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Wide Moat Stocks- Not As Many As You Think

Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Dell’s (NASDAQ: DELL) $24.4 billion dollar LBO puts the final nail in the coffin on one of the great stock stories of all time.  The company would go public in 1988 and could easily be classified as the stock of the decade during the 1990’s.  During that decade, the stock would appreciate at an annual rate of 97%!  However, the next decade would be a completely different story and the final takeout price of $13.65 per share is almost 75% below the all-time high.  Dell isn’t the only company to have this situation unfold, although few have witnessed such extremes during their boom and bust. 

Dell’s story is a good teaching tool to investors that can be blinded by the current financial performance and mistakenly extrapolate these results way too far into the future.  I think economic moats get thrown around too easily and often companies with great near-term performance lack a sufficient competitive advantage.  Dell’s success and demise hinged on a couple key features that in reality were not a long-term competitive advantage.  Below we will take a look at these temporary competitive advantages along with companies that may be in a similar situation.

Lesson 1: Be Leary of Results Leveraged Mostly to Cost Cuts

Dell’s initial success came via selling directly to consumers and being the low cost supplier by cutting out the retailer’s share.  Being the early adopter was a key to its success, but this concept would eventually be replicated.  Advantage lost.  The company was also great at controlling its supply chain and continually extracting cost savings to fuel operating leverage and robust earnings-per-share growth.  This too has its limits as it becomes harder and harder to wring out inefficiencies. 

This situation recently played itself out again with another technology bellwether- Hewlett-Packard (NYSE: HPQ).  Following the tech bubble, the company began in earnest to cut costs.  This was taken to another level when Mark Hurd took the reins in 2006.  As can be seen in the chart below, the stock price moved up as the company did an excellent job of raising operating margins via cost cutting.  But notice how quickly the stock price stopped in its tracks when margins ceased expanding.

<img src="http://media.ycharts.com/charts/6264d446032738fb00504f710298a90e.png" />

HPQ Operating Margin TTM data by YCharts

Cost cutting is great and can propel a stock to short-term outperformance, but it is not a long-term competitive advantage.  The competitive nature of business will limit the upside and sustainability of a company’s margins.  Ultimately, Hewlett-Packard was a victim of slowing sales as the industry struggled amid losing market share to portable devices and persistent product deflation.  Hewlett-Packard may offer up some near-term margin improvement or do some corporate actions such as a share buybacks or possibly even splitting up the company, but they are a company with limited competitive advantages.

Lesson 2:  Consumer Preferences are Always Changing

Dell has been victim of the steady collapse in PC usage that is detailed by Evan Niu at The Motley Fool.  Consumer preferences are always changing.  They can go from euphoria to despair regarding both individual brands as well entire industries.  Dell’s problems are a bit of both, but mostly a result of diminished demand for PCs relative to other portable electronic devices.  This demonstrates the misconception of their wide economic moat at the turn of the century.  Certainly it isn’t possible to foresee the future and innovation is always happening.  Still, a thorough analysis must be done to see potential risks from changing consumer preferences. 

Much of these risks lie in the consumer discretionary and technology sectors.  It doesn’t mean investors should ignore these areas; they just need to be extra diligent on their long-term expectations.    Buying stocks with a built in margin of safety is a must.  During the last decade Dell was a victim of collapsing valuations and weakening fundamentals.  When these two situations happen in unison it almost always leads to a permanent loss of capital. 

Yum! Brands (NYSE: YUM) just reported horrible 4Q12 results that highlight how fickle consumers can be.  The company derives more than 40% of sales from China, a region that is supposed to be filled with growth opportunities.  Instead the company reported that China same-store sales DECLINED 6% in the fourth quarter.  This was driven by weakening trends in the region combined with a negative media report regarding food safety.  Chinese consumers had both the option and the ease to immediately switch to a different restaurant.  This is not symbolic of a company with a wide economic moat. 

The chart below looks eerily similar to that of HPQ highlighted above.  Where do margins go from here?

<img src="http://media.ycharts.com/charts/2928b39833367ba7a5518aed2650fd9b.png" />

YUM Operating Margin TTM data by YCharts

The rise in margins has mainly been driven by growing the China division, which has higher margins than U.S. operations.  However, margins in China fell to 18.1% in 2012 versus 19.7% in 2011.  Same-store sales collapsed from +19% to just +4%.  Slowing growth, margins, and exposure to consumer preferences leaves YUM! Brands with no economic moat.  Most mature restaurant operators have margins in the 12-16% range, with McDonalds being an exception, so it seems hard to envision higher margins in the next couple of years.  Adding further headwinds to the stock is the relatively elevated valuation as measured by the EV/EBITDA. 

<img src="http://media.ycharts.com/charts/ae3cb05683a8444a18c057f46c12d809.png" />

YUM EV / EBITDA TTM data by YCharts

The Foolish Bottom Line

Investing in companies with wide economic moats and reasonable valuation is a prudent strategy, but make sure you are properly labeling a company’s long-term competitive position.  Companies highly levered to evolving consumer preferences or have short-term cost advantages should be scrutinized.  Several companies in the consumer discretionary and technology sectors are incorrectly assigned such prestigious designations only to fall out of favor seemingly overnight.  Hewlett-Packard and Yum! Brands are two companies, along with many others, that have been foolishly given economic moats.

market8 has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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