I spend most of my waking hours studying businesses and the industries they operate in, and trying to identify those businesses that I believe have a long-lasting competitive advantage. Businesses that consistently generate strong free cash flow, or FCF, relative to their sales and net income, and above average returns on equity, or ROE, may have a competitive advantage -- or "moat" as it is sometimes referred to by Warren Buffett -- that protects their profits from the competition.
This advantage can take different forms, such as a strong brand -- think Coca-Cola, Tiffany, or Starbucks; cost leadership -- think Wal-Mart and Costco; or network effects, which means that the service becomes more valuable to users as the number of users increase -- think eBay's PayPal.
In the latter case, an increasing number of people with PayPal accounts will encourage more vendors to accept PayPal as a payment option. With more vendors offering PayPal, more consumers will be enticed to sign up for the ease and security of paying with it. The network effect strengthens the brand and provides organic growth, growing free cash flow and returns on capital, and barriers to entry by potential rivals.
When trying to identify these companies, there are five key principles to keep in mind:
Identifying a company with a moat is hard.
Identifying a company with a sustainable moat is very hard.
Most companies don't have anything resembling a moat.
Stocks of companies that have a sustainable competitive advantage outperform over a long period of time. To drive home this point, I turn to Buffett. In his 1987 letter to shareholders, he wrote: "Only 25 of the 1,000 companies [in a Fortune magazine study] met two tests of economic excellence – an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%. These business superstars were also stock market superstars: During the decade 24 of the 25 outperformed the S&P 500."
You may disagree with my assessment of a company's competitive position or the longevity of that position -- like I said, this is hard work -- and I welcome any and all feedback.
Today, I will discuss FactSet Research Systems (NYSE:FDS). FactSet is a financial technology company that provides data and analytics to investing professionals around the world. The platform provides company analysis, industry analysis, peer-group analysis, credit analysis, earnings estimates, portfolio analytics, fixed-income tools, valuation tools, news, and so much more. According to FactSet's 2013 10-K, it aggregates its own proprietary databases, plus info from 170 third-party data suppliers, 100 exchanges, and 90 news sources all into one place.
The source of FactSet's competitive advantage
I believe that the sheer scale and functionality of its platform provides the company with a competitive advantage, because it would take enormous time and capital for a new entrant to build a comparable platform. Additionally, FactSet consultants, who spend all of their time helping their clients build highly customized financial models, can immediately send customer suggestions and ideas back to FactSet's R&D team to ensure best-in-class customer service, and new innovations and functionalities that strengthen the platform even further.
What do the numbers say?
FactSet enjoys a 92% client retention rate, which provides it with high recurring revenues, predictable earnings growth, strong and growing free cash flow, and consistently high returns on equity. The numbers are staggering. According to the 2013 10-K, FDS has increased revenues and earnings for 17 straight years. According to Morningstar's Key Ratios (and my own calculations), during the past 10 years, FactSet's operating (EBIT) margins have never been lower than 30%, and it has generated an average ROE of 31%, an average FCF margin (FCF/revenues) of 24%, and an average free cash flow to net income ratio of slightly more than 1x, a sign of its high-quality earnings. It currently has about $118 million in cash, and zero debt.
Every industry and company is different; but, in general, I get excited when I find companies that have historically generated ROE of at least 20%, FCF margins of at least 10%, and an FCF/net income ratio of at least 1x. FactSet is especially appealing to me because its high return on equity is driven primarily by high net income margins (23% in 2013 according to Morningstar), and not by leveraging the balance sheet with debt.
What are the risks?
In addition to studying a company's competitive advantage, I spend considerable time thinking about the risks, or what could go wrong. Some of the risks facing FactSet include competition from larger companies like Bloomberg, Thomson Reuters, and S&P Capital IQ, as well as lower-priced online rivals such as Morningstar and Zacks; consolidation and job layoffs in the investment banking industry -- fewer employees means fewer FactSet terminals; a shift toward passive investing and index funds, which may decrease demand for FactSet's very robust platform; technological obsolescence (a better product comes along), or some sort of blackout or glitch on its servers.
According to Morningstar, FactSet currently trades at 25x trailing 12-month earnings, 21x forward earnings, and 21x free cash flow. I can't argue that the stock is cheap at these multiples; but I will point out that 21x FCF starts to look more reasonable when you compare it to FactSet's 10-year average ROE of 31%. At the very least, I encourage you to read more about FactSet and the industry, and put FactSet on your watch list. Until next time, Fool on!
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John Rotonti owns shares of FactSet Research Systems. The Motley Fool recommends FactSet Research Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.