Posts Tagged ‘Wide Moat’


I read widely about investing and the strategy I am most drawn to is Value Investing. To me, value strategies make the most sense because they encapsulate a fundamental principle of investment: buy bargains. Of course, the label value investing encompasses a wide array of different investing strategies. I find many of these strategies attractive, however I feel that some can be applied by individual Do-It-Yourself (DIY) investors while others are best left to professionals. In this post I describe a Value Investing Hierarchy where I organize value investing techniques into 4 categories, ordered by ease of implementation for a DIY investor.


Category 1:  Quantitative Value Strategies

There are numerous quantitative value investment strategies that focus on ordering a predefined index based on a group of financial attributes and then selecting the cheapest subset in that index for investment. Usually the prescription is to rebalance annually by reapplying the strategy to the index each year. For example, the Dogs of the DOW strategy, which I have written about considerably on this blog, fits into this category. Another famous quantitative strategy is the Magic Formula invented by Joel Greenblatt and made famous in his book The Little Book that Beats the Market.  According to Morningstar, the strategy returned 19.9% from the beginning of 1998 to September 30th 2009 which compares very favourably to the S&P 500’s return of 9.4%, see here.  The Magic Formula ranks companies in a given index based on two factors: return on capital (a quality measure) and earnings yield (a value measure), then selects a subset of the highest ranking companies for purchase. For step by step instructions on implementing the strategy see here.

I include these strategies in Category 1 of my hierarchy because they can be implemented by a DIY investor relatively easily. Simple calculations using freely available financial data are all that is required. Importantly, they do not require intensive research or particular insight into the operation of a business or the quality of management. To make it even easier, many of these strategies are freely available on the internet with the annual rebalanced list calculated and published for you each year. The Dogs of the Dow for any given year can be obtained here, and the Magic Formula list can be obtained here.


Category 2: Quality at a Fair Price

Buying quality companies at a fair price is a value strategy famously employed by Warren Buffet. His value metric is a high return on invested capital (ROIC) over long operating histories. Buffet describes companies that achieve this level of performance as possessing a wide moat and buys them when he estimates they are trading at a discount. Implementing this strategy is more difficult for a DIY investor to execute because it involves an intimate understanding of the business as well as an assessment of a company’s management. Not impossible, but it does require more work. Buffet suggests staying within a circle of competence and developing an intimate understanding of the companies within that circle. Buffet’s circle contains many well understood businesses for which information is easily obtainable. For example, the Coca-Cola Company is the largest holding in Berkshire Hathaway’s portfolio and the most widely recognized brand name in the world.

The other important facet of this strategy is assessing a company’s management. This is the more difficult part since unlike Buffett, a typical DIYer doesn’t have access to the management of publicly traded companies. However, you could decide to supplant an assessment of management by using as a proxy the quality of the fund managers that invest in these companies. For example, if you believe that Warren Buffet is good at assessing management you could restrict your circle of competence to the companies Warren Buffet invests in. GuruFocus tracks the investments of Buffet and a number of other investment gurus and the data is updated quarterly. Oftentimes you can purchase the securities they’ve purchased at a discount to the price they paid. Of course, you would also have to wait an entire quarter to find out if they’ve sold a company.

An advantage of assessing management by proxy is that gurus such as Buffet are much more accessible than the managers of the companies they invest in.  Indeed, there is a tome of writing about Buffet and his investing style, not to mention that Buffett publishes his thoughts himself in his annual investment letter which is available here and contains invaluable insight. However, if Buffett’s circle of competence is deemed too restrictive, there are other gurus who have built impressive long term track records employing a similar style. Donald Yachtman and Prem Watsa (for Canadians) are two managers who have very similar strategies and have achieved above average returns.

Another option for assessing management is to pay for it.  For example, as part of its paid subscriber service, Morningstar publishes an assessment of management for many of the wide moat companies that the gurus tracked by GuruFocus invest in. The service is relatively inexpensive at $15-$20 per month and the analyses are updated regularly. In my opinion, these analyst reports and specifically the assessment of management can provide a DIY investor with enough information to draw reasonable conclusions.


Category 3: Deep Value Investing

This category encapsulates a set of strategies that attempt to buy stocks at deep discounts to intrinsic value. The strategy employed by Ben Graham, the father of value investing, would fall into this category. Similar in some respects to Category 1, the strategies in Category 3 focus on quantitative analysis of a company’s financials. For example, Ben Graham had a very stringent set of requirements that a company had to meet before he would consider investing:


Figure 1: Benjamin Graham’s Criteria for the Defensive Investor
P/E Ratio less than 15.
P/Book Ratio less than 1.5.
Book Value over 0.
Current Ratio over 2.
Earnings growth of 33% over 10 years.
Uninterrupted dividends over 20 years.
Some earnings in each of the past 10 years.
Annual revenue of more than $100 Million (1950).

Source: The Intelligent Investor, 4th Revised Edition (pages 184-185).


I found this table at the StingyInvestor site, see here. In contrast to the strategy in Category 1, this technique does not sort stocks from within an index, and thus, there may be periods when no stocks pass the stringent requirements. Norm Rothery, the founder of the StingyInvestor publishes a relaxed version of the Ben Graham screen that returned 26% annually from 2000-2008, see here.

Deep value strategies rely heavily on quantitative analysis and unlike the strategies of Category 2, are not typically concerned with the quality of a company or an assessment of management.  Although this should make it easy for a DIYer, I rank deep value strategies on the third rung of my hierarchy because the stocks selected are often unfamiliar small cap companies that could be thinly traded. An investor would have to be sophisticated enough to take on this illiquidity risk. However, although this is the prevailing wisdom regarding illiquid stocks, I have to add that the concern over illiquidity may be unwarranted. Roger Ibbotson has published research showing that small cap, low liquidity stocks do very well over time returning 17.87% from 1972-2009 (see here). Filtering low liquidity stocks on value parameters does even better, returning 20.63% over the same time period.


Category 4: Distressed Debt

I categorize strategies that focus on distressed debt on the lowest rung of my hierarchy. I debated whether to include it here; however I am attracted to it as one of the purest forms of value investing. It requires the ability to examine a debt instrument that is selling at an 80% discount to face value and determining that it is actually worth 60%. I believe that this is a particularly inefficient segment of the market because distress situations involve sellers who are motivated to sell at deep discounts, giving well informed buyers an advantage. Seth Klarman, one of my favourite gurus, is famous for investing successfully in distress debt situations. One of his most famous investments was the purchase of Enron bonds when they were selling at 10-15 cents on the dollar.  The bonds are currently believed to be worth more than 50 cents on the dollar. Klarman describes this as his favourite type of investment since the situation was complex, difficult to analyze and no one wanted anything to do with Enron. This resulted in a mispricing of the debt and Klarman employed an analyst to focus on the bonds for 4 years in an attempt to understand Enron’s liabilities. You can read a good summary of his approach here.


While the distress debt investment that Klarman is famous for is best left to professionals, there are other distress debt situations that are available to DIY investors. For example, I would classify purchasing real estate under Power of Sale in this category. This kind of investing isn’t as simple as buying and selling equities on an exchange but can be profitable assuming there is an actual mispricing of the asset and the DIYer is clever enough to find it.

Here is a summary of my value investing hierarchy:




This is my attempt to organize the various value strategies I’ve come across and is not meant to be conclusive or comprehensive. Further, while the gurus mentioned in this article are often associated with the strategies I`ve assigned to them, they do not necessarily restrict themselves to that strategy exclusively.  For example, Joel Greenblatt is also a famous distress debt investor and Warren Buffett made his first fortune in investing by using Graham’s deep value strategy. The unifying theme however is that they always buy bargains.




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Why the BTSX won’t go to the Dogs

In my last post I noted that there are fundamental differences between the TSX 60 and the DOW 30 which I believe make comparisons of the Dogs of the DOW and the Beating the TSX portfolio difficult. Specifically, I do not believe the performance of the Dogs of the DOW is a proxy for the Beating the TSX index. The reason lies within the components of the indexes: the DOW contains many companies that have a wide moat around their business compared to the TSX 60 where companies with wide economic moats are concentrated in particular sectors. Selecting for the highest dividends results in a BTSX portfolio that is concentrated in wide moat stocks, making it a fundamentally different group of companies than the original TSX 60 whereas this concentrating effect is absent for the Dogs of the DOW.

To illustrate this effect, let’s first take a look at the sector composition of the TSX 60 (data from Morningstar):

Of note, the Industrial Materials sector makes up 25%  of the TSX 60. With the exception of a few companies like SNC Lavalin and Bombardier, the companies in this sector are miners. The profitability of these companies is closely tied to the commodities that they supply and in general they are not stable, free cash flow generators. Additionally, the qualities that create an economic moat such as brand loyalty, networking effect or switching cost are generally not applicable to commodity producers.  Furthermore they tend to be low dividend payers and are rarely selected for by the BTSX approach.

However, the TSX 60 also contains 10 companies from the financial services sector of which 6 are banks. Unlike  miners, Canadian banks have wide economic moats due to the oligopolistic nature of the industry in Canada.  Similarly, the pipeline companies TransCanada and Enbridge have wide economic moats. Once a pipeline has been built, competition is very difficult because the existing pipeline becomes the most economical means of transporting oil and gas and the regulatory approval to build a competing pipeline for the same route is hard to obtain. Both TransCanada and Enbridge operate the kind of expansive network of pipelines that will provide the long term stable cash flows associated with wide moat companies.

Now let’s consider the companies that constitute the Beating the TSX. Here is a chart of the companies in the BTSX from 2006-2009:

2006 2007 2008 2009
BCE Great-West Lifeco Shaw Comm. Manulife  Financial
Great-West Lifeco Enbridge Power Corp. BCE
TransCanada BCE BCE Power Corp.
Enbridge TransCanada TELUS Sun Life Financial
Bank of Nova Scotia Bank of Nova Scotia Bank of Nova Soctia TransCanada
Royal Bank Royal Bank TransCanada Bank of Nova Scotia
National Bank National Bank Bank of Montreal Bank of Montreal
Bank of Montreal Bank of Montreal Royal Bank National Bank
Teck Resources TD Bank National Bank TD Bank
Number of Bank or Pipeline Companies in BTSX
2006 2007 2008 2009
7 of 10 (70%) 8 of 10 (80%) 7 of 11 (64%) 6 of 10 (60%)

Notably, banking and pipeline companies consistently make up a large proportion of the companies on the BTSX, despite making up only 13% (6 banks and 2 pipeline companies) of the TSX 60.

Now let’s consider the DOW 30. Here is a breakdown of the stocks by sector:

There are a couple of things to note: the industrial materials sector makes up the largest sector in both indexes, but in the TSX 60 most of the companies are miners and 8 of the 15 are gold miners. The industrial materials sector on the DOW is comprised of diversified manufacturers; household names such as GE, Boeing, Caterpillar and 3M. Energy is a much smaller component of the DOW making up only 6.67%  (2 companies: Exxon and Chevron) as opposed to the TSX 60 where energy makes up 21.67% (13 companies). On the other hand, healthcare makes up 10% of the DOW (3 companies: Johnson and Johnson, Pfizer and Merck) while it makes up less than 2% on the TSX 60 (1 company: Biovail). Furthermore, if we look at the consumer goods and consumer services sector, the companies on the DOW are well known global brands (Procter & Gamble, Coke-Cola, Pepsi) which are very different businesses than the consumer sector on the TSX which is mostly made up of retailers that service the Canadian market (Loblaws, George Weston, Canadian Tire, Tim Horton’s). In short, the DOW Jones industrial average is comprised of a number of companies from a range of sectors that have built distinctive competitive advantages and wide economic moats. Companies on the TSX in general have far fewer of these advantages.

In The Five Rules for Successful Stock Investing Pat Dorsey lists the companies that Morningstar considers to have a wide moat and 14 of these are members of the DOW. So, according to Dorsey 47% (14 of 30) of companies on the DOW have wide moats. However, turning our attention to the 2010 Dogs of the DOW we find only 3 wide moat companies from that list: Home Depot, Merck and Pfizer. Repeating the exercise for the 2009 Dogs yields only 2 wide moat companies: Merck and Pfizer. This suggests that investing in the DOW in general would result in a higher percentage of wide moat companies than the Dogs of the DOW since sorting on dividend yield does not correlate with selecting wide moats in the case of the DOW.   This could explain why the Dogs of the Dow has underperformed relative to the DOW over the last 15 years.

In direct contrast, if we accept the argument that the wide moat companies on the TSX are the pipelines and the banks, then the BTSX does in fact single out the wide moat companies and essentially concentrates them into one index.  In my opinion this is a key differentiator and the underlying reason why the BTSX should continue to outperform the TSX 60 over the long term unlike the Dogs.

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In the last post, I took a look at 3 companies in the healthcare industry to determine if they are the kind of business I would consider investing in. All three passed my initial screen, suggesting that they have wide moats and should continue to increase cash flow and generate high returns on equity into the future. This week I will use a discounted cash flow (DCF) analysis to determine a fair price for these businesses.

A DCF analysis requires the following 4 parameters:

Free Cash Flow (FCF) Growth Rate: an estimate of the rate at which free cash flow will grow over the next 5 years

Discount Rate:  the rate used to discount future cash flows

Long Run Growth Rate: the rate at which cash flows are expected to grow in the very long-term

Margin of Safety: rate at which the projected fair value is discounted

For a more detailed description of the DCF process refer to The Five Rules for Successful Stock Investing.

Given the difficulty of forecasting and the inherent error that forecasts are subject to, a DCF analysis is really only useful for firms that operate a stable business where there can be some confidence that past performance will be an indication of future results. This explains why Warren Buffet applies it to wide moat companies with a long operating history. As discussed in the previous article, BDX, JNJ and SYK have impressive operating histories and pass Dorsey’s tests for ROE, and FCF/Sales indicating that these businesses have wide defensible moats.

Let’s start with the FCF growth rate, I will use the 5 year consensus analysis earnings forecast published on msnmoney for my calculation:

5 year projected earnings growth rate as of (13/2/2010)

Symbol 5 year growth rate
BDX 11.40%
JNJ 7.60%
SYK 11.70%

When considering the discount rate, Dorsey typically assigns a discount rate of 9% for stable companies that represent very low risk, 10.5% for an average company and 13-15% for riskier firms. I have assigned a discount rate of 9% for JNJ and BDX to reflect the stable, non-cyclical nature of their business and 9.5% to Stryker to account for the fact that this business specializes in devices and instruments associated with more elective surgeries and therefore may be more influenced by the business cycle. All the companies have been assigned a low discount rate to reflect the stable nature of their businesses and their past history of consistent returns.

With respect to the long run growth rate, I will use a value of 3%. Dorsey uses this value since it mirrors the long run US GDP growth rate. I considered using a value of 4% to reflect my belief that developed world demographics and the developing world’s desire to increase healthcare expenditures means that the healthcare sector will outperform other sectors of the economy over the long-term. I will provide DCF analysis using both values.

Finally, I will use a margin of safety rate of 30% to discount my fair value. According to Dorsey, Morningstar uses a margin of safety of 20% for stable companies, and 30-40% for less stable companies with inconsistent earnings history or which operate within a cyclical industry. It would be reasonable to use a 20% discount rate for these companies given their previously mentioned characteristics, however I have chosen to use 30% to offset the fact that I am using analyst consensus growth estimates which tend to be overly optimistic. Below, the parameters necessary for a DCF calculation are summarized:

Discount Rate 9.00% 9.00% 9.50%
FCF Annual Increase 11.40% 7.60% 11.70%
Perpetuity Growth Rate 3.00%/4.00% 3.00%/4.00% 3.00%/4.00%
Current FCF 1125.70 12636.00 1204.20
Next Year FCF 1254.03 13596.34 1345.09
Shares Outstanding 246.00 2754.34 396.40
Margin of Safety 30% 30% 30%

Table 4 illustrates the 10 year FCF growth forecasts for the DCF analysis. I use a 5 year forecast to calculate the perpetuity values, rather than the 10 year forecast used in The Five Rules for Successful Stock Investing. Ultimately, this should render a more conservative estimate.   The results are as follows:

5 year FCF Forecast $1,733.66 $18,163.94 $2,093.94
Perpetuity Value 3% $29,761.13 $311,814.35 $33,180.91
Perpetuity Value 4% $36,060.09 $379,083 $39,594.50
Discounted 3% $19,342.69 $202,657.93 $21,077.44
Discounter 4% $23,436.58 $246,377.90 $25,151.50
Total Equity Value 3% $24,738.91 $263,323.29 $27,471.21
Total Equity Value 4% $28,832.80 $307,164.80 $31,545.30
Per share value 3% $100.56 $95.60 $69.30
Per share value 4% $117.21 $111.52 $79.58
Margin of Safety Price 3% $70.40 $66.92 $48.51
Margin of Safety Price 4% $82.04 $78.06 $55.71

Changing the Perpetuity Growth Rate by 1% has a significant effect on the Margin of Safety Price  Only JNJ is currently trading below its margin of safety price calculated with a 3% Perpetuity Growth Rate, however all 3 companies are currently trading below their Margin of Safety Price calculated at a 4% Perpetuity Growth Rate.  Not surprisingly, the performance of these companies has not gone unnoticed by a famous investor who also likes to concentrate on cash flow and ROE.  Warren Buffet has been a long time holder of JNJ with recent purchases between $50.47 – $56.60 and has also recently taken a position in BDX purchasing it between $60.88 – 70.94 (see GuruFocus).

Full disclosure – long JNJ, SYK.

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Previously I took a look at the Canadian Telco and cable sector to determine whether the largest operators in that space met my requirements for investment. My analysis pointed to an inconsistent 10 year record that precludes investment for now.

This week I will take a look at the healthcare space by analyzing 3 of my favourite companies: Becton Dickinson and Company (BDX), Johnson & Johnson (JNJ), and Stryker (SYK). BDX is the world’s largest manufacturer and supplier of needles and syringes. JNJ is a giant in the health care space with diverse operations ranging from pharmaceuticals, medical devices and consumer staples. SYK is a manufacturer of devices and equipment for orthopaedic surgeries.

Table 1 and 2 illustrate the 10 year history of free cash flow and return on equity for all 3 companies. Applying Dorsey’s screen of a consistent 10 year history of FCF/Sales ratio of 5% or better and ROE above 15% illustrates the quality of these companies.

FCF/Sales Ratio and ROE

Symbol 5 year FCF/Sales average 10 year FCF/Sales


5 year ROE average 10 year ROE average
BDX 8.96% 11.79% 23.19% 21.46%
JNJ 19.94% 19.38% 28.17% 28.08%
SYK 14.32% 12.99% 20.73% 23.14%

These numbers handily exceed Dorsey’s requirements. Table 2 shows the financial leverage employed. The current leverage ratio for JNJ and SYK is 1.82, 1.31 respectively, both well below the 3 to 4 range that Dorsey considers a red flag. BDX has maintained a higher level of financial leverage (currently 3.6) which is a concern, however the non-cyclical nature of their business should ensure debt obligations are met.  BDX has a credit rating of AA- from S&P.

Lastly, let’s take a look at dividend history. Table 3 illustrates the 10 year dividend history of the companies. All 3 have a perfect record of increasing dividends yearly.  Indeed, JNJ and BDX are dividend aristocrats with a record of 46 and 36 consecutive years of dividend increases respectively. The payout ratio has remained in a steady range for all companies with JNJ the most generous, returning an average of 40% of its earnings to shareholders. Lastly, dividends have been increasing at a healthy rate for all companies with SYK specifically posting a very healthy 5 year increase rate of 49%.  As well, given that the company has close to 3 billion dollars in cash, it seems reasonable to expect further large dividend increases in the future.

The above analysis suggests that all 3 companies have wide economic moats that should protect their businesses long into the future. To paraphrase Buffett, these are great companies, the next question is, are they trading at a fair price? Next time I will try to answer that question by using the discounted cash flow method outlined by Dorsey in The Five Rules for Successful Stock Investing.

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When searching for great companies I want to find a company with a history of strong free cash flow generation, high return on equity and a history of consistent and growing dividend payments.   My philosophy is based on ideas taken from The Five Rules for Successful Stock Investing by Pat Dorsey, Director of Stock Analysis at Morningstar (see about me).

In this post I am going to examine the Canadian Telco and Cable sector by analyzing the quality of 4 of the largest companies in the space: Bell, TELUS, Rogers and Shaw. Phone, cable, and internet services are considered staples in most households and as such, should provide stable cash flows to companies providing those services. Additionally, the sector is dominated by large, well established firms and so it would be reasonable to believe that it is a good place to find companies with good return on equity and a history of consistent dividend payment.

Let’s begin with a look at free cash flow (FCF). Specifically, I’m looking for a consistent FCF to sales ratio of over 5% and an ability to maintain that ratio for 10 years or more.  This is indicative of a strong economic moat according to Dorsey.  Table 1 gives the 10 year history of free cash flow and illustrates that all four companies were unable to consistently produce positive free cash flow over this period.  FCF was negative at the turn of the century (2000-2002) due mainly to large capital expenditures incurred while building out high speed internet and cell phone networks. Indeed, large capital spending is an ongoing consideration in this sector given the necessity of maintaining up-to-date data delivery systems on an ongoing basis. The cost of doing this is prohibitive and acts as a major barrier to entry for new competitors, however it also makes consistent generation of free cash flow a challenge. None of the companies have been able to maintain a consistent FCF to sales ratio of over 5% for the last 10 years.  Failure to achieve this key indicator implies the companies being analyzed are less likely to have maintainable competitive advantages.  The returns of the last 5 years however, paint a more promising picture as all companies except Rogers have posted FCF/Sales ratios well above 5% (Rogers has a very good 4 year record but in 2005 only managed a FCF/Sales ratio of -1.69%). Shaw,in particular devotes a section of their annual report to a discussion of their focus on free cash flow generation, which is certainly an encouraging sign. Unfortunately, it is difficult to assume that the 5 year record is an indicator of future performance given the rapid pace of technological change in this industry.  At this point in the analysis, strict adherence to Dorsey’s method would suggest looking elsewhere for safer wide moat companies to invest in. Depending on your appetite for risk however, you may decide that the recent 5 year record will more accurately represent the future performance of these companies.   If this is the case, I would suggest that at the very least a greater margin of safety should be demanded when determining an appropriate purchase price given the uncertainty illustrated by the 10 year record.

A second key indicator is the ability of a company to generate a return on shareholder equity (ROE). According to Dorsey, a good indication of a defensible economic moat is maintenance of an ROE greater than 15% for 10 years or more.   Further, the quality of ROE should be evaluated with respect to the amount of financial leverage used.  In this regard, Dorsey considers any company with financial leverage of 3 or 4 as a red flag.  Table 2 displays the 10 year history of ROE as well as the financial leverage for each company over the same period. Again the 10 year and 5 year pictures tell two different stories. None of the companies have maintained an ROE of greater than 15% for the 10 years, although once again, the 5 year picture is improving. The question becomes whether the 5 year picture represents the future or whether some new event will occur (technological change, new regulatory environment etc) that returns these companies to negative returns on equity. The financial leverage for Bell, TELUS, Rogers and Shaw is 2.7, 2.6, 3.4, and 3.6 respectively.  The degree of leverage for both Rogers and Shaw represents a red flag according to principles set out by Dorsey. While it may be that the stability of the cable business justifies a higher leverage I would again consider a higher margin of safety when determining a purchase price to account for this uncertainty.

Although not a key Dorsey indicator, a record of growing dividend payments is something I look for in a company (see about me).  The record of dividend payment for these companies does not reflect the stable operating cash flow characteristic of the business. In fact, dividend payment is a relatively recent development for Rogers (paid regular dividend since 2003) and Shaw (paid regular dividend since 1998). TELUS cut its dividend in 2002 and did not raise it again until 2005 while Bell cut its dividend in 2000 and again in 2008. Table 3 illustrates the dividend record by giving the 10 year history of dividend payment, dividend increase and payout ratio. The current dividend yields for these companies appear attractive, however the seemingly inconsistent nature of free cash flow and the weak history of maintaining dividend payments make me skeptical of relying on their long-term dividend growth.

Dividend Share Price Yield
Shaw $0.79 $20.81 3.80%
Telus $1.90 $34.32 5.54%
Rogers $1.08 $31.37 3.44%
BCE $1.73 $27.84 6.21%

Note all data is as of 10/1/2010

In conclusion, despite the perception that the Canadian telco/cable sector contains solid companies with stable economic moats, my analysis suggests a number of caveats to consider before making an investment. Namely the requirement to take on large capital expenditures in the face of technological change jeopardizes free cash flow, return on equity and dividend payment. Given this point of view, I would require a significant margin of safety before being comfortable making an investment. In a future post I will take a closer look at the earnings of these companies and give my opinion on their future prospects.

Disclosure – no positions currently held in these companies.

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