The markets continue to slide this week as year-over-year inflation numbers in the United States came in at a whopping 8.6% in May. This is the highest level of inflation we have witnessed since 1981, and it’s certainly a concern for the markets over the short to mid-term.
It makes sense that many members are now asking us what they should be looking for when it comes to investments during times like this. We felt it would be the perfect time to go over what we look for in a “core” or “foundational” holding within our portfolios, that is what this e-mail will focus on.
Before that, we’d like to remind members of an event we have going on tomorrow inside of the Discord
As a reminder, we have Mark Seed from My Own Advisor and Cash Flows & Portfolios joining us for our second Stocktrades Speaker Series in our Discord.
Thanks to all your question submissions, we have plenty to discuss. We will start by talking about how Mark started his investing journey, then transition to talking about portfolio strategy, and we will close with some direct questions for Mark. Members will be invited up on stage to ask questions once the formal part of the session is complete. While the session will be recorded, we encourage all of you to attend if possible.
The more people we have in the audience, the more quality guests like Mark and Erik (previously) we can attract. Let’s see if we can get more than the 60 we had for Erik last time!
If you’re looking to get into the Stocktrades Discord channel to participate in this among many other discussions, just click here to watch our tutorial video.
What we look for in our core holdings
As we’ve reiterated many times, our Foundational Stocks make up the majority of our portfolios. I (Dan) own 15 of the 21 total Foundational Stocks here at Stocktrades Premium.
There is a certain set of criteria that every potential investment should be put through. The criteria are called Porter’s Five Forces.
Porter’s Five Forces are 5 key elements that an investor can use to research the particular sector or industry that the company operates in to determine the potential for success of the business. As we go through these 5 forces, you’ll likely go through the majority of our Foundational Stocks and notice they tick off practically every box.
For this explanation, we’ll use a company like Telus and the Canadian telecom sector to highlight the Five Forces. However, feel free to run all of the Foundational Stocks, and even all of your investments, through this checklist and see how many of your holdings tick off all the boxes.
Competition
When we invest in a company, we are buying that company now in hopes of the delivery of cash flow in the future. The higher the level of competition, the higher the likelihood of the company losing that cash flow to competitors. This is the first portion of what we would call an economic moat.
When we look to a company like Telus, although there is “competition” in the form of the other Big 3 telecom companies in Rogers and Bell, it is highly unlikely Telus sees a material impact to its business due to competitors. The Big 3 control over 92% of the market share here in Canada, and even smaller companies like Koodo (Telus) and Fido (Rogers) are often subsidiaries of the major companies.
A company that can easily lose market share to competitors is one that will inherently have more risk.
Barriers to entry
The second force is technically called “Potential of new entrants into the industry”, but we feel barriers to entry is a better term. New entrants to the industry that can potentially steal market share from a company is something all investors need to be aware of.
Ultimately, barriers to entry boil down to money. If there is significant capital involved to capture market share in an industry, the more protected an established company in the industry is. This is the second portion of a company’s economic moat.
Using Telus as an example, you likely would not find an industry that has higher barriers to entry than the telecom sector. You could argue that Foundational Stock Canadian National Railway’s industry has higher barriers to entry, but it’s a close race in that regard.
The telecom sector requires billions of dollars of infrastructure to operate. The Big 3 telecoms primarily share towers. For a new player, it seems like an insurmountable task to develop the infrastructure and become profitable. We even witnessed this in 2013 as major US Telecom company Verizon decided to pull out of potential Canadian expansion.
Input costs
Technically called “power of suppliers”, input costs in an industry, especially considering the environment we’re currently in, should be a significant element of your research.
There are a few unique elements to input costs. For one, the popularity of the material. The more common the material, the less power the supplier has. This is because when there is a multitude of suppliers, it often keeps most of them honest.
However, when we have a unique material from a limited amount of suppliers, this is where things get tricky. Case in point: Pollard Banknote (TSE:PBL). The company was growing at a pretty rapid clip, but the company’s stock price cratered in early 2022 due to one primary culprit, input costs.
Pollard has a niche set of materials. Because it creates scratch-off tickets, there are only a particular set of suppliers that can get the company the goods it needs to make its tickets. Here is a direct quote from the company itself:
“The specific technical nature of our raw material inputs makes it more difficult to switch out to alternative inputs. Although the long-term nature of our instant ticket contracts is beneficial, these contracts do not allow for explicit price increases to recover higher costs.”
As a result, it is at the full mercy of these suppliers and as mentioned, the stock price cratered as a result.
Consumer power
Suppliers have the power to hit a company’s bottom line. But, don’t count out the consumer. In fact, without consumers, a company wouldn’t be able to generate any cash flow for investors.
The power of consumers is something we have to investigate when looking at an industry or company. The more power a consumer has, the more risk is present for the company.
Keep in mind, we’re not just talking about the ability of consumers to simply say “I’m not willing to pay this, so lower your prices”, but also a company’s concentration of clients. For example, a company with its top client making up 20% of revenue is at much higher risk than a company with its top client making up 0.5% of revenue.
When we look to Telus as an example, the company is strong in this regard. Not only does it have a wide customer base, to the point where losing a single customer is almost virtually a non-factor, but it also operates in an industry where consumers are willing to pay increasing prices to get services.
The threat of alternative products
The final force is the threat of alternative products. If consumers can find a cheaper or more efficient alternative, this can impact a company’s market share and cash flow. The threat of future innovation and product development can also be a critical element of this.
This one is relatively straightforward. If a company sells tablets, what is the likelihood of a company being able to develop a similar product that is cheaper and can provide the same use case to the consumer? Ultimately, brand power does play a significant role in this regard. For example, even if an off-brand tablet were to be able to function the same as an iPad, people may choose to pay more for the Apple product because of the brand.
In the case of Telus, the alternative products are often cheaper phone plans offered by smaller consumers and even the other Big 3 telecoms. However, as we’ve noticed throughout history, cheaper plans are often replicated by virtually all Big 3 companies and even their subsidiaries. This is likely the weakest point for Telus, but it’s still relatively strong in this area.
Overall, the stronger a company performs in these 5 situations, the more likely we are to consider it a core holding
Companies that tick off all of the boxes above are ones we would consider core holdings. And by that, we mean larger position sizes and added into a regular dollar cost averaging rotation.
These are companies that are likely to perform well regardless of the economic circumstances because of their ability to excel in the 5 situations above.
In saying “perform well”, we do not necessarily mean always returning positive results. This is something investors need to understand. If we see flat markets for a prolonged period, even the best companies tend to struggle. However, prolonged bear markets are nothing more than buying opportunities for the long-term investor as over the long haul, strong companies will outperform.
Just because a company doesn’t tick off all the boxes above, doesn’t mean it’s a poor investment
A company doesn’t need to be a rock star in all 5 forces to be considered a strong investment. However, if we find that a company may not have an advantage in 1 or more of these forces, we’d want to limit our position sizes as the investment is more speculative.
For example, this is exactly why I would be more than comfortable with a 4%+ position size in Telus in my portfolio, but with a high-flying growth company like Lightspeed, I like to maintain anywhere from a 1-2% position in the company.
This will be heavily dependent on things like the overall size of your portfolio, risk tolerance, investment time horizon, and more. It is hard to diversify as much when you have a smaller portfolio. However, fractional shares and commission-free trading have made it much easier to get a head start on building a rock-solid portfolio.
We hope this e-mail puts some strong pre-screening tools in your arsenal as you look to continue building out your investment portfolio. If you have any questions or comments, feel free to pop them in the Discord, or simply reply to this e-mail. We’d be happy to answer them.
