Why is the reason that some companies can grow their business at a high return for decades while others failed to do so or falter after a few years of outstanding growth? What separates them? Is it because of the management? Or is it something else? More importantly, what is the commonalities amongst these high return companies so we can learn how to spot them?
Most companies failed to maintain above-average return in the long run because high profitability attracts competition, competition erodes profitability. If there is nothing to prevent competitors from entering the market, all the profits will get competed away, leaving everyone earning a market average return. This also means those that have succeeded possess some form of barrier, or so-called moats, that prevent competitors from stealing market shares and erode profitability.
Here are the characteristics that enable a business to develop a moat and withstand the onslaught of competitions.
Scale economies mean the fixed cost per unit falls as volume increases. Many fixed cost items such as rent, utilities, salaries, insurance, or manufacturing (in the short-term) don’t increase when production increases. So when more products get produced, these fixed cost gets spread over more units, resulting in lower cost per unit. This is why it is cheaper to produce 10 million tonnes of steel compared to 1 million tonnes; move a truck-full of products instead of half-full; or serve 1,000 customers within a 1 km radius than 100 customers scattered across a 10 km radius. An automotive manufacturer like Toyota; airplanes manufacturer like Boeing; or a chain retailer like Uniqlo all enjoy some form of scale economies in their business.
Scale economies can come from any business activity a company engaged in, not just what it produces. Let’s use Mcdonald’s as an example since we are familiar with what it does. Mcdonald’s has scale economies in several of its business activities such as:
- Purchase – Bulk purchase in ingredients i.e patties, buns, packagings etc.
- Advertising – Nationwide advertising spread across many outlets.
- Supply chain – Lower distribution cost due to numbers of outlets and distance proximity.
These are just a few. Scale economies can come from process—certain ways of doing things that achieve operational efficiencies. Hartalega, one of the largest glove manufacturer, has its own unique production process that can churn out 45,000 pieces of gloves per hour, an amount unmatched by any of its competitors. A location such as where a retailer builds its stores or the location of a quarry can create scale advantage as well. Quarry companies tend to have little competition because stones have a low weight-to-value ratio. High transportation cost makes it uneconomical for quarry companies to serve long-distance customers. Therefore, each quarry has a cost advantage when serving customers within its vicinity. Certain unique assets, such as a mining location that has high-grade iron ore or any natural resource that reduce the cost of exploration, mining, processing or a combination of all three can create cost advantage over others, especially for commodity products.
Not all scale economies is a moat. Mcdonald’s might have a scale advantage in advertising over a standalone fast food store, but advertising itself doesn’t contribute to their abnormal return (share price CAGR of 15% since 1970). In order for scale economies to become a moat, it has to create a barrier.
Let’s say you notice a lucrative market where the existing business (incumbent) enjoys a high-profit margin thanks to lower cost due to its scale economies. You plan to enter the market, increase your market share, achieve scale economies, and enjoy a slice of that profit. Therein lies the problem. To grab those market share, you have to either lower your selling price (less than incumbent) or offer a better value (which increase cost). But the incumbent is going to retaliate by reducing price using their superior cost position to prevent you from reaching the minimum-efficient size (MES)—the size required to achieve the lowest cost, so you will lose money permanently upon entering the market. This is the reason why aircraft manufacturing is an oligopolistic industry (a market dominated by a small number of sellers). If you have an unlimited amount of capital to compete with Airbus and Boeing, would you do it? No. You can’t. Not unless you’re prepared to lose money for a long time. What makes it so hard to compete with them? Because you will never sell enough aircraft to become profitable.
The moat of scale economies also points to something subtle: relative scale matters more than absolute scale. A company doesn’t need to be the biggest in size or revenue, it only needs to be way bigger than the next competitor. Consider a fragmented market with the largest company commanding only 10% market share but is 5x larger than its nearest competitor. The largest company is small compared to the industry as a whole, but its relative scale to its competitor give them a scale advantage with superior cost position. This should also clear up the misconception that scale economies (or any other moat) only exist in large markets such as the US or China.
The value of a network to a user increases when another user joins the network. Whereas scale advantage comes from supply-side economics, a network effect becomes a moat through demand-side economies of scale. Take Uber (or Grab), the more drivers there are within an area, the more valuable the platform becomes to riders due to less wait time as a result of higher density coverage. As more riders use the network to rideshare, it attracts more drivers to the platform because there are more jobs and income to be earned due to fast turnaround time between picking and dropping riders. As a result, this becomes a self-perpetuating cycle that tends to create a winner takes all market, one of the characteristics of a network effect. This is why growth is crucial for companies competing in this field. You might remember Uber (or Grab) doling out benefits and incentives to attract both drivers or riders to use their network during their nascent. Paypal once paid $10 to every new customer and another $10 if they refer a friend. These companies know critical mass is everything. The first mover advantage and the winner-takes-all nature of the market mean there is a big difference whether you’re the first or the second.
A common misunderstanding about network effect is it mainly appears in information technology companies. It doesn’t need to be. Think Microsoft Words or Microsoft operating system; Chicago Mercantile Exchange; Visa or Mastercard; Android or iOS; or consider the video cassette recorder (VCR) war between JVC’s VHS format and Sony’s Betamax format in the late 1970s-80s, these are all network effects. If you buy a futures contract at the Chicago Mercantile Exchange (CME), you have to sell it there as well. As more traders use CME to trade futures, liquidity improve which reduce the bid and ask spread, making the network more valuable for both buyers and sellers. This is the same with Visa or Mastercard. The more merchandisers that accept them, the more they become the preferred payment methods for the consumers, which in turn prompted more merchandisers to accept them in order to retain their customers.
A network is powerful when it serves as a bridge for two fragmented markets (or industries). Drivers and riders are fragmented markets that consist of many individuals. This is the same with auction market such as eBay that serves buyers and sellers, a career platform such as Linkedin that bring together job seekers and hirers, or a property site that connects property sellers with property buyers (or renters). In saying that, there are also many ways a network effect can lose its strength and lower the barrier of entry. One is technological changes. Microsoft Office suites (i.e Words, Excel) dominated the market in the 80-90s but gradually lose its grip with the shift towards internet-based applications such as Google doc or OpenOffice. Another is the ‘standardization’ of the network. If the CME trading system gets ‘standardized’ so traders have the freedom to trade futures contract between CME and other exchanges instead of doing it all within CME, CME will lose its captive power.
One thing to keep in mind when studying a company’s network effect is to understand the intensity of its network and how it can lose its power.
The power of switching cost comes from the uncertainty of changing where the cost can potentially outweigh the benefit of switching. You might also realize that companies that possess a network economy have the captive power to prevent their customers from switching out. If all your friends are on Facebook, it is hard for you to switch to another social network since you would lose all the benefits of networking.
Switching cost are powerful when the products or services provided to the clients are mission critical. That is, there is a tight integration between the products/services and the client’s business. Most software companies integrate their software that manages CRM (Customer Relationship Management), ERP (Enterprise Resource Planning), HR and so on into their client’s business. Switching to another provider becomes a challenge which introduces uncertainty due to the possibility of disruption to the business’s day to day operation. Not to mention the cost of migration and staff retraining on how to use the new software. Therefore, these software companies i.e SAP can leverage this power by increasing their price every year.
A prime example is Bloomberg Terminal. Bloomberg has increased its subscription price by 25% over the past 10 years, now costing $24,000 per year to use the service. Despite a high dissatisfaction on pricing across their user base, the majority of financial institutions still regard it as a necessity to perform their jobs from trading, receiving market coverage to charting tools and research.
Another form of switching cost comes from changing the business model from selling a product/service into a long-term relationship that increases loyalty and retention rate. Take Rolls Royce, one of the leading manufacturer of aircraft engines. They don’t make much profit from selling their engines to airlines. Rather, the bulk of the profit comes from aftermarket service. Rolls Royce provides ongoing repairs and maintenance on a fixed rate per flying engine hour ($/efh). So the more engines there are flying in the skies, the more revenue they make. And consider an aircraft engine has an average lifespan of 20-30 years, it is way more lucrative to provide aftercare services than selling engines. And of course, an aircraft engine is complex. No one has better know-how to repair it other than the company that builds it. Companies that perform sophisticated tasks such as healthcare products tend to benefit from switching cost as well. Or consider elevator manufacturers such as Otis or Schindler that you find in office buildings or malls. Once they’re installed, it makes little sense to pull them out from a building.
When searching for companies that benefit from switching cost, look for ones that provide a high benefit-to-cost ratio. Or in other words, a product or service that is critical to the end product but only cost a fraction relative to the total cost. Take a company that manufacture nuts & bolts to be put onto the wings of an aircraft. It is not easy to change those things overnight by sourcing it from another supplier. It is subject to aviation safety regulatory review and certification. That increases switching cost. On top of that, nuts and bolt is only a fraction to the total cost of building an aircraft. Therefore, the company has the ability to increase their selling price without jeopardizing their relationship with aircraft manufacturers like Boeing or Airbus.
A brand is a powerful moat when it can command a premium price over its competitor or create a change in behavior such that customers would select the brand over another. The moat created by a brand (brand power) should not be confused with brand recognition. Everyone is familiar with brands such as AirAsia or BMW but it doesn’t necessarily mean they have brand power. The litmus test for a product or service to be considered to have brand power is if it changes behavior. Some might say a certain brand of milk has brand power. But would you walk away instead of getting another milk brand if it becomes unavailable (i.e out of stock)? You probably won’t. The brand doesn’t change your behavior.
In general, a brand does a combination of these 3 things:
- Lower search costs
- Create positional value
- Confer legitimacy
Take Coca-Cola as an example that lower search cost. While there are many other cola brands out there selling at a cheaper price, most people are willing to pay a higher price for the Coca-cola brand because they know they’ll get the same consistent taste in their mouth every time. Trying out other cola brands introduce an uncertainty risk for a potentially bad experience. How about Panadol? If your kid has a fever, would you go for the Panadol brand which cost a bit more but one you’re familiar with and works for your kid all the time, or would you go for other generic paracetamol-based pain relievers that could be as effective as Panadol yet cheaper? You’ll pay more to get Panadol for peace of mind.
Aside from lowering search cost, some brands create positional value. Think of luxury brands such as Rolex (A Crown for Every Achievement), Johnnie Walker (Keep Walking), Hermes, or mass consumer brands like Nike (Just do it) or Starbucks. They confer a sense of identity which changes how we feel when we associate ourselves with the brand. Other companies might produce a running shoe as good as Nike or craftsmanship as exceptional as one going into manufacturing a Rolex watch, but you’re not going to pay the same price for them because they don’t change the way you feel.
A brand can also confer legitimacy. Both S&P500 and Moody’s have a monopoly on the credit rating market. Many investors and financial institutions rely on Moody’s credit rating and risk analysis to make financial investment decisions for example. Despite the fact that Moody’s direct involvement in giving low-risk ratings to the risky mortgage securities (while reaping lucrative fees) in the lead up to the global financial crisis (GFC), that has barely put a dent on their reputation.
A brand is never free. It takes time and money to build a brand and more money to maintain it. Few things to watch out when a brand loses its power. Brands are subjected to a change in consumers taste. A shift in preference from sugary drinks towards a healthier option, for example, poses a threat to Coca-Cola’s core business. The increase in private labels over household brands is another. A brand is also susceptible to brand dilution as a result of overexpansion, discount/promotion or anything that can diminish the brand’s exclusivity. Counterfeiting can also damage the reputation of luxury brands.
This moat comes from the inability of incumbents to copy a different, often superior business model for the fear of collateral damage on its existing business model. In 7 Powers, Hamilton Helmer explains the characteristics of counter-positioning as:
- An upstart who developed a superior, heterodox business model.
- That business model’s ability to successfully challenge well-entrenched and formidable incumbents.
- The steady accumulation of customers, all while the incumbent remains seemingly paralyzed and unable to respond.
When Vanguard launch index fund in the 1970s to allow investors to track the market, Fidelity Investments, the biggest investment fund in the days, did little to stop Vanguard until it is too late. Why? Because offering index fund cannibalizes their existing business model. Fidelity earns the bulk of their profits through lucrative fees generated from their active managed funds. Offering index funds will not only erode their margin but also create disgruntled amongst the fund managers who rely on those fees for a living. The uncertainty surrounding the strategy of market average return was another factor. Most fund managers dismissed the effectiveness of index fund. Why would investors choose to earn a market average return when they have a choice to beat it? But the late Jack Bogle would later be vindicated by his vision and turn Vanguard into the largest mutual funds provider.
Clayton Christensen coined the term disruptive innovation in his book Innovator’s Dilemma where incumbents ignore the entrants by dismissing the new innovation or business model as unproven and/or low margin. This typically happens when technology becomes ‘good enough’. Mini mills was a disruptive technology in the steel making industry back in the 1960s. A mini mill can operate at an efficiency one-tenth of a scale of an integrated mill and typically cost $400 million to build—a fraction to the $6 billion price tag for an integrated mill. But none of these incumbents who operates integrated mills adopted the mini mills technology because even though it is disruptive, mini mills produce poor quality steel, at least in the beginning. Steels produced by mini mills such as ones owned by Nucor was only ‘good enough’ for the rebar market—the lowest rung in the steel market with razor-thin margin and comprise only a fraction of the incumbents‘ revenue. It is a market the incumbents are happy to let go and focus their energy on the high-end market such as the sheet steel market. But as metallurgy improves over time, these mini mills begin to attack upmarket. They first move into other bars and rods, then structural steel, and finally, the sheet steel market. Eventually forcing most of the integrated mills to shut down by the 1990s.
A counter-positioning may or may not involve new technology. The war between Netflix’s mail-order service and Blockbuster video rental business model, for example, doesn’t involve any new technology. Blockbuster dismissed Netflix as a company addressing a niche market. Moreso the fact that changing their business model would hurt their profitability. And by the time Blockbuster begin to take Netflix seriously by launching unlimited DVD rentals online in 2004, Netflix is already in the process of pivoting their business model from mail-order to online streaming.
The power of cornered resources can be either tangible or intangible such physical resources (i.e property), human resources (i.e experience), or organizational resources like patents, proprietary information, or regulatory license. A resource can only be considered a moat if it can help a company improve its performance relative to its competitors. This is done in 2 ways:
- Reduce cost (low-cost approach)
- Increase revenue (differentiation approach)
And it has to be inimitable in order to be sustainable. We mentioned earlier that Hartalega has the capability to produce 45,000 pieces of gloves per hour. This unique production process allows them to reduce cost per glove and it is highly inimitable. Or take Corning which produce Gorilla glass used in most smartphones. Their production capability from decades of research and continuous innovation becomes a source of barrier that prevents others from competing effectively.
A patent is another intangible resource that excludes others from using or selling an invention for a limited amount of time. A patent has a finite life i.e a drug patent such as Viagra that expires in 2020. Proprietary information can be KFC’s secret recipe, Coca-Cola’s formula, or proprietary technology such as Google’s search algorithm. How can you determine if proprietary technology is a moat? Peter Thiel’s rule of thumb is the technology has to be at least 10x better than the next competitor.
We also talk about how a quarry that owns a nearby limestone source can create a sustainable moat given that it is unprofitable to move rocks over a long distance. Or consider the 32,500 miles of tracks laid down by BNSF Railway all over the United States. Those physical resources are hard to replicate.
The barrier to this moat comes from its complexity and opacity. Hamilton Helmer use Toyota’s TPS (Toyota Production System) as an example to explains the Process Power:
“Although Toyota offered full transparency regarding NUMMI (a joint venture between Toyota and General Motors that utilize Toyota production technique) practices, GM just couldn’t replicate the NUMMI results in its own facilities. This was not merely incompetence—the inability to mimic the TPS was shared by many…”
Despite having access to Toyota’s TPS, General Motors (GM) and other automotive manufacturers failed to imitate and produce their own cars as efficient as Toyota. As an example, one of the core principles of TPS is to eliminate waste i.e a low inventory level. So GM set their sight on doing that and failed because focusing on low inventory level is missing the forest for the trees. The low inventory level is just a small part of the whole system. And trying to optimize each part of a firm doesn’t optimize the whole firm. TPS works because of the tight integration between Toyota and all of its suppliers underpinned by the core principles and culture of the firm. The sum is more than its parts. The barrier is in the complexity of copying the whole system because it involves trade-offs.
Consider IKEA. IKEA’s success has been studied by others for many years yet not many retailers have managed to replicate their success. Why? The key lies in their strategy in pursuing trade-offs—what to do and what not to do—that culminate into a process power. Everything offered by IKEA from wide parking space, flat packaging, food, in-house design is a strategic fit that complements one another. This can be said for Southwest Airlines as well. In Understanding Michael Porter, Joan Magretta explains Southwest Airlines strategic fit:
“Southwest, in contrast, tailored all its activities to deliver frequent service on its particular type of route at the lowest cost. From the start, it didn’t offer meals, assigned seats, interline baggage checking, or premium classes of service, all of which contributed to the faster gate turnaround times. This enables Southwest to keep planes flying longer hours and to provide frequent departures with fewer aircraft. Gate and ground crews are leaner, more flexible, and more productive than its rivals. A standardized fleet of aircraft boosts the efficiency of maintenance.”
Another reason that makes process power a powerful moat is that you can’t copy it. It doesn’t come with a blueprint. When Ingvar Kamprad started IKEA, Kiichiro Toyoda founded Toyota, or Herb Kelleher established Southwest Airlines, none of them would have envisioned how their businesses would look like today. It is through the process of trial and error that these companies learn how to deliver the best value to their customers, which manifested in the company’s culture.
When you study moat, 3 things to keep in mind are:
1. Moat is dynamic
A moat is not a static process; it is either declining, maintaining or increasing a little bit every day. So it is important to study how a company allocates its capital in order to understand how that affects the size and strength of its moat. So the question is not whether a company has a moat or not. But whether the company is growing it. A company that has no moat but is in the progress of building one will be far more attractive than a company with a strong but declining moat.
2. Type of moat is dependent on company growth
A company can possess different type of moats at different growth stages so it is important to know what you’re looking at. As an example, you’re not going to find a brand in a 5 years old startup. The moats a company typically acquires in the early stage are counter-positioning and cornered resources. But once they are in the growth stage, that is where network effect, scale economies, and/or switching cost kicks in. Branding and process power tend to appear in the late, stability stage.
3. Durability determines value
Moat creates a differential return by suspending mean reversion. Your job as an investor is to determine how long can it last because that determines how much the business is worth (and how much you should pay). A company that earns a 15% ROIC for 20 years is worth paying a lot more than one that earns 20% but only sustain it for 5 years.
Dorsey, P. (2009). The Little Book That Builds Wealth: Wiley
Thiel, P. & Masters, B. (2014). Zero to One Notes on Startups, or How to Build the Future: Virgin Books
Helmer, H. (2016). 7 Powers: The Foundations of Business Strategy. Hamilton Helmer
Christensen, C. (1997). Innovator’s Dilemma. When New Technologies Cause Great Firms to Fail. Harvard Business Review Press
Magretta, J. (2011). Understanding Michael Porter: The Essential Guide to Competition and Strategy. Harvard Business Review Press