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Economic Moats – Part 1 of 3

Like a deep, broad trench that protects medieval castles from invaders, economic moats protect businesses from competitors, allowing them to prosper. In this three part series, I will be sharing why finding economic moats should be central to an investor’s analysis, examples of sustainable moats, where to find them, how to identify them and other intricacies of economic moats.

Why do economic moats matter?

Moats matter for many reasons. First, it allows a company to create more value. As economic moats prevent competitors from stealing their business, companies with strong moats are able to earn greater than average returns on investment and compound money for investors for a longer period of time. In today’s highly unpredictable world, one thing remains certain – businesses will go where the money is. Moats are thus extremely important for highly profitable companies to protect its bottom line.

Placing an emphasis on finding economic moats also enforces investment discipline, making it less likely we will overpay for a hype stock. By forcing ourselves to assess whether a company’s edge is durable, we can prevent ourselves from getting caught in a trap where we invest in a fast growing company whose competitive advantage may disappear overnight.

This brings me to my next point. Investing in companies with economic moats will lower the odds of permanent capital impairment. When a company possesses strong economic moats, it is unlikely that its revenue and earnings will take huge permanent hits due to increased competition. This protects investors from permanent capital loss.

Finally, economic moats help make a company more resilient. As companies launch new growth initiatives, there are bound to be some failures. Even when a new launch completely flops, companies with economic moats are able to fall back on its core business and their ability to generate positive returns will not be severely hindered.

With the points mentioned above, it is safe to say that all things equal, investors should be willing to pay more for a company with an economic moat than one without.

Four commonly mistaken moats

Moats are extremely hard to identify and many investors mis-identify these four characteristics as economic moats. Sad to say, chances are that they will be disappointed as competition increases.

Great products

Great products are very important to win over customers but they are not moats in and by themselves. This is especially so if others can easily copy them.

Strong market share

Bigger is not necessarily better when it comes to digging an economic moat. While there are cases where market share can help build an economic moat, it largely depends on the industry. Kodak (film), IBM (PCs), Netscape (internet browsers), General Motors (automobiles), Corel (word processing software) have shown that market leadership can be fleeting. The question to ask is not “whether a firm has high market share” but rather “how the firm achieved that share”.

Great execution (efficiency)

Being more efficient is an excellent strategy that can help improve profitability by cutting costs. However, unless it is something proprietary that cannot be copied, it is not an economic moat.

Great management

Yes, you don’t want an idiot running the firm but great managers are not economic moats. Managers come and go and as Peter Lynch once said, “go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it.”

Moat 1: Intangible Assets

Brands

Brands are one of the strongest economic moats as they are notoriously hard to replicate. However, a caveat must be said here that popular brands does not necessarily endow it’s owner with a competitive advantage. Brands are only an economic moat if it increases consumers’ willingness to pay or increases customer captivity. For example, Sony is an extremely well known brand but you probably would not spend more on a Sony DVD player than one from Philips, Samsung or Panasonic. On the contrary, many would pay double to get an iPhone compared to other smartphone brands.

The second way brands can create economic moats is by increasing customer captivity. For instance, when you buy a can of coke, you know exactly what you are getting. While The Coca-Cola Company may not able to sell a can of coke for double the price of Pepsi, many people will keep choosing coke over other drinks because of the positive experience associated with the brand.

Patents

While patents can prove to be a very strong economic moat, they have finite life and can be challenged. Furthermore, they are vaguely defined and guessing which team of lawyers will win a patent battle is a game with poor odds. In general, beware of any firm that relies on a small number of patented products for its profits as any challenge may severely harm the company’s profits and will be impossible to foresee.

Patents only constitute a truly sustainable competitive advantage when the firm has a demonstrated track record of innovations as well as a wide variety of patented products. 3M for instance has thousands of patens and hundreds of products.

Otherwise, patents can only serve to give companies a head start to building other more sustainable forms of economic moats.

Regulatory Licenses

This advantage is most potent when a company needs regulatory approval to operate in a market but is not subject to oversight with regards to pricing. Think of utilities versus pharmaceutical companies. Utilities have near monopoly but since water and electricity are basic needs, politicians watch prices like a hawk and it is unlikely that utilities will be able to earn phenomenal returns on equity. Pharmaceutical companies on the other hand, operate in a highly regulated industry but are free to set the prices.

There are two ways to build an economic moat using regulatory licenses, either single licenses or multiple smaller, hard-to-get approvals. The bond rating industry (Moody’s), slot machine industry and for-profit education are all examples of single licenses or approvals. These regulatory licenses are extremely difficult to get, allowing them to earn much greater than average returns on capital. However, this results in an over reliance on that one license. If the government ever chooses to grant more licenses, the profitability of these companies will be severely hindered.

Multiple smaller, hard-to-get approvals thus form deeper and wider economic moats because they are unlikely to all disappear overnight en masse. Common examples would be NIMBY (”not in my backyard”) companies such as waste haulers and aggregate producers – nobody wants a landfill or stone quarry located in their neighbourhood so getting new ones approved is close to impossible. Yet, these markets are highly localised because it is not economical to transport trash hundreds of miles away and trucking aggregates 40 or 50 miles will incur too much cost for producer, pricing them out of the market. This results in a local monopoly.

Contrast this to another industry with strong NIMBY characteristics – refinery. Refined gasoline has a much higher value-to-weight ratio meaning that it can be moved very cheaply via pipelines so distance is not an issue. Thus, this form of economic moat can be found in NIMBY industries that have low value-to-weight ratio (ie transportation costs are high).

Moat 2: Switching Costs

Companies that make it tough to use a competitor’s product or service creates a switching costs. If consumers are less likely to switch, company can charge more, maintaining a high return on capital.

Switching costs come in many flavours and the following is a non exhaustive list:

  • Uncertainty (consumer banks, financial services, asset managers)
  • Highly integrated with a company’s processes (taxation and accounting software, data processers, back-office processing)
  • Retraining costs (Adobe, Autodesk)
  • High upfront costs (healthcare and laboratory equipment)

The issue with finding businesses with high switching costs as an economic moat is that it can be challenging to identify businesses with switching costs unless you use the product yourself as you need to put yourself into the customers’ shoes. Furthermore, consumer-oriented firms generally suffer from low switching costs as you can walk into another clothing store or buy another brand of toothpaste from another grocery store with almost no effort. Businesses marketing consumer goods thus have to compete on economies of scale or brand.

This means that in order to find businesses with high switching costs, investors have to look at other areas such as at the workplace instead of their personal consumption patterns.

So far, we have learnt why economic moats are so valuable, some traps when it comes to identifying economic moats and two forms of sustainable competitive advantage. In the next article, I will be covering another two highly desirable moats that investors should keep an eye out for, stay tuned by joining my telegram channel here!

Posted on by CTKS

Common Stocks and Uncommon Profits

Despite being a classic, “Common Stocks and Uncommon Profits” remains one of the best investment books I have read as it contains many timeless principles on how to profit from the stock market. Here, I will share some of Philip Fisher’s most valuable insight on assessing whether a company is a suitable investment.

Scuttle-buttling

A term coined and popularised by Fisher, scuttle-buttling refers to the act of obtaining information of a company from those who deal with it. This includes competitors, vendors (suppliers), customers, employees, university and government researchers, ex employees and executives of trade associations.

You should note that the executives of the company itself, the very people who should know the company best, are not on that list. And neither is the media. This is because it is often not in the executives’ interest to be completely upfront about everything regarding their business. Additionally, the press does a rather poor job reporting what truly matters.

Social butterflies will thus be overjoyed to learn that their broad network can give them invaluable insight into businesses that the general public do not have access to. Others, on the other hand, will find that they may not have such connections and in most situations, they may even have none.

Thankfully, scuttle-buttling is not the be-all and end-all when assessing a company. It is merely one of the methods investors can utilise to obtain surprisingly accurate information. Occasionally, the opportunity to utilise this technique will arise and investors should know what kinds of questions to ask.

15 points to look for in a company

1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years

This is a point that is repeated time and time again by may wildly successful investors. We want to invest in a business that has a long runway, not one that has a spurt in growth that quickly drops off in a few years. This does not mean that the revenue and earnings must increase every year as revenue and earnings don’t grow linearly. A few bad years are fine as long as the general trend in the long run is clearly increasing.

There are two types of businesses that can accomplish this. The first type is those that are “lucky and able” to do so. Their revenues grow due to unforeseen increase in demand out of the firm’s control. Many natural resource companies fall into these category where stumbling into an extremely valuable deposit can make or break the company – it is mostly a product of luck and cannot be foreseen. The second group is the “lucky because they are able” group. They strategically position themselves for growth by creating new products of entering new industries. Such companies actively seek out new business prospects. This category is where we wish to concern ourselves.

2. Does management have determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?

The companies that have the greatest appreciation in price are those that are able to achieve prolonged periods of high growth. It thus goes without saying we wish to invest in companies that are actively reinvesting profits to achieve even greater growth.

A simple marker for this is to look at how much a firm invests in research and development. The best results usually arise when R&D is devoted to products that are complementary to the current business model. Think about Apple expanding their product line and Microsoft investing heavily into gaming.

3. How effective are the company’s R&D efforts in relation to its size

The question to ask here is “how much profit does $1 investing in research produce?” This looks like a rather straightforward question but is actually relatively challenging to answer. A simple comparison can be made between the percentage of revenue invested in research each year and the growth in revenue and earnings can bear some insight. However, investors have to be aware that the fruits of R&D may only show up materially in five or even 10 years down the road. Thus, they have to be looking at a long period for such comparisons to be useful.

4. Does the company have an above average sales team

In today’s competitive world, most products don’t just sell themselves. The ability of a company’s sales team is almost as important as the product itself. An outstanding product will not be profitable if a company does not know how to market it and push it out to customers. However, the ability of a sales team is intangible and there is no financial ratio to assess this. Thus, many investors choose to ignore it. This is where scuttle-buttling is useful as employees and customers will almost surely have insight that the general public do not.

5. Does the company have a worthwhile profit margin

Firms with higher margins are more resilient during periods of high inflation and are able to maintain profitability even if competition increases. Persistently high margins are also an indication of an economic moat that allows the company to charge a premium while keeping competitors at bay.

Occasionally, low margins are temporary as majority of profits are reinvested. Such was the case with Amazon and Netflix in the past. These company can prove to be interesting investments as they may be underappreciated by the general public. Otherwise, it is wiser to stick to firms with higher profit margins.

6. What is company doing to maintain or improve profit margins?

While a surge in demand may improve a company’s profit margins, the effect is only temporary. We are more concerned with long term structural changes that will create sustainable improvements in the company’s margins. Some examples include reducing costs by harnessing economies of scale or building an economic moat that will allow it to raise prices and/or protect it’s profit margins from competitors.

7. Does company have outstanding labour personnel relations

Fisher argues that the benefits of excellent relations compared to mediocre ones is underestimated. To get a rough gage of labour relations, look at employee turn over rate, whether there is unionisation and a history of constant and prolonged strikes. However, do note that having unions and strikes are not instant red flags, how they interact with the company is much more important than whether there is a union.

8. Does company have outstanding executive relations

We hope to see that the company promotes executives based on ability and not connections. This is often an issue in family led organisations. Scuttle-buttling can yield many useful information regarding this point. When there is an executive position being filled, we hope to see that it is someone from inside the company rising through the ranks. Be wary of companies that consistently hires new personnel to fill the highest levels of management. This could signal that the there is a lack of talent or that the management is not fair.

9. Does company have depth to its management

We don’t want the company to be a one man show where the entire company depends on one personality. We want teamwork, all the way at the highest level of management. This is definitely a hard quality to assess but a look at the management compensation can provide some hints. Furthermore, we can use an elimination process – it is easier to spot which companies are a one man show.

10. How good are the company’s cost analysis and accounting controls?

Cost analysis and accounting controls are crucial to making good business decisions. However, this is hard to analyse. The best investors can do is analyse other metrics such as profitability as a company that performs well in other areas will likely do well in this as well.

11. Are there other aspects of business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition

Looking at a company’s growth and earnings may not be sufficient to ascertain if they are outstanding investments. There may be other aspects apart from their core business that is crucial to their growth strategy. Some examples include handling insurance, real estate, patents, customer relations and service, sales team and manufacturing know how.

12. Does company have long term or short term outlook on profits?

As buy-and-hold investors, we want to invest in a company to be able to compound earnings for a very long time. It thus follows that we don’t want to invest in a company that maximises short term profits in order to pump up it’s stock at the expense of reinvestment for future growth.

This can be observed from a company’s actions and growth strategy which can be found in it’s annual reports. I find it useful to pen down some of the pointers of the company’s growth strategy and brainstorm on where evidence of such actions will show up, be it increased expenditure on sales and marketing or increased R&D. These plans have long gestation period and it is useful to go a few years back to see how the company has progressed.

13. Will it require equity funding that will dilute current shareholders?

Take a look at debt, cash flows and cash on hand and compare it to how much they need to reinvest in order to achieve their goals. If they are short on cash and have exhausted all debt options, they will likely need to issue shares in the short term. This will dilute shareholders and might mean that the company may not be a good investment.

14. Does management talk freely about its affairs when times are good but “clams up” when troubles and disappointments occur?

It is part and parcel of business to have ups and downs. By the law of averages, not all new initiatives will succeed and there is bound to be costly failures. Even the best companies in the world such as Microsoft and Amazon are not spared from these failures. Such failures present excellent opportunities to assess the management team. Executives that clams up either has no plan or does not have a sense of responsibility to shareholders.

15. Does company have management of unquestionable integrity?

This is undoubtedly the most important factor in assessing whether a company will make a great investment. Even if all the other 14 points are excellent but management is not honest, investors should stay away from the company as it is unlikely that management will be fair to shareholders.

These 15 points can be used as a checklist. With the exception of the last point, it is not necessary to be outstanding in all the other 14 points for a company to qualify to be a good investment. A company that lacks in one or two points but does exceptionally well in the other points can still make an excellent investment. I hope that this article summarises what to look for in a company and helps you make sound investment decisions in time to come.

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Multi-baggers: InMode

InMode is an Israeli company that develops and markets energy-based, minimally-invasive medical treatment in three main aesthetics market. Namely face and body contouring, medical aesthetics and women’s health.

InMode seeks to fill a “treatment gap” which comprises of patients who are

  • in the age range of 35-60 years old
  • looking for comparable results to plastic surgery, but without the shortcomings of full surgery (downtime and scars)
  • large population of patients whose skin is not responsive to other procedures
  • affordable, office-based, out-patient procedure

The industry in which InMode operates in is expected to reach USD$141 billion by 2028, representing a CAGR of 14.7% over that period. Today, North America is the dominant regional market, accounting for 37%. However, Asia Pacific is expected to register the fastest CAGR on account of rising target population.

As mentioned before, lower cost, shorter downtime and reduced side effects compared to traditional means help bolster demand for minimally-invasive procedures.

As you can see, InMode’s platforms can be categorised into three main types: Minimally Invasive, Non-Invasive and Hands-Free.

Additionally, their products are capable of doing a wide variety of procedures and they have more than one solution for each procedure. This increases consumer choice and caters to their various needs.

InMode’s products have three main components:

  1. Platforms – Includes user interface with touch screen
  2. Handpieces and Hands-free applicators – The mode of application of energy over treatment area
  3. Proprietary Software – manages proper system performance and capable of automatic temperature control, system calibration and detection of any malfunction. This allows the practitioner to focus on the treatment as the system is automatically managed by the software.

As of 2020, most of InMode’s revenue is generated from the US market. However, growth in revenue from the international market outstrips that of the US market. This is evident by the rising proportion of revenue coming from the international market.

InMode has a very established distribution network spanning worldwide. They are thus poised to tap on international growth, particularly in Asia, which is expected to see the greatest rise in demand for such procedures.

I won’t bore you with numbers so I will just bring your focus to a few key points. However, you are encourage to analyse deeper if you wish to.

As a small company with market cap of USD$4 billion, InMode has demonstrated robust profitability that leave most growth companies in envy. Despite a lackluster second quarter in 2020 due to the Covid-19 Pandemic, InMode quickly recovered and achieved 32% growth in revenue from 2019 to 2020. This is a testament to the resilience of their business and adaptability of their management and staff.

The largest expense for InMode by far is sales and marketing. I expect this to continue to rise in the future as InMode expands their distribution network. This is their main method to drive sales growth and I would be happy to see them spending more in this area if it results in sustained revenue growth.

Lastly, InMode has consistently high gross profit margins (84-86%) and operating margins (35-38%). This indicates the presence of some form of economic moat that allows InMode to earn supernormal profits.

InMode’s growth strategy comprises of four main pillars:

  1. Increase sales presence to target and expand addressable market globally – investors can observe this by watching their expenditure on sales and marketing over time
  2. further penetrate existing customers and drive recurring revenues through the sales of consumables and services – investors can thus expect that recurring revenues as a percentage of total revenues will increase over time
  3. Leverage existing technology to expand into new minimally and non-invasive applications – we can monitor this by keeping our eyes peeled for new product releases
  4. Tuck-in acquisitions and strategic partnerships – InMode is at the stage where they are bringing in truckloads of cash and are capable of acquiring smaller companies. However, investors need to keep a look out on whether their acquisitions are sensible and worth it

Using the assumptions shown, I value InMode’s intrinsic valuation to be about USD$66 per share. At the time of writing, InMode’s share price closed at USD$46.85, representing a margin of safety of around 29%.

The compensation for the President and Chief Medical Officer is relatively high compared to other companies. However, on account of the CEO and CTO’s extremely modest compensation, this can be interpreted as a recognition of key talent and that InMode is not a one-man show. This is also indicative of a fair and humble management, both desirable attributes in my opinion.

Additionally, the CEO and CTO both have greater than 10% ownership in the company. As you may recall from my previous post, owner-operators are key attributes of multi-baggers.

Another point to note is that Steve Mullholland is the owner of one of the patents of InMode’s products. His significant ownership of more than 10% also indicates his confidence in the company.

Together, insiders own almost 38% of the company and have significant skin in the game. Shareholders can thus be assured that their interests are aligned.

I see three main risks with InMode.

  1. InMode faces competiiton from larger pharmaceuticals which may have greater resources
  2. Main form of economic moat is patents, which will expire eventually
  3. CEO was co-founder of a similar company (Syneron Candela) and left that company for unknown reasons. There is a real possibility that he may leave InMode abruptly as well

Investors thus have to monitor these three aspects closely. Particularly on the second point, the earliest expiration date on some of InMode’s oldest patents is 2027. Thus, they have five years to develop other economic moats such as brand recognition or cost advantage.

To sum it up, InMode operates in an favourable industry with excellent economics. As a small company, they have a proven track record of growth, high ROE and profitability. Their consistently high margins are indicative of some form of economic moats. To top it all off, management is fair, modest and owner-operators. InMode thus checks the boxes of a potential multi-bagger. In fact, I have already taken a long position on InMode.

If you wish to discuss further about InMode or investing in general, feel free to reach out to me here or join The Dollar Sapling telegram channel to start a discussion!

Disclosure: I am long InMode. I wrote this article myself, and it expresses my own opinions. I am not receiving any compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: I am not a financial advisor and this information should not and cannot be construed as financial advice. It is merely for me to keep track of my thought processes. Any investment involves the taking of substantial risks, including (but not limited to) complete loss of capital. Always do your own analysis and research before making any financial decisions and consult a qualified financial advisor if you have to. Click here for the full disclaimer.