What’s interesting about moat is that if a moat needs to be continuously built, it isn’t a moat at all. How do you know if you’re paying up or overpaying for the moat? This time we invert the conundrum of moat to explore the symptoms of false-moat trap.
Over the past few months, I have spent considerable time studying about business, their longevities, moats, what helps them sustain, and what dilutes them over time.
As an investor in stocks, studying what makes a few businesses really great and their moats sustain over a long period of time, and on the other hand, what makes a majority of businesses bad and their moats, if any, fleeting has been an interesting aspect of my work.
So, while I have not yet arrived at any Eureka moment on how and why some moats sustain over a long period of time, and how can one identify in advance when a moat is shrinking, there have been some thoughts that I have formed through such reading.
I had shared some of those thoughts in my last post in the June 2015 Special Report. This post is a continuation of what else I have learned about moats, and especially about the dark side of investing in either emerging moats or ones that have already had a proven past.
I’m sure you may be wondering, “What could be the dark side of moats?”
Well, without trying to lay down any clear theories on the same, what I will be sharing below are just a few thoughts on the risks of investing in moats that you must keep in mind when you are buying such businesses that seem to be in their full glory and not destined to failure in the future.
But then, like s**t happens in real life, it often happens when it comes to investing…and that’s what makes it such an interesting game where you must keep learning…and evolving.
Let’s Start with…Destruction
When changes in the natural environment accelerate, so do the extinction rates of the Earth’s creatures. It happened to the dinosaurs and again to many species during the Ice Age. Many scientists believe we may be entering another such period.
The same happens in business, and as per Harvard Business Review, we are clearly entering a period where the extinction of the slow, the inflexible, and the bureaucratic is about to happen in record numbers.
Look at the business world around you, and you will realize that companies are losing their leadership positions (and their moats) as quickly as never before.
A list of the top 10 banks in India today contains only seven that were on the list a decade ago. A similar pattern holds for consumer goods. And for healthcare. And for retail. And for most other industries.
Some of this, business historians might say, is simply due to what Joseph Schumpeter supposedly called “creative destruction” — a desirable culling of businesses that can’t keep pace.
As per a three-year study done by Bain & Company of enduring profit and relative competitive ability to adapt in a world of increasing velocity and uncertainty, here were some findings –
• Nearly two-thirds of 70,000 companies globally with market data available now destroy value. More than 42,000 of these earned shareholder returns (dividends + stock price appreciation) below inflation.
• Only 9% of companies achieved even a modest level of sustained and profitable growth. What’s more, the percentage of companies earning their cost of capital has steadily declined.
• Just 100 companies globally accounted for US$ 10 trillion – around 50% – in net returns (returns above inflation) generated by all companies combined.
On reading about this research, the first questions I had were – “What separated these top 100 from the rest? What created such inflation-beating returns from these 100 and not from most others?
Well, the Bain report suggested that about 25 of these 100 gained thanks to the commodity bonanza that unfolded during the last two decades (for example, the price of a barrel of oil rose from US$ 20 in 1992 to nearly US$ 150 in 2008).
But among the rest, the study found, the majority of companies produced great returns thanks to what it termed as a Repeatable model – companies that had a strong, well-differentiated core business, a great culture built over time, and ones that continuously evolved with changing times.
In short, these were companies that found a way to replicate their success again and again.
Although some lost their way temporarily, all are characterized over the long term by their simple focus on their historic core, which allowed them to continuously grow their profit pools, and tap into new ones.
But wait, we were talking about destruction here, and not what makes businesses sustain their greatness over a long period of time, right? So, let me get back to the topic.
Now, most people think that creative destruction is a process where innovative new products cripple established but big, dinosaur companies. But the irony of creative destruction is that it is often the less innovative, more mundane changes that are the most disruptive.
Take new, disruptive businesses like Uber and Airbnb – extremely simple, mundane ideas that are slowly destroying the dinosaurs from their respective industries.
Clayton Christensen wrote about this in his brilliant book The Innovator’s Dilemma where he says,
.occasionally disruptive technologies emerge — innovations that result in worse product performance, at least in the near term…..generally disruptive technologies underperform established products in mainstream markets. But they have other features….they are typically cheaper, simpler, smaller, and frequently, more convenient to use.
In The Halo Effect:…and the Eight Other Business Delusions That Deceive Managers, the author Phil Rosenzweig writes…
Looking for those few golden companies that succeed decade after decade may be a delusion, but it’s one that managers are eager to grasp/ After all, showing how companies tend to rise and fall over time doesn’t make for a very compelling story. We prefer to read about EXCELLENT and VISIONARY companies; we want to know the secrets of their success so we can try to do likewise. We yearn to find out how we can avoid the seemingly inevitable fate of decline and death.
It’s a far more appealing story than the one suggested by the facts: that success is largely transitory and that most companies that have done well in the past won’t outperform the average in the future.
Does this mean that all company performance is just a matter of luck? Is it roughly equivalent to someone who flips a coin and gets heads ten times in a row, but stands no greater chance to flip heads on the eleventh try than anyone else? Not at all.
Success is not random – but it is fleeting. Why? Because as described by the great Austrian economist Joseph Schumpeter, the basic force at work in capitalism is that of competition through innovation – whether of new products, or new services, or new ways of doing business. Where most economists of this day assume that companies competed by offering lower prices for similar goods and services, Schumpeter’s 1942 book, Capitalism, Socialism and Democracy, described the forces of competition in terms of innovation.
The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers, goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.
Every piece of business strategy acquires its true significance only against the background of that process and within the situation created by it. It must be seen in its role in the perennial gale of creative destruction; it cannot be understood irrespective of it or, in fact, on the hypothesis that there is a perennial lull…
So, it’s entirely normal and very predictable that companies fall back after outstanding performance.
Several researchers have studied the rate at which company performance changes over time. Pankaj Ghemawat at Harvard Business School examined the return on investment (ROI) of a sample of 692 American companies over a ten-year period, from 1971 to 1980. He put together one group of top performers with an average ROI of 39% and one group of low performers, with an average ROI of just 3%.
Then he tracked the two groups over time. What would happen to their ROIs: would the gap persist, would it grow, or would it diminish? After nine years, both groups converged towards the middle, the top performers falling from 39% to 21% and the low performers rising from 3% to 18%.
The original gap of 36% had shrunk to just 3%, a decrease of nine-tenths. Now, as Ghemawat pointed out, a persistent difference of 3% isn’t zero – it’s nothing to sneeze at.
But the main point is that high performance is difficult to maintain and the reason is simple: in a free market system, high profits tend to decline thanks to what one economist called “the erosive forces of imitation, competition, and expropriation.”
Consider for that matter my study of the available data for 230 of the BSE-500 companies for the past ten years. After excluding companies with extreme performances on the return on capital employed (ROCE) front – greater than 30% and less than 0%, I was left with 177 companies.
In FY05, the top 20 of these companies earned an average ROCE of 27% while the bottom 20 earned 5%. After ten years, in FY15, the ROCE of the same top 20 fell to an average of 20%, while it rose for the bottom 20 to 14%. Thus, a gap in ROCE between the top and bottom performers of 22% a decade back has now shrunk to just 6%.
Now, you may argue that I must not look at group averages while picking up companies on their individual strengths and weaknesses.
But my point is that these studies, and others like them, all point to the basic nature of competition in a market economy. Competitive advantage or moat is hard to sustain.
Sure, if you want to, you can look back over decades of business history and pick out a handful of companies that have endured (like Motherson Sumi and Pidilite from my study of BSE-500 list), but that is a selection based on outcomes.
On the whole, if we look at the full population of companies over time, there is a strong tendency for extreme performance in one time period to be followed by less extreme performance in the next.
To revise a well-known phrase – Nothing recedes like success. Suggesting that companies can follow a blueprint to lasting success maybe appealing, but it’s not supported by the evidence.
But don’t get me wrong here. I am not advocating avoiding businesses with great past track record in the fear that the performance would trend lower in the future…due to enhanced competition that may reduce profitability, or under the basic premise of creative destruction.
In fact, Ben Graham had this advice for most investors – who are less trained as compared to stock analysts or fund managers – in his Security Analysis…
…the untrained buyer fares best by purchasing goods of the highest reputation, even though he may pay a comparatively high price. But, needless to say, this is not a rule to guide the expert merchandise buyer, for he is expected to judge quality by examination and not solely by reputation, and at times he may even sacrifice certain definite degrees of quality if that which he obtains is adequate for his purpose and attractive in price. This distinction applies as well to the purchase of securities as to buying paints or watches. It results in two principles of quite opposite character, the one suitable for the untrained investor, the other useful only to the analyst.
1. Principle for the untrained security buyer: Do not put money in a low-grade enterprise on any terms.
2. Principle for the securities analyst: Nearly every issue might conceivably be cheap in one price range and dear in another.
Now, the biggest reason I am worried here – and that’s what I call the dark side of investing in moat businesses is – what Graham writes…
We have criticized the placing of exclusive emphasis on the choice of the enterprise on the ground that it often leads to paying too high a price for a good security. A second objection is that the enterprise itself may prove to be unwisely chosen. It is natural and proper to prefer a business which is large and well managed, has a good record, and is expected to show increasing earnings in the future. But these expectations, though seemingly well-founded, often fail to be realized. Many of the leading enterprises of yesterday are today far back in the ranks. Tomorrow is likely to tell a similar story.
It’s the Price You Pay!
Yes, my biggest worry as far as people (or myself) investing in moats – whether established or emerging – is related to the price paid – which often hovers around the very thin line between paying up and overpaying.
Even Graham advices the untrained investor to focus on high-quality businesses not because these are almost always the safest, but because there are greater risks for the investor in other directions – like low quality businesses underlying cheap stocks.
Now, here is a list I jotted down in my investment notebook a few days back on the potential dangers of moat investing (I am just trying to look at such businesses using inversion – What could go wrong?). Take a look at this list –
1. It’s difficult to differentiate between sustainable and fleeting moats (hindsight bias works best here, because when you are enjoying the benefits of moat, you may be like a frog in boiling water who won’t give much attention to any gradual, but permanent, deterioration in business conditions);
2. Established moats have the risk of making companies complacent, and their managers arrogant and overconfident (Nestle, Nokia);
3. Moats cause innovative thinking on the part of potential competitors, thus sowing seeds of bigger disruptions (if you can’t cross the moat with crocodiles and piranhas, maybe you strike from air);
4. Moats can overshadow slow contrast effects on businesses (again, frog in boiling water syndrome);
5. Moats may make investors complacent and easy prey for status quo bias (who wants to miss out on a nice, ongoing party);
6. Overpaying vs paying up for a moat is very difficult to ascertain.
Now, while I had counter arguments for the first four points, especially given that these were business-specific and not in my control as an investor, it was the points on complacency and overpaying vs paying up that caught my attention again and again.
And the thought of paying excessively for a moat that may be hit by competitive forces in the future hits me harder more when I read what Warren Buffett wrote in his 2007 letter to shareholders (emphasis is mine)…
A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.
Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty.
A moat that must be continuously rebuilt will eventually be no moat at all.
Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.
But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.
Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it.
Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.
So it goes back to what I discussed on moats in the 30th June Special Report – when looking at moats that can really sustain, keeping aside the price, go with those where the businesses are simple, scalable, and largely secured against future disruption. And then look at the price, and avoid overpaying.
Overpaying or Paying Up for Moats? That’s the Question!
I will be lying if I can spell out a fool-proof process of valuing companies that show signs of future promise and sustainability of moats. Especially with emerging moats, it’s not only difficult but impossible to look through such business that have not had a long past track record and operate in a world that’s changing so fast.
But over a period of time, I have learned to trust the simplest models when it comes to approximately valuing such businesses, and then keep reviewing my assumptions from time to time, or in light of any new information.
One such model is reverse DCF, where instead of creating my own cash flow projections, I challenge Mr. Market to assess whether the cash flow growth it is assigning to the business, to justify the current price, is reasonable or not.
After all, this is what Graham taught through Security Analysis…
The essential point is that security analysis does not seek to determine exactly what the intrinsic value of a given security is. It needs only to establish either that the value is adequate—e.g., to protect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight.
Anyways, the second method is that of using exit multiples, as Prof. Sanjay Bakshi shared in an interaction with me in March this year.
Now, with most emerging moats or undercover businesses that show signs of great future promise, it’s important to keep reviewing your valuation assumptions from time to time, or you may end up selling a stock just after it multiplies your money 2-3x. Like I did with my purchase of Page Industries in 2009 after it multiplied 5x from my original purchase of around Rs 300.
The moat was really emerging then, but I stood with my static valuation model and had to pay a heavy price in terms of opportunity loss (the stock is now around Rs 14,500, or about 10x from the selling price).
While I have been lucky so far to not get involved in overpaying for a high-quality business, I try to always remember Graham’s warning –
In the field of common stocks, the necessity of taking price into account is more compelling, because the danger of paying the wrong price is almost as great as that of buying the wrong issue.
…the new-era theory of investment left price out of the reckoning, and that this omission was productive of most disastrous consequences.
Beware – Some Good Companies Go Bad
One of the most common business phenomena is also one of the most perplexing – when successful companies face big changes in their environment, they often fail to respond effectively.
Unable to defend themselves against competitors armed with new products, technologies, strategies, or just simpler business models, they watch their sales and profits erode, their best people leave, and their stock valuations tumble.
Some ultimately manage to recover – usually after painful rounds of downsizing and restructuring – but many don’t.
One of the biggest reasons good companies go bad and their moats shrink beyond repair is paralysis – inability to change with changing times. The problem is not an inability to take action but an inability to take appropriate action.
The fresh thinking that led to a company’s initial success is often replaced by a rigid devotion to the status quo.
This also holds true for investors. In the face of changing times and facts, we often show an inability to change our pre-existing and opinions (and especially when we have overpaid for stocks). So we also suffer from paralysis of sorts, which is one of the biggest killers of investment returns.
It’s thus important for us to, first avoid overpaying for moats – even the best of them, and then keep a close watch on whether the moat has to be continuously rebuilt – for that’s no moat at all.