Unfortunately, the world is filled with deceptive stock “tips” that are designed to rip you off. It shouldn’t be this way, as those providing investment advice should do so with your best interests in mind, not theirs. With that in mind, I’d like to offer you some advice — some stock tips, so to speak — that should prove to be much more valuable than any tip you’ll hear at that party this weekend.
Stock tip No. 1: Competitive advantages matter
A competitive advantage is a company’s edge over its peers that gives it the ability to generate premium returns for its investors. Warren Buffett has famously termed this advantage as a company’s “moat,” which can be anything from patent protection to its visionary leadership. The stock tip here is to find a company that has a competitive advantage that can endure through all business cycles.
National-Oilwell Varco, Inc. (NYSE:NOV) is one good example. CEO Pete Miller has summed up his company’s moat by saying, “No well is drilled, nor any drilling rig exists, without some equipment on it from National Oilwell Varco.” The company can boast of this advantage because it’s captured 60% of the market share in its industry. While the company’s business is affected by the volatility of oil prices, it’s a business built to last the test of time, as evidenced by the fact that it’s been in business for more than 170 years.
Stock tip No. 2: Smart capital allocation is imperative
If there’s one thing companies know how to do, it’s spend shareholder money. Unfortunately, not all spend it wisely, and all too often companies expend to grow in an effort to build an empire. That usually doesn’t turn out too well.
On the other hand, companies that grow with shareholders in mind typically produce phenomenal returns over the long term. Take Exxon Mobil Corporation (NYSE:XOM), which, while it’s taken a lot of flak for not being able to grow its oil and gas production in real terms, has grown each share’s interest in its production volumes by 5% annually over the past five years:
Its nearest competitor, Chevron Corporation (NYSE:CVX), has grown production per share by only 2% annually. The key is that when Exxon invests capital, its average return on that invested capital over that same period was just under 25%, while Chevron’s return on capital employed averaged in the high teens. This advantage helped Exxon Mobil Corporation (NYSE:XOM) make stronger returns, which then allowed it to plow more cash back into share repurchases and therefore increased production per share by a greater amount. That philosophy has built an empire that’s not likely to crumble anytime soon.
Stock tip No. 3: Beware of debt
As I mentioned, some management teams are too focused on building their empire. Doing so can have disastrous effects, one recent example being Chesapeake Energy Corporation (NYSE:CHK). The problem here is that the company used debt to fund its ambitious growth plan, and when the natural gas bubble burst, Chesapeake was left scrambling to dig itself out of that hole. Now the company has been forced to sell assets at less than ideal prices to meet its multibillion-dollar funding gap. Even as natural gas prices have risen, the company is still struggling to make ends meet, and a lot of investors have been burned in the process. That’s why I can’t stress this point enough: Beware of companies using debt to grow, especially when profits are economically sensitive, because what can go wrong, unfortunately, is what usually does go wrong.