Stepping out of Net Nets

When compared, Stock markets outside of the U.S is less enticing because they lack big brand names like Microsoft, MacDonald or Coca Cola. Most investors know that these companies have what Warren Buffett likes to call an “Economic Moat”

Of course investing in companies that have economic moat is a great idea, however there are some problems;

  1. The price already reflect the value of the economic moat and most of the time you are paying a premium for it.
  2. You may have already missed the growth potential of these companies and they are now in the mature stage.

So how do you invest in companies that have economic moat when they are still small and unattractive?

Well the newspaper is not going to report on them, analysts are not going to cover them and nobody is going to tell you about them. You have got to do the digging, you are responsible for your own money and more importantly your own thinking.

With globalization, successful companies have expanded to emerging markets for growth but what happens when the emerging markets becomes developed? Business rise and business falls but how sure are you that the next rising company is one from the U.S? Over the next few decades the population numbers and purchasing power will be growing significantly in other countries. Local companies have several advantages such as first mover advantage, loyalty, consumer preference, government protection and lower transportation cost.

This is where your home ground can be fertile hunting place for potential investments. We want to be looking for companies that are not only great in their respective countries but can also be great in other countries. A property developer will find it difficult to have a competitive advantage to gain market share in foreign countries.

Imagine a specialty Eco friendly concrete maker that has plants in China and operations in multiple Asian countries. Asia’s population is set to grow to 4 billion and many of the developing countries in Asia will have to build infrastructure to support it. They also have consistently higher gross profit margin(28%) when compared to a larger competitor(23%) this may be due to the fact that they can charge higher price for their products.

Although it’s market capitalization is above the net current assets they have low debt level and the working capital is not in question. It is selling above net net because it has been generating a steady earnings and giving a decent return over the past few years. The ROE is around 7% which is decent considering the low leverage by the company.

So far the company has passed most of the criteria but we also have to look at the price. It is not our typical cheap net net stocks however the price to book value is at 0.68 which means it is still a bargain.

  • Management [Pass]
  • Earnings [Pass]
  • Business [Pass]
  • Economic Moat [Pass]
  • Price [Pass]
  • Margin of Safety [Pass]
This will occur, for example, when a company has outstanding only common stock that under depression conditions is selling for less than the amount of bonds that could safely be issued against its property and earning power — Benjamin Graham

Because of the low debt levels of this company, they can easily raise more money against its property and earning power therefore the price is acceptable. However how do we know if the margin of safety is adequate? For this case we have to employ a more advance and different way of reasoning to determine the margin of safety.(courtesy of Ben’s book on Margin of safety — Chapter 20).

The margin of safety lies in an expected earning power considerably assume the going rate for bonds. Assume the bond rate is 5% and the earning power is 10%; then the stockbuyer will have an average annual margin of 4% accruing in his favor. Some on the excess is paid to him in the dividend rate; even though spent by him, it enters into his overall investment result. The undistributed balance is reinvested in the business for his account. In many cases such reinvested earnings fail to add commensurately to the earning power and value of his stock. But, if the picture is viewed as a whole, there is a reasonably close connection between the growth of corporate surpluses through reinvested earnings and the growth of corporate values.

Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 50% of the price paid. This figure is sufficient to provide a very real margin of safety — which, under favorable conditions, will prevent or minimize a loss. If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favorable result under “fairly normal conditions” become very large. That is why the policy of investing in representative common stocks does not require high qualities of insight and foresight to work out successfully. If the purchases are made at the average level of the market over a span of years, the prices paid should carry with them assurance of an adequate margin of safety. The danger to investors lies in concentrating their purchases in the upper levels of the market, or in buying non representative common stocks that carry more than average risk of diminished earning power.

  • So the question is this a representative common stock?
  • does it carry more than average risk of diminished earning power?
  • Is it purchased at average level of the market?
  • Under favorable conditions does the margin of safety enough to prevent or minimize a loss?

If yes; good profit possibilities combined with small ultimate risk, therefore, Accumulate.