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High switching costs may not be good for customers but they are great for companies. High switching costs act as a deterrent to switching providers. It is more likely that a customer will stick with a particular brand or service if switching providers would cost a significant amount of money, time, and energy. This is exactly why cable companies and cell phone companies charge cancellation fees to customers. Businesses will often remain clients of device makers and document storage firms due to the high switching costs. Intellectual Property Patents, copyrights, and trademarks can guarantee a companys revenue stream for years into the future. Drug makers rely on patents to protect their creations and keep clients from selling similar products until expiration. Copyrights can help boost the revenue streams of movie studios, music labels, and book publishers. A trademark gives a company a way to distinguish itself from its competitors. Final Thoughts These are just a few of the types of economic moats that exist. A business model, unique product, and pricing structure can all be economic moats for a company. Be sure to distinguish companies with true economic moats from companies with fake economic moats. For example, a company like CVS may appear to have a wide economic moat because you recognize the name but truly it does not. There is nothing that differentiates a company like CVS from Walgreens, Rite Aid, or Albertsons. Picking the winner in the competitive drugstore industry can be like throwing darts at a dartboard. A lack of an economic moat is the reason that I sold Gamestop back in 2008. Ask yourself the following questions before investing. - Does this company have an economic moat? - Is the companys moat wide, narrow, or non existent? - What is this companys competitive advantage? - Is there a competitor that is rapidly taking market share from the company? - Can this competitive advantage sustain the company over the next 10 to 20 years?
investment opportunity but I would rather not take the chance. Its easier to just invest in businesses that you understand.
few years. If you can find these companies early, you will be smiling all the way to the bank. Would you ever invest in a company with negative earnings?
2. Invest in companies with an honest, accountable management team. You want company management to tell you the truth when they have a bad quarter. I like executives that admit that they just plain blew it last quarter and will focus on improving results next quarter. Watch out for CEOs that make a bunch of excuses and blame things like cyclical trends or the weather for their porous results. Companies with accounting scandals who fudge their numbers are a no-no. 3. Invest in companies with CEOs whose pay matches their performance. CEO pay has been a hot topic over the past two years. Corporate executives have been in the crosshairs due to their lofty salaries. I have no issue with company management teams making millions of dollars annually as long as their performance merits it. CEOs like Reed Hastings of Netflix (NFLX) and Jeff Bezos of Amazon (AMZN) have done a great job of growing their companys market share and deserve every dime that they have coming to them. Avoid management teams that are just about bankrupting the company with extremely high salaries despite the poor performance of the stock. There are too many CEOs that treat the companys bank account as if it were their own piggybank. 4. Invest in companies that outperform their competitors. Stats do matter when investing. Find companies whose management metrics are better than their peers. A good place to start is by looking at ROE and ROA. Return on equity (ROE) measures the rate of return on capital provided by shareholders. Basically it demonstrates how effectively company management is using your money. Return on assets (ROA) is another useful metric because it judges how efficiently a company is managing its assets. Other useful statistics are return on investment (ROI) and return on invested capital (ROIC). What CEOs do you think have done a great job of managing their companies?
A high debt to equity ratio illustrates that a company is relying heavily on debt to finance growth. Companies with high debt to equity ratios are more likely to fall prey to financial difficulties and bankruptcy. That is because they may find it difficult to service their debt load during economic slowdowns.
Follow Buffetts lead Look for companies that have a debt to equity ratio below 0.50. Buffett is even more conservative preferring to invest in companies that have a debt to equity ratio that is below 0.30. Buffett likes to see companies that can grow earning using equity and not large amounts of debt. Its important to note that some industries require using debt to finance expansion because they are very capital intensive. In these situations look for companies whose debt ratios are lower than competitors. You have to be careful about investing in companies whose debt to equity ratio is much higher than industry peers.
Look for companies with low Price to Earnings ratios, low Price to Book Value ratios, and a low Price to Sales number.
Mark Riddix is the founder of Buylikebuffett.com and MarkRiddix.com. He has also published the book, Your Financial Playbook. Visit us on the web at http://buylikebuffett.com. If you would like to sign up for my monthly stock picks newsletter and private investor forum, you can by registering online here.