June
5, 2003 7:00 a.m. Moat-ivation
What
do happy stocks have in common?
ll happy families
resemble one another, but each unhappy family is unhappy in its own way,"
wrote Tolstoy in Anna Karenina.
You could say the
same for stocks.
All happy stocks
are pretty much alike, while unhappy stocks lose their value for all sorts
of reasons — fraud in the case of Enron Corp., bad mergers in the
case of AOL Time Warner (AOL), inadequate business plans in the case of
FreeMarkets Inc. (FMKT), whose shares have plummeted from $350 to $7 in
three years.
What do happy stocks
have in common? Moats.
To understand what
a moat is, consider these three companies: Whole Foods Market (WFMI), Forest
Laboratories (FRX), and International Game Technology (IGT). Each has at
least doubled in price over the past three years, a period during which
the Dow Jones industrial average has dropped nearly 2,000 points.
But first some background:
When you buy a stock, you become a partner in a business. It's the business
that counts, not the numbers you see every day in the stock pages, not the
lines on analysts' charts. Your task is to find good businesses at good
prices, or let someone else find them for you, or own an index fund whose
performance reflects the market (and the economy) as a whole.
A good business is
one that makes good profits — or, to be more precise, generates a consistent
and substantial flow of cash over time. That cash can either be distributed
to investors in the form of dividends (and we should see more of this behavior
since the passage of the recent tax cuts) or kept and reinvested by the
company, whose value (and stock price) will rise as a result.
Running a business
is tough — and the main reason is competition, which puts constant
pressure on the prices a business can charge customers. So, if you can find
a business that has some protection against competition — that is,
a moat — you may have found a happy stock.
"You need a moat in
business," Warren Buffett, the chairman of Berkshire Hathaway (BRK.A), once
said, "to protect you from the guy who is going to come along and offer
[your product] for a penny cheaper."
Warfare is the prevailing
environment in all sectors of the economy. It is wonderful for consumers
because it means lower prices and better quality, but it can be hell for
competitors. Long before the terrorist attacks of Sept. 11, 2001, the war
in the airline sector was so fierce, it killed off many of its most celebrated
combatants, including Eastern, Pan Am, and National. Even in a good year,
a company like Delta Air Lines (DAL) earns only about $5 on each $100 in
sales, and those profits are depleted quickly in the purchase of new planes
— all to keep up with the competition.
Airlines are commodity
businesses; that is, they peddle a product, like bushels of wheat, with
few distinguishing features. Consumers choose among air carriers mainly
by looking at prices, so the few successful airlines — Southwest (LUV),
JetBlue (JBLU) — are the ones that keep costs low. While cost cutting
helps businesses thrive, it's not a moat. Eventually, competitors —
even those with tough unions — cut costs too, and it's hard to boost
profits. As much as I admire Southwest (I am a longtime owner of the stock),
I recognize that the company is still exposed to severe competitive forces,
which prevent it from raising prices and making the kind of profits that
moat-protected companies make.
A moat keeps the enemy
at bay. It can be a great brand name or a special way of doing business
or a series of patents. In short, a moat is an attractive profit-making
asset that other businesses can't easily copy. Coca-Cola (KO) is a good
example — not just because of a secret formula for syrup but because
of a brand name (the most recognized word in the world after "okay"), built
over a century of advertising and word of mouth.
Coca-Cola stock has
been a dud lately, and it may suffer in the future as global tastes change.
But over time it has performed magnificently because, in its own sector,
it is difficult to assail. Coke earns about 30 percent annually on its invested
capital. Its book value and earnings have quintupled in the past 15 years,
and dividends per share have risen from 14 cents to 88 cents. It has a gorgeous
balance sheet, generates gouts of cash, and has minimal capital-spending
requirements.
Let's look at some
other moat-protected businesses, more obscure than Coke, that have boomed
in tough times:
• Whole Foods.
Selling groceries is a commodity business if there ever was one, but this
chain has found a productive niche. Growing by acquiring local and regional
natural-foods markets such as Fresh Fields and Bread & Circus, Whole Foods
owns and operates the nation's largest chain of natural-foods supermarkets
— 143 stores in 25 states. Since it went public in 1992, Whole Foods
has increased its cash flow, in a Beautiful Line, in every year but one.
Earnings over the past decade have risen from 15 cents to $1.40 a share,
and the stock has increased more than eightfold in price. Over the past
12 months it is up 7 percent, compared with a loss of 13 percent for the
benchmark Standard & Poor's 500-stock index.
The moat, in this case,
lies in the company's reputation for selling food, vitamins, and personal-care
products that customers see as more healthful than the stuff they get at
Winn-Dixie or Wal-Mart. Certainly, the large chains can sell organic and
natural foods, too, but the consumers who buy such products are highly conscious
of who is selling them. They will, it appears, pay more to shop at a place
they trust. Whole Foods also competes with local natural-foods stores, but
those tend to be small and not so well-stocked.
One way to tell whether
a company has a moat is to look at its profit margins compared with those
of its competitors. High margins mean a broad moat. In this case, Winn-Dixie
(WIN), a well-run company with more than 1,000 stores, last year had a net
profit margin (earnings divided by sales) of 1.3 percent. Whole Foods had
a margin of 3.1 percent.
Whole Foods is still
a small chain, with an average of just five or six stores per state. It
could cut costs with a more efficient distribution network — especially
since two-thirds of the products it sells are perishable, a big proportion
for a supermarket. Are there enough customers out there for healthy groceries?
Probably. But understand that one deficiency of well-protected companies
is that they stake out small markets and have a difficult time expanding
because demand is lacking.
Price is a consideration
in any investment, and Whole Foods, with a price-to-earnings (P/E) ratio
of 34, is not cheap. The good news is that the price has fallen about 15
percent in the past month while sales growth, even in a sluggish economy,
remains powerful. Value Line expects both sales and earnings to rise at
an annual average of 16 percent or more for the next five years. You don't
get that kind of growth in this kind of industry without a moat.
• Forest Laboratories.
Drug companies are classic moat-protected businesses. They spend enormous
sums (an average of $900 million) to bring a drug from the lab to the market
— and that investment alone provides a barrier to competitors. And
once the drug is patented and approved, it has strong legal protections.
Generic competitors are managing to breach patent fortifications, but, compared
with most businesses, drug companies retain broad moats.
Sales of Forest's blockbuster
drug, Celexa, continue to rise impressively — up 43 percent to $1.1
billion last year alone. The company also makes Aerobid for asthma and Tiazac
for hypertension, among others, and it has a new anti-depressive, Lexapro,
that should attract business as Celexa's patent defenses begin to expire.
Smaller drug companies
like Forest have their ups and downs since they often depend on just one
or two hot products — Celexa, for instance, represents nearly half
of Forest's total revenue. Still, a well-managed pharmaceutical firm typically
has several new medicines in the pipeline. Forest has some excellent prospects,
including an Alzheimer's drug, and, even if the pipeline is dry for a spell,
the company, with no debt and $1.3 billion in cash, will be able to endure.
Again, my point is
not to encourage you to buy Forest but to understand how a stock can rise,
as this one has, by 133 percent over three years at the same time the S&P
falls 31 percent.
• International
Game Technology. Gambling is a delightfully recession-proof industry.
When times are good, people pour money into casinos. When times are bad,
states adopt and expand lotteries. International Game Technology benefits
both ways. It develops slot machines and other sophisticated gambling games,
including the obnoxiously ubiquitous "Wheel of Fortune" machine, and it
provides software and hardware for lotteries, now legal in 39 states and
100 countries.
IGT's moat comes from
its technology. It is simply the best at what it does — making innovative
games, such as progressive slot-machine systems that produce multimillion-dollar
jackpots. IGT also links its machines to popular brand names, including
"Jeopardy" and Elvis. Other companies can make slot machines, but no one
else can make Slotopoly or Party Time. Through strong research and development,
smart marketing, and acquisitions of such competitors as Anchor Gaming (which
readers may remember as one of my old favorites), IGT has built a 70 percent
market share. When you're that big, you have pricing power.
The company's growth
has been phenomenal. Earnings have risen from 8 cents a share in 1993 to
an expected $4 or more this year; total revenue, from $478 million to more
than $2 billion, with a net profit margin of 16 percent. Cash flow is abundant
and capital-spending requirements insignificant. IGT shares have more than
tripled in the past three years. They fell sharply as a result of the Sept.
11 attacks but recovered quickly. In the last year alone, they're up 45
percent.
Again, IGT isn't cheap
— about $88 — but why should it be? It trades at a P/E of 23,
which sounds reasonable for a company that has increased its earnings at
an annual rate of more than 20 percent for the past 10 years. Growth will
slow in the future — it has to — but it appears that the company's
moat is awfully secure.
Reputation, patents,
technology — those are just some of the moats that businesses build
to protect themselves from marauders. No moat is permanent, and even the
broadest moat can be breached by clever competitors. But, in general, a
wide moat makes a happy stock — and a happy investor.
—
James K. Glassman is a fellow at the American Enterprise Institute
and host of TechCentralStation.com.
Among stocks mentioned in this article, he owns Berkshire Hathaway and
Southwest Airlines. This column originally appeared in the Washington
Post.
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ll happy families
resemble one another, but each unhappy family is unhappy in its own way,"
wrote Tolstoy in Anna Karenina.
