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How to stock pick for long-term compound growth

Some valuable lessons from Warren Buffett and Morningstar.

There are many different opinions when it comes to investment styles, be it active vs passive or trading vs buy and hold. For many, a long-term strategy with a focus on quality wide-moat companies is viewed as a sure-fire way to succeed in compounding wealth.

The question is how can you identify these so-called high-quality companies and what attributes should you look for? Legendary investor Warren Buffett, as well as Morningstar, offer some valuable lessons:

  • Look for companies with sustainable competitive advantages or moats. Firms that can successfully fend off competitors and have a unique product/service offering.
  • Focus on long-term intrinsic value, not short-term earnings. What matters is how much cash a company can generate for its owners in the future and over time. Here it helps to ignore short-term news flow and focus on through-the-cycle potential for earnings delivery.
  • Demand a margin of safety. Future cash flows are, by their nature, uncertain. To compensate for this, always buy companies for less than their intrinsic value, thus at a reasonable valuation.
  • Be patient. Investing is about long-term success. This means that you need to be willing to hold on to these companies despite all the noise and market fluctuations. Something we have become accustomed to of late.

It’s important to understand the quality of the business you own. When you buy a stock, you own a piece of the underlying business. The best companies tend to find investment opportunities that you might not have thought about, or that you wouldn’t be able to pursue as an individual, increasing the intrinsic value of their business.

Buffett often refers to the term “economic moat”: a company’s ability to keep competitors at bay over time. Morningstar builds on this idea to rate companies based on their “moat,” or the strength and sustainability of their competitive edge.

Below I highlight two companies rated as having a wide moat by Morningstar with reasonable valuations, leaving an attractive upside to Bloomberg Average Analyst Target Prices. These companies have predictable cash flows so analysts can more accurately estimate how much the businesses are worth.

1. Honeywell (HON, current price USD192, Bloomberg Average Analyst Target Price USD220)

Honeywell is a software-industrial company that provides technology solutions. The company operates four segments: aerospace, building technologies, performance materials and technologies, and safety and productivity solutions. The aerospace segment supplies products, software and services for aircraft to original equipment manufacturers and other customers in various end markets.

Honeywell’s wide economic moat can be attributed to intangible assets and switching costs, and secondarily to cost advantage.

The key to Honeywell carving a wide moat is the firm’s increasing ability to leverage its software technology across its massive industrial installed base. This software technology is integrated into both mission-critical operations, such as cockpit control during commercial aircraft flights, and in customer operations, through diverse offerings like warehouse automation in factories or connected solutions in buildings.

2. Alphabet (GOOGL, current price USD2 553, Bloomberg Average Analyst Target Price USD3 472)

Alphabet is a holding company. The company’s segments include Google Services, Google Cloud and Other Bets. Google Services includes products and services such as ads, Android, Chrome, hardware, Google Maps, Google Play, Search, and YouTube. Google Cloud includes Google’s infrastructure and data analytics platforms, collaboration tools, and other services for enterprise customers. Its Google Workspace collaboration tools include applications like Gmail, Docs, Drive, Calendar and Meet. Its hardware products include Pixel phones, Chromecast with Google TV and the Google Nest Hub smart display.

Alphabet’s wide economic moat can be attributed to sustainable competitive advantages derived from the company’s intangible assets, as well as the network effect.

Alphabet holds significant intangible assets related to overall technological expertise in search algorithms and machine learning. Google’s brand is also a significant asset, as “Google it” has become eponymous with searching and the firm’s search engine is perceived as being the most advanced in the industry.

Alphabet’s network effects are derived mainly through its Google products such as search, Android, Maps, Gmail, YouTube, and more. The addition of each new ad and advertiser improves the efficiency of Google’s programmatic advertising offerings, allowing the firm to better monetise the network.

Remember that these shares should be viewed in the context of your holistic investment portfolio and that it is always advisable to consult with a certified financial planner before making any changes.

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Franske Neiteler

PSG Wealth Pretoria-East

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