February 2016 Press On Research Issue

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Huge Margin Of Safety And Potential Competitive Advantages Mean As Much As 341% Gains For Us

February 2016 Press On Research Issue

By Jason Rivera

Press On Research Volume 1 Issue 9

When you think of investing in microcaps the last thing you think about is finding a company with gigantic competitive advantages.

Of course we search for companies that have them.  But we rarely find these companies.

After all small companies are small for a reason…

Most of the time they’re newer businesses that haven’t refined their business models.  Are struggling to find niches to thrive in while fending off giant competition.  And are just trying to stay afloat as they grow sales and profitability.

These are a few of the reasons why here at Press On Research I haven’t talked much about competitive advantages at this point.

Almost 100% of companies with huge long-term competitive advantages are the biggest companies in the world.

I can only think of a handful of microcaps I’ve evaluated over the years that have had even small short-term competitive advantages.

And only a few that if they got bigger, could have massive advantages over competition.  And none that already had them.

So why am I talking about competitive advantages here on Press On Research?  Because I’ve found a $263 million company that’s building a massive competitive advantage now.

But this isn’t even the best thing about the company…

Even if it takes them decades to build their competitive advantages to the scale of a world dominator, or it doesn’t build its competitive advantages at all.  It’s so undervalued now that it doesn’t matter.  We still should make a ton of money owning this company over time.

It’s selling between 20.9% and 341% below its true value.  And its priced now as if the market expects the company to go out of business as its selling at a 25.9% discount to just its net asset valuation.

This is one of the most conservative valuations investment analysts do.

But this company is far from terrible…  It’s profitable on an operating margin basis in eight of the last ten years.  And on an return on invested capital (ROIC) basis has been profitable every year of the last ten.

It’s grown revenues 3.67 times in the last ten years.  It’s got a strong balance sheet that’s in a net cash position.  And its operations are becoming more efficient over time.

Best of all this company operates in an industry that’s necessary to governments around the world.  And will remain so for decades to come.

This all means that not only will the company not go out of business, but that it’s already a good to great business priced far below its true value.

By buying this company we get to combine the ideas of two value investing giants Benjamin Graham and Warren Buffett.

But most important for you is this means we should expect great returns over time… Even if the company isn’t able to build its advantages.  If it does this company could become a multi bagger in the long-term.

But before we get to all this I need to explain what competitive advantages are.

What Is A Competitive Advantage?  And What Kind Of Advantages Are There?

A competitive advantage is simply something that gives you advantages over competitors.  They’re simple to understand as outside investors.  But difficult – impossible in some industries – to cultivate over the long-term.

Why? Because in most cases competition works to erase any competitive advantages over time.

Let’s start by talking about the kinds of competitive advantages companies can have.

In general there are five different advantages companies can build.  And often if you have one kind of advantage over competition you may have others as well.

Patents, Brand Names, Trademarks, Etc

These advantages are things like patents, trademarks, copy rights, customer lists, or brand names that protect valuable assets the company owns or have the rights to use.

Think Altria and Philip Morris, Louis Vuitton, Coach, Michael Kors, Ralph Lauren, etc.

These can be indefinite assets in the case of trademarks, copy rights, and brands.  Or short to long-term – one to 30+ years – in the case of patents.

If a company has a lot of these assets make sure to check how long they’re supposed to last, especially when it comes to patents.  This information is in the company’s annual reports in the footnotes.

These assets are listed on balance sheets under terms like indefinite lived assets, intangible assets, or the other names above.

Unless you have an ultra-powerful brand like Marlboro, these are the weakest competitive advantages to keep over the long-term.  Why? Because even immensely profitable drugs like Viagra come off patent in time.

These are also the only kinds of advantages you’ll find listed on a balance sheet.  The rest of the bunch you can only find doing thorough analysis on a company and knowing what to look for.

Network Effects

Network effects come from having a large network of customers using your service.

When networks reach a tipping point it makes it difficult for similar companies to compete because the more people you have.  The fewer – generally –will use competitor sites that are similar.

This competitive advantage is a gigantic barrier to entry for smaller competition.  But the network effect can also tip backwards if you don’t continue to do things well.

Current companies that have gigantic network effects are ones like Facebook, EBay, and LinkedIn.

Yes, there are similar – much smaller – companies out there but unless you search for them they’re hard to find.  And they only operate in niches.

Many times once a company gains this advantage over competitors it becomes almost impossible to compete if you offer similar products.

The only time these advantages don’t work is if you’re doing something a lot better and your competition is getting worse.  Think MySpace before Facebook came around.

If you’re trying to cultivate this competitive advantage you either need to be different or a lot better than competition to gain any share.

Even then you’re still hoping to gain enough subscribers and customers to reach the tipping point so this effect will swing in your favor.

The next two competitive advantages many times go together so I’m combining them.

Economies of Scale And Low Cost Operator Advantages

The economy of scales advantage comes when you’re so big you can lower your costs below competitors.  This gives you a huge advantage with customers because you can have lower prices for goods you sell.

The keyword within this advantage is efficiency.

The more efficient you are as a company the lower costs you’ll have.  The lower costs you have to charge to customers.  The more profitable you’ll become at the expense of non efficient competition.  Even if they’re bigger when you start.

When it started Wal-Mart was smaller than K-Mart.  Now K-Kart is almost nonexistent due to Wal-Mart’s competitive advantages and efficiency.

Companies gain these advantages because they do more business and sales than similar companies.  So their costs spread out over a wider range of products and suppliers.

Some giants like Wal-Mart have so much power over suppliers they can negotiate lower prices when they buy products as well.  Furthering their advantage.

This can be a double edged sword though if not cultivated right.

If not done well this can also lead to a chase to the bottom to ever lower profitability.  The container shipping industry is one example.  It’s efficient and cost effective but has always struggled to stay profitable.

If done well this can lead to crushing of competition and a huge barrier to entry which keeps smaller companies out of the industry.  Or crushes non efficient competitors already on the market.

Other companies not mentioned above that have a combination of these two advantages are GEICO, Coca-Cola, Pepsi Co., Altria, and Philip Morris.

Regulatory/Government Aided

At first you’d be surprised to see a government/regulatory aided competitive advantage right?

After all governments around the world do everything they can to end monopolies.  And try not to help certain companies at the expense of others in an industry.  But this backfires when the law of unintended consequences comes in to play.

This can be the most powerful competitive advantage of all.  Why?  Because if an industry is highly regulated by government it keeps competition out.  And whoever is already “in” gains all the business.

This explains why Altria, Philip Morris, British American Tobacco, Lorillard, and the other tobacco giants have dominated their industry for decades.

It also explains why they have generated such huge profits for so long.  And why newer, smaller, and more innovative companies haven’t disrupted the industry.

If you’re going to get regulated and taxed to death what’s the incentive for smaller more innovative companies to come into the industry?

There isn’t one.

Take a look at the taxes on cigarettes below as an example of why small companies can’t get into the tobacco business.

The dollar numbers above are the average per state tax rate per pack.  These are on top of the federal per pack tax rate of $1.0066 as of July 2014.

These taxes combined with the other regulations at cigarette companies are why cigarettes cost so much.

This is also why when this advantage combines with something like a powerful brand name – Marlboro –companies can continue to raise prices.  And still get customers to buy.

This means higher margins, greater profitability, and higher returns for shareholders.  At least until governments raise taxes again and the process of raising prices starts again.

All tobacco related companies enjoy this competitive advantage.  And today’s recommendation does as well… But I’ll get back to this later.

For more information on competitive advantages go to the following links.

• Competition Demystified By Professor Bruce Greenwald.
• Understand Competitive Advantage by Professor Bruce Greenwald.
• All Strategy is Local by Professor Bruce Greenwald

Having a combination of the above advantages over the long-term enables higher margins than the competition.

If the company grows in a healthy way with these competitive advantages – and higher margins – value within the company grows and compounds

As will shareholder returns… Whether it’s stock gains, dividends, buybacks, or some combination.

Today’s company is building the government/regulatory competitive advantage over the last several years…

***

I go on from here to describe everything about the company.  Its competitive advantages.  Some giants it works with.  Its valuation and margins.  And everything else great about the company.

I also detail its risks to make sure subscribers are comfortable owning it for the long-term before recommending subscribers buy it.

If you’d like to subscribe to Press On Research to get this issue and all past issues you can do so at the previous link.  And if you’re already a free Value Investing Journey subscriber you can subscribe to Press On Research for a 50% discount of only $49 for one year.