The Power Three

Selena Gomez and Richard Thaler may find this shameful, but I used to build and sell collateralized debt obligations (CDOs). Phew. I said it. It was actually somewhat of a natural progression from traditional fixed income sales as our institutional clients pressed for these in the early to mid-2000s. CDOs can really be built out of any pool of assets and/or securities that produce a predefined cash flow stream; including mortgages, bank loans, credit default swaps and, as Selena and Richard focused on, other CDOs themselves.

One of the things that most amazed me during my experience on the structured fixed income desk was our reliance on the major credit rating agencies. Most of our biggest institutional investors could not touch anything that did not have a minimum rating from two different agencies – one of which had to be either Moody’s or S&P – preferably both. These agencies owned us, which gave me the impression that they could charge us whatever the heck they wanted. What were we going to do? Go to a competitor? Nope, not going to happen because our clients won’t buy it. This got me wondering what they did with all the money we sent them. They didn’t have any factories, ships, trucks, inventory or anything that needed to be purchased or maintained. They had people and IT.

I figured I better own these stocks, and anyone who looked like them…

The “Besting Dart Throwing Monkeys with a Clipboard” conversation highlights a lot of important variables when screening individual securities. In my experience, three of them matter the most as it relates to risk adjusted returns over the long term: i) high profit margins (i.e. net profit margins > 10%, return on equity (ROE > 15%), high ROIC less COC); ii) low capital expenditure requirements; and iii) a sustainable, strategic competitive advantage. These are companies that effectively print money, don’t have to put much of it back into the business and nobody can take it away. Just like the debt rating companies. Other examples include the top credit card providers, dominant search engine company, and long live resource royalty owners.

What makes these sorts of companies “supreme” investments is that they tend to produce top tier returns, but with a lower degree of both market and margin volatility. The first two elements can be vetted through public financial statements. The last factor is a little more ambiguous. The test I use to qualify a company’s competitive advantage is to consider “if I had financial backing from a multi-billionaire to set up a business to compete with this company would I have a hope?” When the answer is definitively ‘no’ or ‘quite unlikely’ then the company under evaluation probably has a pretty sustainable competitive advantage. Another way to evaluate for a sustainable competitive advantage is the endurance of the company’s profit margins. A long history of strong margins is indicative of a sustainable competitive advantage.

These businesses are extremely uncommon and they are almost never “cheap”. When I do find them, and have determined there is still a sufficient margin of safety, I need to own them.