cost.
Now we have gotten a sense of the industry specific, both with ExxonMobil and Intuit. Let’s dig into the numbers of each of these companies to see if we can spot any difference in growth, margins, earnings and risk.
Let’s split the following process into four different sections.
- Section 1: Sales and earnings
- Section 2: Profitability
- Section 3: Cash flow
- Section 4: Financial health
Section 1. Sales and earnings
Let’s have a look at and compare sales/revenue for ExxonMobil and Intuit
At a first glance we can identify a much more consistent sales growth for Intuit than for ExxonMobil, while Intuits sales growth have been 6% year over year on average for 8 year, ExxonMobil have seen a decline in sales growth by negative 3% on average for 8 years. While the long-term average growth rate for the US economy is 3%, this is telling me that Intuit is growing its business twice as fast on average than the whole economy. So far by just the sales, Intuit looks like a company we would like to continue investigate.
Let’s now look at the earnings per share or often called EPS.
Not unexpected do we identify the earnings of ExxonMobil to be volatile and not very consistent, but again that’s just the nature of companies without competitive advantage. On the other hand, intuits earnings is very consistent and growing year over year, except one year in 2015 were they had a drop and we would like to investigate that year specific to identify if its just temporary depressed or if there is a shift in the underlying fundamentals of the business. The recorded earnings can very often not tell the whole story if a company is earning more or less, this is because proper accounting can influence the reported earnings.
Section 2. Profitability
Now, let’s have a look at the profitability of each of the two companies.
ROE is the return on equity and is simply the net income divided by shareholders equity. Generally, we would like to see high numbers consistently, but to high numbers could also indicate that we would like to investigate further, to see what is pushing ROE higher. We should always compare ROE to debt levels, because debt can boost ROE and it could look like a company is very profitable, when all it does is taking on large levels of debt. Both ExxonMobil and Intuit is having high consistently levels of ROE except the last 3 years for ExxonMobil. Overall, we would be satisfied with these numbers, but we always have to check debt first.
Section 3. Cash Flow
Now we will investigate the real cash flow that is getting in and out of a company.
I included the EPS here as well, so we can compare it to FCF. FCF is the Free Cash Flow generated by the company and is much more telling the actual earnings story. The FCF is in this example confirming the EPS story, with a volatile Cash Flow for ExxonMobil with a high of 24 billion and a low of 3 billion in a 8 year period is not very consistently. Intuits cash flow is much more consistently and growing and that’s a sign of competitive advantage. I will urge investors to also look at cash flow statements and compare it to the EPS, because EPS can easily be manipulated to tell whatever the company wants it to tell.
Section 4. Financial Health
For our last step in this basic approach we will look over the financial health of the two companies.
FL is the financial leverage that a company have, this is the formula of total assets divided by shareholders equity.
The higher this ratio, the more debt is used in its capital structure. In this example of ExxonMobil and Intuit, the ratio seems fine and neither of the two companies seems to have excessive debt levels. If we see high levels of 4,5 or higher over longer periods, the company is considered to be riskier.
Overall, I would rather investigate further about Intuit and more about their business model, then try to estimate a business value in were I would be considering buying shares of the company.
ExxonMobil looks to be a fair company, profitable and in good financial shape without too much debt, but the competitive of the business and potential revenue growth is making it hard to value the business worth. But remember that even the greatest company in the world could be a bad investment, if you pay to much for it. Therefore, it’s important to figure out a business value and then use a margin of safety to determine what is your entry price. The riskier the business, the higher the margin of safety should be.
In the end I would like to compare the performance of these two companies from 2009 to 2018 to see how true competitive advantage can outperform over time.
Intuit has not only outperformed ExxonMobil by far, but over twice as much as the broad market as well, to archive these types of performance you got to have some type of competitive advantage over time, to be able to keep competitors away. A $100.000 investments in ExxonMobil would have turned out to be worth $116.190 in this period or similar to a 1.68% annual compounding return.
$100.000 invested in the market would have turned out to be worth $325.000 over the same time period, similar to a 13.9% annual compounding return.
For our competitive advantage company Intuit, a $100.000 investment would have been worth $736.000 in this period, similar to a 24.8% annual compounding return.
Our key lesson is to understand different industries dynamic and how some companies is simply just better positioned to make money over time than others.
Buy them at reasonably prices and hold for the long run.