What to look for in a good long-term investment

By Rachit Tibrewala Portfolio Manager CFA, CFP - Louisbourg Investments Inc.

 

Investors are always seeking good long-term investments. But just what makes a business a good investment in the long run?

One important thing to watch for is a company with a sustainable advantage over its competitors, also known as a sustainable moat. Coined by Warren Buffett, this term refers to a company with something unique or special that makes it hard for competitors to lure customers away.

 

How do high barriers to entry make a business sustainable?

Investors often fund companies with temporary moats. Temporary implies that their first-mover advantage in the industry will probably fade away sooner than later. Attractive businesses without a sustainable moat attract competition – and have their high margins competed away.
If you are investing in a company to gain short-term returns from its initial success, a temporary moat may be favourable to you. But if your objective is to stay invested without worrying about diminishing profit margins, then look for a company with sustainable high barriers to entry.

Characteristics of such companies include: intangible assets such as a brand or patents; high costs involved in switching to a competitor; and a strong, established network. These and other characteristics result in lower competition.

 

New to investing? Watch for this factor before making your pick.

Return on invested capital(ROIC) is an important factor in ensuring a company remains dynamic by sustaining high-profit margins. ROIC is one of the primary measures used to assess a company’s efficiency in profitability and allocating capital. Higher profitability and/or lower-invested capital leads to higher ROIC. Since lower-invested capital is largely a function of industry and management abilities, investors should look for companies that continuously aim to reduce overall debt and shareholder equity.

A high ROIC is important as an investment criterion for another reason. It means the company is more likely to achieve sustainable long-term value creation. A company able to generate a high level of ROIC is viewed favourably by investors – and often trades at premium valuation. This is a great incentive for management teams. Higher stock prices improve managements compensation, as a major part of it is based on stock-based compensation.

 

How to compare performances of different companies using ROIC.

Since ROIC reveals generated returns, we can use the ROIC metric to compare how the company employs its capital, also known as weighted average cost of capital (WACC). If the cost of the capital (WACC) is greater than the ROIC (cost is higher than return), it means the company has been unable to generate any value for its owners. If this trend continues, the company is unlikely to be a good long-term investment. If ROIC is greater than WACC, the company is creating value,  as it is generating returns higher than its cost. This is why a high ROIC and a low WACC are highly sought after.

As mentioned, a high-ROIC company is likely to trade at a premium valuation. Keeping an eye on long-term trends and investing when stocks are out of favour and reasonably priced is another key way to achieve good long-term returns.

 

Conclusion

Warren Buffett famously said there are no called strikes in investing. In baseball, strikes occur when you swing and miss. In investments, it is important not to swing at every stock, but rather invest in companies with good long-term fundamentals. To find those investment opportunities, consider the foundational steps described above.

If you would like hear more about our investment process, or have questions about the information in this article, please contact us today at info@ciccone-mckay.com.

 

Appendix
ROIC Calculation: Net operating profit after tax (NOPAT)/capital invested
NOPAT = earnings before interest and tax (EBIT) *(1-Tax Rate)
Capital invested = total debt - cash + shareholders’ equity
Weighted average cost of capital (WACC) = (weight of equity x cost of equity) + (weight of debt x cost of debt).