What differentiates a good business that earns a long-term above-average return from a mediocre business that, at best, only earns a return close to its cost of capital? A good business can control its supply while a mediocre business can’t.
Take Ferrari. Ferrari has a 24% operating margin with above-average return on capital, higher than most car manufacturers like Porsche, McLaren, and Lamborghini. Economics 101 teaches you supply follows demand. If there is a high demand for Ferrari cars, then the industry will increase supply to fulfill those demands. Eventually, Ferrari’s return on capital and operating margin should fall in line with other manufacturers. But you know this won’t happen. Only Ferrari can produce a Ferrari. Other car manufacturers can’t do it no matter how much capital they have. If you want the latest Ferrari model, you have to get it from Ferrari. And chances are you won’t get it.
Ferrari controls the number of cars they produce each year to ensure that demand always exceeds supply. It is a deliberate strategy. Ferrari stated that “We pursue a low volume production strategy in order to maintain a reputation of exclusivity and scarcity among purchasers of our cars and deliberately monitor and maintain our production volumes and delivery wait-times to promote this reputation.” You can pursue scarcity only if you have control over supply.
To extend this further, Ferrari can control supply because they have a differentiated product. The exhilarating driving pleasure coming from the V12 engine sound, the prancing horse logo, and the design are experiences that cannot be replicated by others. And a business that can control its supply possess pricing power to raise selling prices over time due to demand inelasticity.
There was a story where Tom Russo, a partner of Gardner Russo & Gardner, was on a flight and his colleague ordered a Jack Daniel’s, “the steward informed him that they only had Jim Beam, another brand of whiskey. His colleague replies: “No thanks, I would rather have water.” Russo argued that if the steward came back and said “Yes, you can have Jack for a dollar more than Jim Beam”, his colleague would not have minded.”
Warren Buffett once made a speech on the power of differentiation, “if you walk into a drugstore, and you say ‘I’d like a Hershey bar’ and the man says ‘I don’t have any Hershey bars, but I’ve got this unmarked chocolate bar, and it’s a nickel cheaper than a Hershey bar’ you just go across the street and buy a Hershey bar.
Through supply control, these businesses create a barrier that prevents competitors from copying them. But most businesses don’t possess the characteristics found in Ferrari, Jack Daniels, or Hershey. In Security Analysis, Benjamin Graham and David Dodd wrote:
A business which sells at a premium does so because it earns a large return upon its capital; this large return attracts competition; and generally speaking, it is not likely to continue indefinitely. Conversely in the case of a business selling at a large discount because of abnormally low earnings. The absence of new competition, the withdrawal of old competition from the field, and other natural economic forces, should tend eventually to improve the situation and restore a normal rate of profit on the investment.
The wide-ranging return of most businesses tends to converge towards the normal rate of profit over time with no excess return (or economic profit) because profit is shared equally by all the players. This is common for businesses selling undifferentiated and commoditized products or services. For example, if you’re a steel manufacturer and you wanted to buy iron ore, you don’t specify whether you want iron ore produced by BHP Billiton or ArcelorMittal. If a miner asked for a higher-than-market selling price, you just get them from the cheaper one next door.
In saying that, there are some price-takers selling commoditized products who have the ability to earn an above-average return. These businesses rely on cost advantage instead of differentiation to control their supply. In Strategic Logic, Carlos Jarillo explains the reason why there are so few oil companies in the world despite them earning a generous margin selling petrol which is a commodity is that “the amount of money necessary to carry out these activities is enormous, as is the scale on which these activities must be carried out to obtain costs comparable to those of the current competitors.”
This is why companies like Costco have earned an excess return of 15% over the past 30 years despite selling the same products as other retailers like Walmart (with the exception of their own private label Kirkland). Costco relies on keeping its business as efficient as possible to reduce gross margin and pass all the savings to their members. Therefore, creating a flywheel effect where customers’ loyalty increases scale economies that leads to lower cost and selling price which begets more loyalty. Other retailers who have a higher cost structure have to sell at a loss just to match Costco’s gross margin. GEICO uses the same low-cost business model to sell car insurance as well.
Or consider Hartalega, one of the largest glove manufacturers. No hospitals are going to pay an extra penny for gloves produced by Hartalega over other manufacturers. Despite this, Hartalega still managed to achieve the lowest production cost per glove through innovation and efficiency, allowing them to earn a higher margin than its competitors.
When you want to find out if a business can earn an above-average return (or excess return) over a long-time, the first thing to do is to find out if they have a differentiated product. And the litmus test for that is “can they raise their prices over time?” If a business doesn’t have a differentiated product, then the next question is “are they the lowest cost producer?” A business only has the ability to build a moat and earn an above-average return by controlling their supply, either in the form of differentiation, that is, the impossibility of others to supply the demanded products (i.e Coca-Cola, American Express, Apple), or through cost advantage, the difficulty of doing so at a cost that would make the effort worthwhile (i.e GEICO, Costco, Hartalega).
Buffett, W. (1991). Three Lectures by Warren Buffett to Notre Dame Faculty, MBA Students and Undergraduate Students. Tilson Funds. Retrieved from https://www.tilsonfunds.com/BuffettNotreDame.pdf
Fernand, L. (2018, March 6). Tom Russo: Good investors must have the “capacity to suffer”. Morningstar. Retrieved from https://www.morningstar.com.au/learn/article/tom-russo-capacity-to-suffer/165669
Graham, B. & Dodd, D. (2008). Security Analysis: McGraw-Hill Education
Jarillo, J. (2003). Strategic Logic: Palgrave MacMillan