All that glitters

Investors chasing hot stocks often mistake buzz for something meaningful:
a deep competitive advantage

Rob McConnachie on long-term horizons
Globe Investor Magazine, May 22, 2008
Illustration by Simon Pemberton

When I run into someone from the investment industry, especially during times of volatile markets such as these, I’m often asked the same two short-term-focused questions: “What do you like these days?” and “Are you playing the (insert current hot commodity) market?”

The answer to the second question is usually a succinct no—and usually, but not always, it comes fast enough to ward off the follow-up debate on where the commodity in question is headed.

I’m not interested in loading up on commodities right now. They have been working well for people lately, and will continue as long as the superficially plausible macro story about booming demand from China or India remains intact. But for long-term investors, such as myself, it’s a game loaded with risk.

What many investors may be unaware of is that while the current values of a lot of these commodity companies imply higher and sustainable underlying commodity prices, the probability of this, history has shown, is doubtful. Old-fashioned microeconomics dictates that the more commodity-like the product and the lower the barriers to entry, the faster excess profits attract competition—driving prices and profits down. So while everyone is trying to make a quick buck by chasing gold—or uranium or potash— stocks, I’ve got my eye elsewhere.

What I like these days is the same thing I’ve always liked: companies with long competitive advantage periods (or CAPs). I want companies that will generate and increase free cash flow over the long term.

Two examples are Thomson Corp. and Moody’s. Until recently, I’ve found such companies to be richly valued because of the markets’ recognition of their CAPs as well as the scarcity of these businesses. It’s been a waiting game, but the good news is that these companies have finally been attractively valued, as investors are now overwhelmingly fixated on the short-term outlook rather than on long-term business values.

With the recent acquisition of Reuters, Thomson has become a clear leader in delivering electronic content and analytics to legal and financial professionals.

Moody’s is a credit-rating agency that, along with S&P, enjoys a roughly 80% duopolistic market share. The business essentially acts as a toll collector on publicly issued debt. The price of the stock has dropped by about half since last summer, as the market focuses on the lower earnings from rating structured-debt products (all of the subprime-related instruments), and the risk that Moody’s will get sued for its subprime-related ratings record. The good news is that the company has faced litigation in the past, and has yet to suffer a material loss. The courts in the U.S. view it as a publisher, and, as such, it’s protected by the First Amendment. Given this, I believe its long-term competitive position remains intact.

So what sector doesn’t look attractive? I’ve spent a lot of time digging into the cable and telecom sector recently. The stocks have been hammered, and the free cash flow generated by the wireless divisions is strong. The sector should be attractive, but their CAPs are questionable for many reasons.

We came away worried that new competitors arising from the auctions of new wireless spectrum licences will drive pricing and profits down across the industry. Pricing has been continuously decreasing for wireless carriers outside of Canada; it’s only a matter of time before it happens here. There is even a risk that new technologies could come along that will seriously displace wireless networks. These considerations have made me uncomfortable in taking a position in the sector.

Companies with long CAPs are rare, but they provide substantial returns over the long run, with few drawbacks.

Rob McConnachie, CFA, is the chief investment officer of Dixon Mitchell Investment Counsel, a Vancouver-based wealth management firm.