Ask the Fool

Castles, Companies Need Moats

Q: What does a “moat” refer to in business-speak? — P.O., Walnut Creek, California

A: Just as with a castle, if a company has a wide moat, it will be hard for any enemies to attack it. Thus, a moat refers to the sustainable competitive advantages a company may have that can protect its market position and defend against competitors or would-be competitors. Competitive advantages can include patents, a strong brand, economies of scale, barriers to entry, and high switching costs.

Think of Apple as an example. Its strong brand attracts many customers who associate it with high quality and good design, and once they’re in the Apple environment, it can seem like too much of a pain to switch out of it.

Boeing, meanwhile, encounters few new competitors because it’s so costly to start manufacturing aircraft.

Q: What is the U.S. inflation rate, and how does it compare to that of other countries? — S.S., Greenville, North Carolina

A: The United States’ inflation rate was recently about 2.5 percent, according to the International Monetary Fund, below the long-term average of about 3 percent per year. Meanwhile, it was 0.7 percent in Switzerland, 1.1 percent in Japan, 2.5 percent in China, 2.7 percent in the United Kingdom, 2.8 percent in Russia, 5 percent in India, 11.4 percent in Turkey, 22.7 percent in Argentina and 13,864.6 percent in Venezuela.

That Venezuelan rate reflects the phenomenon of hyperinflation, when inflation is occurring at rates higher than about 50 percent monthly. When prices rise that quickly, the money that people have in their pockets and savings accounts rapidly loses its value and the economy is dangerously destabilized.

Hyperinflation, often triggered by governments printing too much money, occurred in Germany after World War I and more recently in Zimbabwe.

Fool’s School

Red Flags Signaling Bankruptcy Risk

When a company files for bankruptcy protection, many of its stockholders are taken by surprise and often lose most or all of their investment. You can save yourself a lot of heartache and dollars by learning to spot warning signs among your holdings.

A company goes bankrupt when it runs out of the cash it needs to operate. To assess a company’s bankruptcy risk, start with its debt load. Borrowed money can be helpful to a company, boosting returns in good times. But it can also amplify risk in bad times. A debt-laden company suddenly facing declining sales can cut its dividend — but it still has to make its interest payments, and eventually its principal repayment. Worse still, when the economy goes south, access to additional financing can be costly — or not available at all.

The amount of debt a company can handle is influenced by its industry. A utility company with predictable cash flows, for example, can manage debt better than retailers or manufacturers whose cash flows can fluctuate widely. (It can be helpful to compare a company’s debt level with those of its competitors.)

Industry aside, compare a company’s debt load to its cash — what it currently has on its balance sheet, and what it can generate. Ideally, it will be able to pay any debt due in the next year (often referred to as “short-term debt”) with cash on hand and make its interest payments many times over with its free cash flow. (You can find figures for assets, cash flow, debt and more at sites such as morningstar.com and finance.yahoo.com, which offer data from companies’ financial statements.)

Look for other warning signs, too. Is its pension plan underfunded? Is its industry vulnerable to rapid obsolescence? Is it under investigation for any irregularities? Is the company buying back shares at inflated prices with money it should be using in better ways? Is it paying dividends when it can’t afford to?

Stay away from companies that appear to be candidates for bankruptcy court.

My Dumbest

Investment

Dividend Power

I retired from a bank in Mississippi in 1990 with some shares of the company’s stock. I added a little more money to it and let it ride. After less than a decade, the mere $175 that I’d invested had grown to be worth more than $1,800, counting dividends received. The dumbest thing I did was not buying more stock early on! — M.H., Gulfport, Mississippi

The Fool responds: Your story illustrates the power of reinvesting dividends. When many investors receive dividends from their investments, they take them out in cash. Or they might just leave the cash in their brokerage account.

A more effective wealth-building strategy is to have your dividends automatically reinvested in additional shares of the company’s stock. Some brokerages will do that for you, and with ones that don’t, you can simply take the cash that accumulates in your account and, on your own, buy shares of the same stock or stock in even more promising companies.

Not every investment will do as well as yours did over a few years, of course — you reaped the equivalent of annual returns of more than 70 percent! The stock market’s average annual return is closer to 10 percent. You’re right, though — investing meaningful sums early and letting them grow for decades is a great way to build a substantial nest egg for your retirement.

The Motley Fool Take

A Towering Portfolio Candidate

Usage of cellphones and smartphones is still growing rapidly around the world. So telecom companies need to keep adding broadcast equipment to handle the traffic, and that means more equipment on structures like cell towers and rooftop spires.

If you’d like to profit from this scenario, consider American Tower (NYSE: AMT), with a dividend recently yielding 2.1 percent. It’s a real estate investment trust (REIT) that’s one of the world’s largest owners of towers and other structures designed to hold telecommunications equipment. As telecom companies would generally rather not have to spend money building towers or buying land, American Tower can lease space to multiple clients on the same structure. This has been a lucrative arrangement, as the company has grown its bottom line by an average of 16 percent annually over the past decade.

EDITOR’S NOTE: The Motley Fool is an investment column created by brothers David and Tom Gardner and distributed by Andrews McMeel Syndication.