I spend most of my waking hours studying businesses and the industries they operate in, and trying to identify those businesses that 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, meaning that the service becomes more valuable to users as the number of users increases (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 PayPal. 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, please keep in mind five key principles:
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 will 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 MasterCard (NYSE:MA). MasterCard is a payment processing company that earns fees for processing credit and debit card transactions on its super-fast network.
Unlike traditional credit card companies, MasterCard does not provide credit and therefore faces no default risk.
MasterCard has two reinforcing competitive advantages: It is a trusted, globally recognized brand and it benefits from network effects. In other words, the company's strong brand encourages consumers to obtain a MasterCard, and as more and more consumers open a card, more stores will accept MasterCard as a form of payment. The network works in the reverse direction as well. As more stores accept MasterCard, more consumers will choose to carry a MasterCard in their wallet.
MasterCard's business model is not capital intensive so it can operate with very little (or even zero) debt, and its steady stream of fees provides a strong and growing free cash flow and almost obscene returns on equity.
According to Morningstar Key Ratios, over the past five years, MasterCard has generated average returns on equity of 43%, an average FCF margin (FCF/revenue) of 34%, and an average free cash flow-to-net income ratio of 1 times (indicating the high quality of its earnings).
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 a FCF/net income ratio of at least 1 times. MasterCard is especially appealing to me because its high returns on equity are driven primarily by high net income margins (37% in 2013, according to Morningstar Key Ratios), and not by leveraging the balance sheet with debt.
Furthermore, MasterCard is positioned to profit from three long-term secular growth trends: the shift away from paying with paper, the growth of online shopping, and the continued increase of the middle class in emerging markets.
MasterCard does face considerable risks, including a fiercely competitive payments industry (especially in mobile payments), heightened government regulation of interchange fees, and legal fines and costs associated with defending its business model from additional class action lawsuits (it has already agreed to pay billions in fines).
MasterCard currently trades at 29 times trailing 12-month earnings, 22 times forward earnings, and 26 times free cash flow. I can't argue that the stock is cheap at these multiples, but I will point out that 26 times FCF starts to look more reasonable when you compare it to MasterCard's five-year average ROE of 43%. In the very least, I encourage you to read more about MasterCard and the industry and to put MasterCard on your watchlist.
John Rotonti has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola, Costco Wholesale, eBay, and MasterCard. The Motley Fool owns shares of Costco Wholesale, eBay, and MasterCard and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. 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.