Tuesday, December 22, 2009

Beyond The Numbers

Companies with strong ROIC and strong ROE numbers may have competitive advantages. On the other hand, there could be many reasons for high returns, which could trick the investor into believing a competitive advantage is present. Therefore, it's important for the shareholder to identify the competitive advantage before accepting it as true.

Rising (or falling) commodity prices could make companies which sell (or buy) commodities look like they have an advantage. Temporarily strong markets, or temporary weakness in competitors can also have the same effect. These occurrences will result in elevated returns for extended periods, occasionally for several years. Managements for these companies will of course take credit for such uncontrollable but favourable circumstances, and will claim that the abnormally high returns are due to their effectiveness in securing a competitive advantage for the company. Therefore, the shareholder must investigate the situation, and apply his own business sense to determine if the advantage is for real.

Unfortunately, there is no formula one can apply to determine if a competitive advantage exists. Investors must use good judgement, conduct diligent research, and educate themselves by reading the examples of successful investments of the past. Competitive advantages come in all shapes and sizes. For example, Dover Downs (DDE) discussed on the site yesterday, may have an advantage due to strong opposition from the state for new entrants to the gaming industry. Solitron Devices (SODI) may have an advantage due to the fact that its end customer (the military) prefers American manufacturers (even though the trend in the general industry is for low-cost, overseas products) and stresses reliability over price.

Philip Fisher's book Common Stocks with Uncommon Profits helps guide the investor in thinking about whether a company in question has a competitive advantage. We will be summarizing the book later this week.


Rayhaan said...

Yo barel, thanks for reviewing phil fisher at last ,its eagerly aw8ed. One quick question: are trailing p/e ratio any useful in ur opinion?if yes to wot extent

Saj Karsan said...

Hi Rayhaan,

Yes I believe trailing P/E can be useful as a way to screen for stocks that might be trading cheaply relative to their earnings. You can't buy solely on the basis of trailing P/E though...further investigation will be required.