When you're looking to invest and trying to figure out which stock to buy, remember that what you're buying isn't just a piece of paper with fancy writing on it. What you're buying is a small fraction of a business. Remembering that is absolutely critical to becoming a successful investor. Keep it in the forefront of your mind, and investing success will very likely find you. Forget about it, and you'll be facing an uphill battle.
Why does a business matter?
The stock market is a fickle place. One minute, a company's stock can be Wall Street's darling; the next, that same security can be absolutely despised. A company's stock price can and will jump around for no apparent reason, but the business behind that stock tends to be significantly less mobile on a day-to-day basis. If a stock price tends to move more rapidly than the business it represents, it follows that a stock and its underlying business are not always worth the same amount.
As an investor, you may buy the stock, but what you end up with is the business. And why exactly would you want to pay more for a stock than its underlying business is really worth? You wouldn't -- and that's why, when looking at a stock to buy, you must look at its underlying business.
Three legs to a business
When analyzing a business, you have three critical parts to consider -- the company's operations, its finances, and its competitive moat. Just like a stool needs at least three legs to be stable, a company needs to be in control of all the parts to be a decent investment candidate. Companies may be strong in two of the three areas, but if they're weak in a third, that area becomes an Achilles' heel.
Tough operations
Take emerging satellite radio duopoly Sirius (NASDAQ:SIRI) and XM (NASDAQ:XMSR). They're both undisputed leaders in the industry, which is attempting to do for radio what cable did for television -- transform it from a free, bland medium to an edgy, subscriber-supported one. Yet in spite of the strong moats that come with being the first and largest players in the industry, neither company has turned a profit yet. They have a heck of a moat and sufficient financing to accommodate their start-ups, but their business? It's brutal.
It's expensive to design, build, and launch a satellite. Once it's up there, as XM knows all too well, it's virtually impossible to repair. The company must bear the costs of the satellites (and their replacements) regardless of the number of subscribers it has -- and when something goes wrong, the repair is mandatory, or else the business could quickly cease. Add to the fixed overhead of the satellites the costs of acquiring subscribers and the costs of the exclusive talent needed to keep those customers happy and paying, and it all adds up to a lot of money being shelled out before the first dime of revenue comes in.
Granted, if the two can get large enough subscriber bases, their business models can turn hugely profitable at the same time that the huge costs of entry prevents other competitors from entering the field. Yet you only need to look as far as the cable television business and such bankrupt firms as Adelphia to see the risks inherent in such high fixed-cost businesses.
Inch-deep moat
On the flip side, oil firms such as ExxonMobil (NYSE:XOM) and ChevronTexaco (NYSE:CVX) have been practically minting their own cash recently, as their businesses have benefited from the high market price of oil. Their profits, while strong, are inextricably linked to the price of oil. When new supply comes on the market or sustained high prices start forcing people and businesses to consume less, the price of oil will fall. And the profits of the oil companies will fall along with it. With a dozen or more companies, each selling virtually indistinguishable products, fierce price competition forces the entire industry to essentially wax and wane together.
Money trouble
Let's not forget the financial aspects of investing. Without the money, what exactly is the point of investing? For an example of a company with a formerly strong moat and a once-solid business that is slowly being torn apart by finances, look no further than General Motors (NYSE:GM), the once-great automobile manufacturer in my own portfolio. Along with fellow car manufacturer Ford (NYSE:F), General Motors once ruled the American roadway. Unfortunately, that dominance brought with it lax financial controls and a loss of monetary discipline.
Significant costs became structurally and permanently embedded in the company's operations, rendering General Motors unable to profitably compete against smaller, more nimble, and less-encumbered brands. As a result, Honda and Toyota managed to overcome GM's moat and wear away at its business to the point where the former titan of the roads is now gasping for survival.
A well-balanced company
Of all the companies available in the market, few have strong moats against competition. What's more, few have solid financials and strong underlying businesses. An exception is pharmaceutical giant and Motley Fool Inside Value selection Pfizer (NYSE:PFE). With its gigantic R&D arm and the arsenal of patent-protected compounds it produces, Pfizer is literally in the business of building and maintaining its moat. Sporting a coveted AAA debt rating, its financials are second to none. And thanks to the large number of brands with billion-dollar annual sales, not even the recent and ongoing controversy surrounding Pfizer's Bextra and Celebrex pain relievers look as though it'll cause permanent, irreparable damage to the firm.
When companies have solid financials, strong business models, and deep moats against competition, they make great candidates for consideration. When the companies possess all of the above and trade for below their true worth, they make excellent investments. Lead Inside Value analyst Philip Durell picked Pfizer at the height of the painkiller controversy, when its shares were near their lowest, knowing that the company's well-balanced strength would allow it to survive and prosper. His analysis appears to be paying off, as Pfizer has significantly outperformed the market since his selection.
Take advantage of Philip's ability to uncover well-balanced companies trading at discounts to their fair value. A free 30-day trial to Inside Value starts here.
Fool contributor and Inside Value team member Chuck Saletta owns shares of General Motors. The Motley Fool has a disclosure policy.
