Peter Thiel is a co-founder of PayPal and Palantir Technologies, which specialized in big data analytics. While it is more apt to call him a tech entrepreneur than an investor, he knows something about moats and good thinking.
Peter Thiel explains the differences between perfect competition and monopoly:
“Every firm in a competitive market is undifferentiated and sells the same homogeneous products. Since no firm has any market power, they must all sell at whatever price the market determines. If there is money to be made, new firms will enter the market, increase supply, drive prices down, and thereby eliminate the profits that attracted them in the first place. If too many firms enter the market, they’ll suffer losses, some will fold, and prices will rise back to sustainable levels. Under perfect competition, in the long run no company makes an economic profit.”
“The opposite of perfect competition is monopoly. Whereas a competitive firm must sell at the market price, a monopoly owns its market, so it can set its own prices. Since it has no competition, it produces at the quantity and price combination that maximizes its profits.”
Companies operating under the perfect competition environment can only earn a return similar to its cost over the long run because there is no barrier to prevent new entrants from entering the market. As a result, all economic profit gets competed away in the long run. In contrast, monopolies are companies that possess moats. Moats create a barrier that allows them to retain the majority of the profit and earn a return above its cost (economic profit) over the long run. These moats can come in the form of scale economies, network effect, switching cost, branding, counter-positioning, cornered resources, and process power. The nature of these two environments also points to something subtle: high growth industries doesn’t guarantee winners.
“Your company could create a lot of value without becoming very valuable itself. Creating value is not enough—you also need to capture some of the value you create.”
There is a misconception that the best place to find great companies or future monopolies is in high growth industries i.e artificial intelligence, self-driving, robotic, lithium, cannabis etc. But think of some high growth industries in the past that produce enormous value to the economy from automobile, television to personal computer and internet, how many companies in these industries end up as monopolies? And how many that didn’t? If anything, high growth industries are the hotbed of perfect competition.
The precondition of a company to have moat is its ability to defend its profits. In other words, the ability to capture value is what differentiates monopoly from perfect competition, not the growth rate of the industry. Perfect competition is like everyone in the crowd decides to tiptoe to get a better view of a parade. The end result is no one gets it. This also illustrates the danger of financial modeling that often ignores the second-order effect. Your financial modeling might show positive NPV (net present value) for a piece of state-of-art machinery that can increase production by 50%, but the question is, do you have the ability to retain those profits or will they get passed onto the customers in the form lower selling price once your competitors get their hand on that machine?
“Growth is easy to measure, but durability isn’t. Those who succumb to measurement mania obsess about weekly active user statistics, monthly revenue targets, and quarterly earnings reports. However, you can hit those numbers and still overlook deeper, harder-to-measure problems that threaten the durability of your business.”
“If you focus on near-term growth above all else, you miss the most important question you should be asking: will this business still be around a decade from now? Numbers alone won’t tell you the answer; instead you must think critically about the qualitative characteristics of your business.”
This is the hard part of investing, and also the fun part of it. Quantitative metrics tell you the past growth rate but it rarely reveals the durability of a business. And growth is only as good as the ability to defend it. A fast-growing business that has zero durability is not worth any more than a business that has no growth. The right question to ask is not whether earnings are growing, but “is the company building or growing its moat?” The durability of the moat is the uncountable that counts. A strong earnings track record is not evidence of a moat just as a lack of growth is not the absence of one. For one, companies that are growing their moat generally have high capital expenditure and expenses going into distribution, sales or R&D, and generate negative cash flow in the process.
“Simply stated, the value of a business today is the sum of all the money it will make in the future.”
What you’re trying to estimate is the future cash flow, not what’s in the past. What has been invested in the business over the past 10 years and the cash flow it generates thereafter is not important. What’s important is the capital allocation decision made today. What is the expected future cash flow for these investments? In order to answer that, you need to have a good grasp on the durability of a business. And to understand durability, first, you have to understand the 7 moats.
Thiel, P. & Masters, B. (2014). Zero to One Notes on Startups, or How to Build the Future: Virgin Books