Porter’s five forces framework gave me the perspective to analyze any business’s competitive intensity and profitability trends in my initial years. I preferred companies that build sustainable competitive advantages (entry barriers) to fend against competitors – “companies with Economic Moats” as Mr. Buffet terms it. “The Little Book That Builds Wealth” by Mr. Pat Dorsey provides interesting insights on the evaluation of economic moats. He describes in a lucid style how to identify companies with moats that continue to generate above-average profits, Return on Capital Employed (RoCE), and cash flows helping investors in them compound wealth for many years.
Key insights from the book are:
Moats must provide either pricing power or cost advantage useful in defending high RoCE.
For companies with strong past returns, find out the existence (if any) and durability of a moat to get comfort on continuity of that trend.
Investment returns have two parts: one that reflects financial performance and another that reflects the exuberance or pessimism of investors (speculative part). One can forecast the former part only; therefore buying a wide moat business in times of pessimism (at lower valuation) will be a great opportunity eventually.
Four factors that affect valuation are:
1. Risk to future Cash Flows estimates
2. Growth in Cash Flows
4. Durability of Moat
Higher the Risk lower the Valuation; higher the factors in 2 to 4, more the Valuation.
It is easier to create moat in certain industries v/s in highly competitive industries. The fourth-best player in structurally attractive industries may have a wide moat than the number one player in the latter.
Differentiating a durable competitive advantage from a temporary advantage reduces the chances of permanent capital impairment. Growth in intrinsic value protects investment returns even for purchases at a higher valuation.
Understanding of moat gives insight into whether the business is going through a temporary or terminal problem. I can relate this to an opportunity in corporate banks with strong liability franchise and capital adequacy v/s that in wholesale funded, capital-starved banks, the former is more likely to see improvement in return ratios.
Mistaken moats discussion clarifies that market share, size, brand, and management competencies matter less than moats. Bet on the horse than on the jockey.
Intangible sources of the moat: e.g. brand is a moat if a consumer is willing to pay more for it, being on top recall is not enough. Patents can be moat if the company has a track record of innovation and diverse patented products. E.g. A pharmaceutical company targeting the US generic market, with a diverse product pipeline of approved An abbreviated new drug applications (ANDAs) should be more valuable than the one with a couple of ANDAs.
Switching costs as moat improves clients’ stickiness. I can relate this to Bloomberg, which can charge more as users are reluctant to spend time learning a new system.
The ‘network effect’ builds a wide moat for a services company as users increase. Consider one of India’s reputed stock exchange’s F&O volume growth, as more buyers and sellers using the exchange, liquidity increased, strengthening the moat further.
Cost efficiency is a solid moat in industries lacking pricing power. Companies’ with a lower cost of production are more resilient and enjoy supernormal profits when supply shrinks. The source of cost competitiveness should be durable like sourcing/location advantage and the threat of substitution should be lower. Consider best-operating efficiencies as a moat for Airline Company. Economies of scale are more valuable in businesses with higher fixed costs.
As the competitive landscape can change fast if the moat is likely to erode one must act early. Disruptions have severe consequences and can make wide moat non-existent. A famous example is what digital photography did to Kodak.
Consolidation is akin to an industrial earthquake. Sharp shifts in bargaining powers follow it. A recent example is the pricing pressure we see in the US Generic market post-consolidation in distribution.
The entry of irrational competitors can severely damage the profitability of the business, aren’t we noticing that in Indian Telecom space with a drastic drop in Revenue and EBITDA pool.
The company’s decision to invest in non-core areas in a quest to grow size may be an early sign of erosion of moat.
– Repost from UTI Mutual Fund