Economic Moat
- Find businesses with an “economic moat,” companies that earn excess returns over an extended period of time because of competitive advantages
- Return on capital is the best benchmark of profitability
- Companies with economic moats can reinvest cash flows at a high rate of return for a long period of time, companies without moats will see decreased cash flows as competitors move in
- Moats provide a margin of safety for your capital
Mistaken Moats
- Economic moats are structural and depend less on managerial brilliance
- Most common “mistaken moats” are great products, strong market share, great execution, and great management
- The question to ask is not whether a firm has a high market share, but rather how the firm achieved that share
- Being more efficient is not a sustainable competitive advantage unless it is based on some proprietary process that can’t be easily copied
- Characteristics of moats: intangible assets that allow it to sell products that can’t be matched by competitors, high customer switching costs, network economics, and cost advantages
Intangible Assets
- If a company can charge more for the same product than its peers just by selling it under a brand, that brand constitutes an economic moat
- Be wary of a firm that relies on a small number of patents, as these can be challenged
- Look for firms with a track record of successful patents for insight that new products will replace the old ones
- Companies that require regulatory approval are not subject to economic oversight on how they price their products have wide economic moats
- The best kind of regulatory moat is one created by a number of small-scale rules, rather than one big rule that can be changed
Switching Costs
- A company can extract more money out of its customers if these customers are unlikely to move to a competitor
- Switching Costs can strengthen or weaken with time
- Switching costs occur when the costs/risks from switching outweigh the benefits/costs
- Need to have a thorough understanding of the customer experienced to understand switching costs
Network Effect
- Value of products and services increases with the number of users
- Network-based businesses tend to create natural monopolies and oligopolies
- Network effect is much more common for businesses based on information and knowledge transfer rather than physical capital
- Information is a non-rival good; many people can use it at once
- A network might open up to other participants removing the benefits of the network effect
- Benefits of having a larger network are non-linear
Cost Advantages
- Need to determine if cost advantages can be replicated by a competitor
- Cost matters most when price is the determining factor in a customer’s purchase
- The originator of low cost process can make a lot of money as competitor work to catch up
- Process-based cost advantages can create a temporary moat if incumbents are unlikely to replicate them immediately and new entrants can’t copy the process or doing so is unlikely to destroy the industry’s economics
- Location-based cost advantages are more durable than process based
- Access to a unique world-class asset is a cost advantage (world-class natural resource deposits
Size Advantages
- Absolute size of a company matters much less than its size relative to rivals
- The higher level of fixed costs relative to variable costs, the more consolidated an industry tends to be because the benefits of size tend to be greater
- Scale based cost advantages include: distribution, manufacturing, and niche markets
- Large distribution networks are extremely hard to replicate
- Once the fixed costs are covered the incremental profit is very large
- Manufacturing scale allows fixed costs to be spread over a larger volume of production. It is also easier to specialize and mechanize production.
- Being larger than competitors in niche markets can confer huge cost advantages because it makes no economic sense for a new entrant to spend the capital necessary to enter the market
Eroding Moats
- Being technologically supplanted by a competitor is a fact of life for many technology companies
- Technological disruption is more severe when it effects non-tech companies
- Consolidation of a once fragmented group of customers can destroy a moat now that they have pricing power
- Labor differentials can erode location-based moats as cost savings from low-cost labor offsets transportation costs
- An irrational player in the competitive landscape can destroy a moat if they take actions that support political or social goals but result in lower profitability
- For less profitable companies “no-moat” investments can hurt return on capital enough to make the entire corporation less attractive
- When customers refuse to pay up for a product or service the company’s moat may be eroding
Finding Moats
- Look for economic moats in industries that are less competitive and more adept for competitive advantages
- Business service firms usually have wide-moats because these companies are able to integrate themselves in the business process
Management
- The competitive dynamics of an industry will have a much greater impact on whether a company has an economic moat than any management decision
Testing for Moats
- Has the firm historically generated high returns on capital?
- Does the firm have competitive advantages?
- Are these advantages likely to last?
What’s a Moat Worth, Valuation
- We don’t need to know the exact value of a business, just need to know if the current price is less than the value of the business
Four most important concepts that underpin valuation of a firm:
- Likelihood that estimated cash flows will materialize (risk)
- How large these cash flows will be (growth)
- How much investment will be needed to generate cash flows (Return on Capital, Capex)
- How long business can generate excess profits (economic moat)
- Investment return: earnings growth and dividends
- Speculative return: exuberance or pessimism of other investors
- We can’t guess about speculative return but we can approximate investment return
Tools for Valuation
- Don’t use P/S to compare companies in different industries, use P/S when looking at high-margin businesses that may have hit a speed bump
- When using P/B thing about what makes up book value. Book value may include accounting goodwill or exclude certain brand benefits that would have a large impact on book value. Use P/B for financial services companies
- When using P/E use an earnings estimate based on an average year for the company. When comparing P/Es make sure to consider the economic moats of each of the comparison companies
- P/CF from operations can give investors a more accurate picture of what is going on in a business because some businesses record more CF than earnings
- If you take the reciprocal of P/E which is E/P you can compare earnings yields to bond yields
- Cash Return: (cash flow from operations – CapEx) + Net interest expense / (market cap + net debt)
- Cash return tells investors how much free cash flow a Co is generating relative to the cost of buying the whole company, including debt
When to Sell
- Ask yourself these questions: Did I make a mistake? Has the company changed for the worse? Is there a better place for my money? Has the stock become too large a portion of my portfolio?
- Each time you buy a stock write down why you bought it and what you expect to happen to the company’s results. When things go bad pull out that piece of paper and see if those reasons still make sense
- Selling a modestly undervalued stock to purchase a super-cheap stock is a good strategy
Related Book Notes
