Posted on by CTKS

Economic Moats – Part 3 of 3

In the previous articles on economic moats, we learnt how companies can create lasting competitive advantages and why it is important to invest in companies that possess these. In this final article of the series, I will be sharing where to find economic moats and other pertinent things to look out for.

Finding Moats

One of the biggest advantages being a retail investor is that we can invest our money wherever we prefer. We are not forced to invest in industry A or industry B so we are free to ignore what we don’t like and buy what we do. This is especially important if we wish to build a portfolio of companies with economic moats because it is a lot easier to dig a moat in some industries than others. Some industries are brutally competitive while others are less competitive and able to sustain solid returns on capital. That’s the reality of life, the economics of some industries naturally support economic moats while others do not.

In technology, software companies tend to have an easier time creating moats than hardware companies. This is not simply an accounting issue but has a strong basis on the way these two broad categories of products are used. A piece of software often needs to be integrated with other pieces of software to work properly, which leads to higher switching costs.

Companies that cater directly to the consumer, like restaurants and retailers, often have a very hard time building competitive advantages. With low switching costs, customers can simply walk down the street with minimal effort required to look for a better deal. People often confuse trend and hype for economic moats. However, investors should be wary because it could very easily be copied or fall out of favour.

On the other hand, companies that provide services to businesses have a much easier time creating economic moats. This is because they are often able to integrate themselves with their clients’ businesses, creating high switching costs and pricing power.

Another thing to note here is that moats are absolute, not relative. The fourth-best company in a structurally attractive industry may very well have a wider moat than the best company in a brutally competitive industry. Hence as intelligent investors, we don’t have to invest in every part of the market. Simply go where the money is.

Measuring a company’s profitability

Now that you know where to look for economic moats, what is the best way to measure a company’s profitability? In order to do so, we have to look at how much profit the company is generating relative to the amount of money investing in the business.

Investing in a company is similar to investing in a mutual fund. A mutual fund takes investors’ money and invests it in stocks or bonds to generate a return, and a mutual fund with a 12 percent return is going to compound shareholders’ wealth faster than a mutual fund with a return of 8 percent. Companies are similar. A business that can generate huge returns relative to the investments made is going to compound money for shareholders much faster than a capital intensive business that generates mediocre returns.

The first method to measure return on capital is using return on assets (ROA). Very broadly speaking, a non financial company that can consistently generate an ROA of 7 percent is likely to have some kind of competitive advantage. However, this metric works well if a company’s balance sheet is purely assets, but many firms are at least partially financed with debt, which give their returns on capital a leverage component that we need to take into account.

The next metric is return on equity (ROE). ROE measures the efficiency that a company uses shareholders’ equity. However, one flaw of ROE is that companies can take on a lot of debt to boost their ROE without becoming more profitable. Thus, it is a good idea to look at ROE alongside how much debt a company has (debt-to-equity ratio). As a rule of thumb, companies that can consistently crank out ROE of 15% without excessive financial leverage is likely to have some form of economic moat.

Finally, there is return on invested capital (ROIC), which is the best of both worlds. It measures the return on all capital invested which includes both equity and debt, thus removing the distortion that debt can have on ROE. As with ROA and ROE, a higher ROIC is preferable to a lower one.

Management and moats

This may sound counter-intuitive but management does not matter as much as we may think when it comes to building economic moats. While we can all remember companies such as Starbucks that managed to dig an economic moat in brutally competitive industries, these are the exceptions rather than the rule. When it comes to whether a company has an economic moat, the competitive dynamics of the industry will have a greater impact than any managerial decisions.

This is not to say that the quality of the management does not matter. Great managers can add value to a business and I’d much rather have intelligent capital allocators at the helm than a bunch of clowns. But the truth of the matter is, management itself is not a sustainable competitive advantage. Managers come and go but companies in a tough industry are stuck there.

The bottom line is that we should bet on the horse, not the jockey. The quality of management matters but far less than economic moats. As Warren Buffet puts it, “When management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

Eroding Moats

Finding a great company with strong economic moats is not the end of the process. We have to continuously monitor the business performance as there are a number of ways that moats may be eroded.

  1. The first way that a company may lose its competitive advantage is if it loses the technological race to stay on the cutting edge. Most technology companies have a hard time building a lasting competitive advantage because of how fast technology advances. As long as they do not continuously innovate and improve their offerings, a better product will eventually breach their moat.
  2. That being said, technological disruption can pose as a threat to non-tech companies as well and can occur at the most unexpected moments. This is because these companies can look like they have a strong moat before a technological shift permanently hurts their economics. Think about Kodak, which for decades dominated the market for analogue photography, and which today struggles to compete against digital cameras. A similar story can be told for newspapers vs the internet.
  3. Shifts in the structure of industries
    1. Consolidation of a once-fragmented group of customers can also harm economic moats because it increases their bargaining power
    2. Entry of low-cost workforce
    3. Entry of irrational competitor/government-linked entity
  4. Bad growth. This is used to describe company ventures into areas outside of its expertise that are unsuccessful. This inefficiency of capital allocation brings down their return on capital, making the company less attractive as an investment.

These developments will result in increased competition and reduced pricing power. The end result is that the company will have lower profitability and returns on capital. Therefore, one useful sign of moat erosion is when a company that has regularly been able to raise prices starts getting push back from customers.

Competitive analysis of a company

Finally, I would like to leave you with this three step process that Pat Dorsey, a guru on economic moats, uses to determine whether companies have moats. His book, “The Little Book That Builds Wealth” has been a tremendous inspiration for this series and I’d definitely recommend picking it up if you’d like to learn more about economic moats.

  1. We want to look at returns on capital over as long a period of time as possible, as a poor year or two does not disqualify a company from having a moat. If the company has not earned decent returns on capital and the future is not likely to be appreciably different from the past, there is no moat. After all, a competitive advantage should show up in the numbers, and a firm that has not yet demonstrated the ability to earn a greater than average return on capital is a long shot that we shouldn’t bet on.
  2. Step two is trickier and involves identifying a competitive advantage. This is a challenging but crucial step because it is entirely possible that even a company with a record of good returns on capital might not have a moat. In such a case, the company’s profitability can very quickly fall off a cliff if the trends change or competitors copy them. If we didn’t think about why high returns will stay high, we would just be driving by looking in the rearview mirror, which is rare a good idea. Thus, it is necessary to think carefully about what exactly the company’s competitive advantages are and how it will keep competitors at bay. Knowing this will allow us to tell if the firm’s economic moat has been breached.
  3. Once we have identified the competitive advantage that allows the company to generate greater than average returns, we have to figure out how durable that advantage is. Because this is more of a craft than a science, we shouldn’t try to slice things too finely. Pat Dorsey recommends dividing companies into just three categories: wide moat, narrow moat, and no moat.

In this series, I have explained what economic moats are, why they matter and how to identify them. I hope that you will be able to apply these pointers to your investment analysis and that they will help you make wiser investment decisions and become wealthier.

Posted on by CTKS

Economic Moats – Part 2 of 3

In last week’s article we covered the value proposition of economic moats, the four horsemen of false moats and two examples of sustainable competitive advantages. In this article, I will be going through two more economic moats that are extremely hard to breach.

Moat 3: Network Effect

The network effect is by far one of the most sustainable economic moats. It can be found in industries where the value of the good or service increases with the number of people using it. In other words, the most valuable network-based products will be the ones that attract the most users, creating a virtuous cycle that squeezes out smaller networks and increases the size of dominant networks.

By virtue of its characteristic, the network effect is much more common among businesses based on information or knowledge transfer than among business based on physical capital. This is because information is what economist call a “non-rival” good.

Rival goods are goods that can be used by only one person at a time. On the flip side, non-rival goods mean that one additional person using the good does not diminish the amount available to the next person. In today’s information age, there are more and more industries that can potentially build an economic moat using the network effect. Think of social media networks (Facebook, Instagram, Twitter), payment networks (American Express, Visa, Mastercard, Paypal), ecommerce platforms (Amazon, Alibaba, Ebay) and video sharing platforms (Youtube). The greater the number of users of these platforms, the greater the content, convenience and options there are and thus the greater the value provided to all users.

Even financial exchanges benefit from network effects. As more buyers and sellers aggregate on an exchange, there is greater liquidity. The added value to users of the network is that greater liquidity leads to lower spread, which reduces costs. That’s how futures exchanges such as the Chicago Mercantile Exchange (the Merc) and the New York Mercantile Exchange (NYMEX) become so profitable with wide moats.

However, the same cannot be said about stock exchanges which have weaker moats despite having deep pools of liquidity as well. This is evident by falling returns on capital of stock exchanges in recent years as competition has moved in while futures exchanges have maintained very robust profitability. The reason for this is that futures contracts are captive to an individual exchange – if I buy a futures contract on the NYMEX or the Merc, I have to sell it there. This means that liquidity is limited to each futures exchange. Whereas for stocks, liquidity is not limited to any exchange because people can buy on one exchange and sell on another.

The takeaway here is that for a company to benefit from the network effect, it needs to operate a closed network. When networks open up, the network effect can dissipate very quickly.

One way to identify network effects is to do some financial sleuthing to see whether operating income per node (customer/branch) increases as the number of nodes increases. This may be an indication that the value proposition to customers is increasing as the network expands, thus giving the company some pricing power.

Moat 4: Cost Advantages

When it comes to cost advantages, the question is not so much whether the company has cost advantages, but whether competitors are able to replicate it. Some cost advantages can be durable while others can easily be replicated by a competitor. In order to answer this question, we have to dig deep and find out how these cost advantages arise.

Another pertinent point to be said about cost advantages is that it matters more in industries where price is a large portion of the customer’s purchase criteria. The more price sensitive the consumer is with respect to purchasing the good, the greater the value of having a cost advantage is to the company.

Without further ado, let’s talk about the four ways of getting sustainable cost advantages.

1. Process advantages

In theory, process advantages should not exist long enough to constitute much of an economic moat. After all, if a company figures out a way to deliver the same quality for cheaper, competitors are sure to try and replicate it. This does happen but in reality, it takes much longer than one might expect.

Examples of businesses that have dug moats using process advantages are Southwest Airlines and Dell. Southwest did so by flying only one type of jet, minimising expensive ground time and cultivating a thrifty employee culture. Dell cut out distributors, sold direct to buyers and kept inventory very low by building PCs to order.

The real question is not how these companies achieved the cost advantages but why competitors did not just copy them. In the case of airlines, those premium airlines were unwilling to create a culture like Southwest simply because their business is built around treating some passengers like royalty and charging them for the privilege. As for Dell, its competitors were too reliant on the resellers and retailers. In both cases, competitors would literally have to blow up their existing business in order to replicate these processes.

However, fast forward both cases, their moats are significantly weaker today than they were five or 10 years ago. This is because new competitors have entered the industry and replicated these processes. So, process-based moats are worth watching closely because the cost advantages often slips away as competitors either copy the low-cost process or invent one of their own.

2. Advantageous location

These type of cost advantages are more durable than one based on process because locations are much harder to duplicate.

Mentioned in the previous article as well, waste and aggregate produce share a unique quality – low value-to-weight ratio. Thus, it is very uneconomical to transport these goods far away. So, companies with landfills and quarries located closer to their costumers almost invariably have lower costs, which means competitors that are further away will be priced out of the market. Combine this with the fact that nobody wants more landfills and quarries than necessary in their town, both enjoy extremely strong economic moats as localised monopolies. Ironically, these businesses that people often shun make excellent investments!

3. Access to unique, world-class asset

This third type of cost advantage is typically limited to commodity producers. If a company is lucky enough to own a resource deposit with lower extraction costs than any other comparable resource producer, it will likely have a competitive advantage. One interesting example is a company called Compass Minerals, which operates in the rock-salt industry. Due to the geology and the massive size of its mine, Compass is able to produce rock salt at some of the lowest costs on the globe. Coupled with its great location that allows Compass to ship salt into the American Midwest at low cost along rivers and canals, Compass has a pretty durable cost advantage over its competitors. This is an example of how two competitive advantages can come together to create an even stronger economic moat.

Such cost advantages are not limited to companies that dig stuff out of the ground. Aracruz Cellulose, a Brazilian company, is not only the largest producer of paper pulp in the world but also the lowest cost producer. Well, when Eucalyptus trees mature in about seven years in Brazil compared with 10 years in Chile and 20+ years in America, its no wonder that Aracruz is able to produce more pulp with less capital invested than anyone else.

4. Economies of scale

When thinking about cost advantages that stem from scale, remember one thing: The absolute size of a company matters much less than its size relative to rivals. Two massive firms that dominate an industry – Boeing and Airbus for example – are unlikely to have meaningful cost advantages relative to each other.

In order to understand scale advantages, it’s important to remember the difference between fixed and variable costs. Take a local grocery store for example, its fixed costs are rent and salaries for some base level of staffing, The variable costs would be the cost of merchandise and perhaps extra compensation for high traffic times of the year. Contrast this to a real-estate brokerage office. Aside from an office, a phone, a car, and a computer, there are little fixed costs. Very broadly speaking, the higher the level of fixed costs relative to variable costs, the more consolidated an industry tends to be, because the benefits of size are greater.

Cost advantages arising from greater scale can stem from large distribution networks, manufacturing scale and dominating niche markets (it is much better to be a big fish in a small pond than a bigger fish in a bigger pond).

Although manufacturing scale tends to get all of the attention in Economics 101, cost advantages stemming from large distribution networks or dominance of a niche market are just as powerful – and, in an increasingly service-oriented economy, they are more common as well.

Some companies go one step further. By continually passing on cost advantages arising from greater scale in the form of lower prices to customers, they dig a unique moat known as scale economies shared. Lower prices results in more customers and greater spending per customer, resulting in greater scale. As the company repeatedly share the cost savings with customers, a virtuous cycle arises, creating a sustainable economic moat while continually benefitting the consumers as well. This strategy has been successfully employed by retailers such as Costco, Walmart and Amazon. These businesses focus on increasing the value proposition they bring to customers by simultaneously driving prices down and improving the customer experience. Scale begets price reductions which then begets scale. This method of creating a mutually beneficial relationship with customers is truly one of the most sustainable economic moats out there.

In this article, we have learnt that network effects can lead to a very durable economic moat and cost advantages may also be a competitive advantage in price sensitive industries. However, there is no use in knowing the theory of economic moats if we are unable to put the knowledge to use and identify companies with durable competitive advantages. Therefore, in the final article, I will be sharing where to find economic moats and how to identify them. Join my telegram channel here to make sure you don’t miss it!