Five Keys to Long-Term Profits

It's no secret that share price appreciation goes hand-in-hand with earnings growth.

If only it were that simple.

Screening for companies with the strongest outlooks will only get you so far.

You might know that Chinese search engine Baidu (Nasdaq: BIDU) is expected to deliver +40% compounded annual earnings growth during the next five years. But so do about 10 million other people that are watching the stock. That optimism is already priced into the shares, which trade for about 50 times forward earnings at this point.

That doesn't necessarily mean Baidu's meteoric ascent is over, but any future gains are hardly a slam dunk. The surest path is for the market to rethink (and revise upward) its growth assumptions, which in this case won't be easy.

The real winners spotted the company's potential back in 2006. They understood what surging Internet traffic, skyrocketing paid search revenues and a highly scaleable business model could do long before it actually played out. Then they held on tight as the shares went from $50 to $450.

My point here is that it's far more important to focus on the means than the end.

If the crash of 2008 taught us anything, it's that all those numbers on a firm's balance sheet and income statement can change with the financial weather. So I prefer to spend less time monitoring sales and profits and more time evaluating the underlying factors that influence them.

If for no other reason, they can give you a critical "heads-up" that changes (either positive or negative) are right around the corner.

  A flash-in-the-pan stock rally can come from anywhere. But virtually all long-term wealth creation stems from durable competitive advantages. Companies like Baidu have something that their rivals just can't emulate -- and that's why they've been so successful.

These advantages form economic moats that help businesses defend their territory from marauding competitors. The wider the moat, the longer a company can hold rivals at bay and continue generating outsized returns for shareholders. Warren Buffett won't even sniff at a company without a moat to protect its returns on capital.

One of the most basic rules of stock analysis is that it can be misleading to compare the profit margins of companies in different sectors. After all, a grocer pocketing 5% of every dollar in sales might be best-in-class, while a biotech firm with margins of 25% could be the group's laggard.

Most experts will tell you that it's best to compare grocers to other grocers and biotechs to other biotechs. And that may be true. But they're missing the bigger picture. Instead, ask yourself this: Why can some industries maintain profit margins five times greater than others?

The answer lies in the "Five Forces" diagram below, which was developed by Harvard Business Professor Michael Porter.

Let's briefly examine each of these forces:

• Competitive Rivalry: This refers to the competitive intensity of the industry itself. Obviously, concentrated industries with only a handful of players tend to be less competitive and more profitable than fragmented industries (like fast-food) where hundreds of players try to undercut each other.

• Barriers to Entry: Success always invites competition. But some industries are harder to crack into than others. It's usually best to look for industries with high barriers to entry that shut out would-be competitors. These barriers can take the form of anything from government regulation to capital requirements. Anyone can start an online retail business, but coming up with the billions needed to buy a fleet of cruise liners is a different story. This is why barriers to entry can be so valuable -- and why, as I tell my readers in this month's issue of Market Advisor, shares of companies like Stericycle (Nasdaq: SRCL) and Bally Technologies (NYSE: BYI) have exploded for more than +1,000% during the past 10 years.
   
• Threat of Substitutes: Products or services that are easily replaceable can't command top dollar -- customers will simply switch to option "B". Therefore, industries with no close substitutes are preferable. Computer makers, for example, can't get too far without semiconductors.
   
• Bargaining Power of Suppliers: The first three factors were horizontal, but the last two are vertical. If you are making bicycles, and there's only one tire supplier in your area, then you have no choice but to buy from them. They hold all the cards. But if there are a half dozen tire makers, you can negotiate a better deal -- particularly if you're the biggest purchaser on the block.
  
  
• Bargaining Power of Customers: In a monopoly, there are many buyers, but just one dominant seller. The flip-side is a "monopsony," where there are many sellers, but just one buyer (like specialized defense equipment sold to the government). In this case, it's the buyer that calls all the shots.

We've barely scratched the surface here -- but you get the idea: a company's profitability and stock are both governed by the competitive framework of its industry.

All of these forces interact to determine whether a specific industry is highly attractive to investors, or screams, "stay away!"

We see these forces at work all the time. Sometimes suppliers must cave to the demands of a powerful buyer like Wal-Mart (NYSE: WMT). Other times it's the buyers that must yield to the demands of the seller -- like when BHP Billiton (NYSE: BHP) dictates iron-ore prices to steelmakers.