Tuesday, November 10, 2009

Newsletter Part 2

Greetings. This letter is a follow-up to the last in which I wrote about talented investment managers searching for great companies to grow your money. Let me start by emphasizing that investing is not just about buying stocks. Fixed income investments—high- interest savings accounts, bonds, high yield debt and so on—have an important role in a portfolio. For the moment, though, I’m looking at stock selection. A later newsletter will look at fixed income investing.

But back to my last newsletter where I wrote--

As an investor you want to own the best companies that will grow their stock price over time because they are better at what they do than their competitors. Better companies do well, regardless of broader economic conditions, because they take existing business away from other companies.

So the best companies do two things: build a better mouse-trap and take business away from the other mouse-trap builders. Let’s illustrate this by looking at the example of Ryanair, an investment choice of Geoff MacDonald of Edgepoint Wealth. Anyone who has travelled in Europe has likely heard of the discount airline called Ryanair. You may have even flown with Ryanair and, perhaps, not been thrilled with their service. But you will likely fly with them again because their tickets are 50% or less than the competition and, for many flyers, price matters most. What you may not know is that Ryanair has grown its market share from zero to become the largest airline company operating in Europe in just ten years. They were able to do this because they created a competitive advantage through innovation.

What were these innovations?

1. Sell airline tickets over the internet. This allows for software in the background to provide very sensitive price monitoring and changes moment by moment. For example, you may start filling an empty plane by offering tickets for a few dollars. As soon as the amazing price attracts buyers, you start putting prices up. The software manages the ebb and flow of ticket demand and pricing until you fill the plane, all the while ensuring that you fly at a profit.

2. Fly to alternative airports. Traditionally, every airline wanted to fly into a city’s major airport. That’s where the services were and the fancy airports. The problem is that airlines pay huge fees to the major airport. Ryanair decided to break this monopoly by flying to smaller airports near the major cities, and in Europe there is lots of choice. Just think of all the airport options around London, England. Ryanair enjoyed massive savings by taking advantage of this opportunity.

3. Buy planes cheaply. How do you do this? Ryanair noticed that Boeing and other plane manufacturers operate a cyclical business, meaning that the cost of a new plane varies widely over the course of an economic cycle. In a recession when fewer people are flying, traditional airlines stop buying planes. As a result, a Boeing is desperate for orders of new planes. At those times, Ryanair puts in an order for 5 planes a year for the next 5 years. They are able, this way, to buy planes at a 50% discount which amounts to a saving of many millions of dollars.

I don’t know about you, but I find this stuff pretty neat. But coming back to my point about great companies, Ryanair takes business away from its competitors through discount ticket prices. And this allows them, very simply, to identify a route in high demand—say London to Paris—fly their plane, and steal customers from the other airlines because Ryanair’s ticket is half the price. Over the last ten years, they have been busy filling planes in good economic times and bad: there may be fewer people flying in the recession, but all the more reason to fly cheaply.

The other aspect of successfully investing in great companies is to buy the stock when it’s cheap. An investment manager can do this two ways: [1] identify a great company and its potential before this potential is widely known; [2] buy the company’s stock when it is out of favour or being ignored and its price drops. Geoff MacDonald bought Ryanair during this recent recession when investors sold off shares in airline companies believing that fewer passengers meant airlines would not survive. MacDonald, convinced of the competitive advantage of Ryanair, bought the stock during the sell-off. He and his investors have done very well with Ryanair stock over the last few months.

How long will MacDonald hold on to Ryanair stock? He will sell it off when he’s made a lot of money on it and when he has identified another company that represents a better opportunity for growth than Ryanair.

My goal is to identify investment managers with the ability and dedication to buy great companies. We look to them to grow our money and history shows that the best managers are able to do this for us over time, regardless of economic conditions. Yes, stock investing will have its ups and downs, but over the long term our patience should be rewarded.

Bye for now,

Tom

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